NYT: Be Warned: Mr. Bubble's Worried Again

NY Times

Be Warned: Mr. Bubble's Worried Again

By DAVID LEONHARDT
Published: August 21, 2005

ABBY JOSEPH COHEN, the Goldman Sachs strategist then making a name for
herself as Wall Street's optimist in chief, sat directly to Alan
Greenspan's right. One chair away was Robert J. Shiller, a largely
unknown Yale economist.

As they ate lunch in a stately dining room at the Federal Reserve that
day in December 1996, Mr. Shiller argued that the stock market had
risen to irrational levels. In a soft, Midwestern-tinged voice, he
asked Mr. Greenspan, the Fed chairman, when the last time was that
somebody in his job had warned the public that the stock market had
become a bubble.

Mr. Greenspan listened without giving his opinion, and Mr. Shiller went
home assuming that he had been farther away from Mr. Greenspan than Ms.
Cohen in more ways than one. Three days later, however, driving his son
to school in the family Volvo, Mr. Shiller heard on the radio that
stocks were plunging because Mr. Greenspan had asked in a speech
whether "irrational exuberance" was infecting the markets.

"I may have just started a worldwide stock-market crash," the professor
told his wife, Virginia, who accused him of delusions of grandeur.

Today, nine years after his lunch with Mr. Greenspan and five years
after the markets finally did crash, Mr. Shiller is sounding the same
warning for real estate that he did for stocks. In speeches, in
television and radio interviews and in a second edition of his
prophetic 2000 book, "Irrational Exuberance," he is arguing that the
housing craze is another bubble destined to end badly, just as every
other real-estate boom on record has.

These, in short, are his second 15 minutes of gloom. He predicts that
prices could fall 40 percent in inflation-adjusted terms over the next
generation and that the end of the bubble will probably cause a
recession at some point.

Despite being a boyish-looking 59-year-old academic economist with a
halting speaking manner, he has become the bugaboo of the
multibillion-dollar real-estate industry. Its executives, like many
Wall Street economists, say that low interest rates and a growing
population will keep house prices rising, even if future increases are
smaller than recent ones. On Monday, the National Association of
Realtors reported that the median home price climbed to $208,500 in the
second quarter, up 14 percent from a year earlier.

"Shiller is predicting the mountain goes into the sea," Robert I. Toll,
the chief executive of Toll Brothers, a home builder, said in a recent
interview, without having been asked about the economist. "He's selling
himself."

To Mr. Shiller, though, it is a question of history, not salesmanship.
Most people have never looked at decades and decades of home prices,
because such data have been almost impossible to find. Stock-market
charts often go back almost a century. Housing charts typically start
sometime in the distant decade of the 1970's.

But Mr. Shiller has unearthed some rare historical housing data for
other countries. Using old classified advertisements, he was then able
to fashion a chart for the United States that goes back to the 19th
century.

It all points to an unavoidable truth, he says. Every housing boom of
the last few centuries has been followed by decades in which home
values fell relative to inflation. Over the long term, the portion of
income that families spend on their shelter stays about the same.

Builders become more efficient, as they are doing today. Places that
were once sleepy hinterlands, like the counties south of San Francisco
or a patch of desert in southern Nevada, turn into bustling centers
that take pressure off prices elsewhere. Even now, the United States
remains a mostly empty nation.

"This is the biggest boom we've ever had," said Mr. Shiller, who bought
into the boom himself in 2002, with a vacation home near one of
Connecticut's Thimble Islands. "So a very plausible scenario is that
home-price increases continue for a couple more years, and then we
might have a recession and they continue down into negative territory
and languish for a decade.

"It doesn't even attract that much attention," he continued. "There
will be many people thinking it was a soft landing even though prices
may have gone down in real terms by 40 percent."

MR. SHILLER begins his story 400 years ago, in the country that helped
invent the idea of a bubble. In 1585, workers in Amsterdam began to dig
a canal through the city. It became known as the Herengracht, or
gentlemen's canal, for the fashionable row houses that soon sprang up
on its banks. Merchants moved into many of them, and the canal remains
one of the city's finest addresses today.

In recent years, a Dutch economist named Piet M. A. Eichholtz heard
about a book from the 1970's that traced the Herengracht's history,
including records of every sale. But his efforts to track down a copy
failed - until he was browsing through a secondhand bookstore in
Amsterdam almost a decade ago, not long after Mr. Shiller's lunch with
Mr. Greenspan, and stumbled across one.

It had all the details Mr. Eichholtz wanted.

To translate the sales into an index of prices over the years, Mr.
Eichholtz turned to a method invented by Mr. Shiller and a colleague.
The United States government uses the same process for its best-known
measure of house prices, which is published every quarter by the Office
of Federal Housing Enterprise Oversight, the chief regulator of Fannie
Mae and Freddie Mac.

The beauty of the method is that it does a better job of capturing the
experience of homeowners than a simple average of house prices does.
That average can rise when a bunch of new McMansions get built, even if
existing houses have become no more valuable. The Shiller index, by
following the same set of houses over many years, tracks the actual
financial return that houses produce for their owners.

On the Herengracht, those returns have often been fantastic for 25 or
even 50 years at a time. Home prices soared in the first half of the
17th century, around the time of the tulip mania. But they came
crashing down in the 1670's, when the prime minister was killed, and
partially eaten, by a mob of angry Dutch, and the country nearly
disintegrated. Prices lagged inflation during the Napoleonic wars but
surged after William became king in 1814 and the country
industrialized.

Again and again, the cycle repeats itself. But there is essentially no
long-term trend, beyond a general rise in house prices that roughly
matches gains in peoples' incomes. As Amsterdam became a global city
and its population exploded, demand for homes increased - but so, too,
did supply.

PRICES have hardly become more stable over the last 400 years; in fact,
they've jumped up and down more in the 20th century than they did
during the 18th and 19th. Only the 17th century, that time of
cannibalized prime ministers, was more volatile.

"A whole lot of the price increases you see in houses is imaginary,
because it's just inflation," said Mr. Eichholtz, a professor at
Maastricht University. "People say, 'I have a house. It protects me
against the economic imbalances or misfortunes of the country.' The big
lesson is that real estate does not give you the protection that people
think it does."

A history of Norwegian house prices that Mr. Shiller has found shows
the same pattern. As does his index of American house prices, until the
blastoff of the last decade. In chart form, it looks eerily similar to
the stock chart from his 2000 book.

But this is actually a happy story in many ways. Over the long course
of history, families have not been forced to devote an ever-larger
chunk of their money to the roof over their heads. They instead can
afford better health care, new technologies and - as Mr. Shiller
pointed out during lunch this month at a steakhouse in midtown
Manhattan - leisurely restaurant meals.

Still, history is easy to forget during times like these. Mr. Shiller
says that a steady shift toward freer markets around the world has
caused people to think much more about the importance of what they own.
The best description, he said, comes from President Bush, who often
talks of "an ownership society." (Mr. Shiller has tried, without
success, to find out who in the White House had coined the phrase.)

When his undergraduates were reading through old newspapers, they found
that stories about house prices were once confined to the back pages of
business sections. Today, real estate often seems to be topic A in the
national conversation.

Many people have made huge profits from selling homes, and many more
have paper profits. When people get together with friends, they want to
find a subject that makes others happy, Mr. Shiller says, and real
estate fits the bill, just as stocks did in the 1990's.

"It's very much like studying a disease epidemic. It's a contagion,"
Mr. Shiller said. "When it goes in an up direction, it's very
impressive. But it can also work in the down direction."

This psychological approach has been at the core of his work for years.
In the 1970's, when his wife was studying psychology, he would soak up
the discussions that she and her fellow graduate students had over
dinner at the Shillers' house in Delaware. A decade ago, his beliefs
about herd behavior led him to his lunchtime conversation with Mr.
Greenspan.

Mr. Shiller takes no credit for the phrase "irrational exuberance." He
does not remember using it during the conversation. He recently
searched through his daily diary, which he keeps on a computer, from
the early 1990's and found only one phrase that was at all similar. In
1991, he used "overexuberant" to describe an exercise that had left him
feeling sore.

His good friend, Jeremy J. Siegel, an economist at the University of
Pennsylvania, stumbled upon a 1959 quotation from Fortune magazine in
which Mr. Greenspan discussed "over-exuberance" in the financial
community. The phrase is probably his. He may even have to dust it off
again soon. He recently called some local markets "frothy" but
emphasized that there was no national bubble.

Even so, Mr. Shiller has little company for his radical notion that
house prices could fall by 40 percent. Many economists say that
interest rates are low enough and demand for housing in big urban areas
is high enough to keep from prices from falling very far. Mr. Shiller
himself confesses to some doubt.

"I don't have any certainty," he said. "I have a lot of humility" about
any prediction.

"We do have a shortage of land in the prestige areas, and so there is a
potential for them to go up," he added. "But I just know that the trend
over the last century has been for new prestige areas to appear."

If he is right, the Herengracht also looks due for one of its
occasional corrections. Prices there have doubled, even accounting for
inflation, over the last decade or so. It almost seems like they might
never fall again.