Robert Shiller on Bubble Thinking

Yale economist Robert Shiller, author of Irrational Exuberance, writes about the causes of the housing bubble in The Atlantic:

Many culprits have been fingered for the housing crisis we’re in today: unscrupulous mortgage lenders, dishonest borrowers, underregulated financial institutions. And all of them played a role. But too little attention has been paid to the most fundamental cause, the same one that was at the root of the many booms and busts that Sakolski chronicled years ago: the contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they’re going to keep forming. And unless we apply that understanding to the bubble we’re trying to recover from, we risk calamity....

Speculative bubbles are fueled by the social contagion of boom thinking, encouraged by rising prices. Sooner or later, some factor boosts the transmission rate high enough above the removal rate for an optimistic view of the market to become widespread. Arguments that this boom is unlike past bubbles—I call them “new era” stories—become more prominent and seemingly credible. In the recent housing boom, such optimism was much in evidence. A survey that Karl Case and I conducted in 2005, for instance, found that on average, San Francisco home buyers expected housing prices to increase by 14 percent a year over the next 10 years. About a quarter of the respondents reported truly extravagant expectations—occasionally more than 50 percent a year....

Few people seem immune to boom thinking. The recent bubble grew so large partly because the very people responsible for the financial system’s oversight came to share the general public’s rosy expectations. They may not have believed as fervently in the boom, but they still accepted the idea that it would not end badly. Builders kept building, and ratings agencies did not temper their sunny assessments of mortgage securities until after the crisis had begun. In October 2006, Frank Nothaft, the chief economist at Freddie Mac, a major securitizer of home mortgages, told me that Freddie Mac had financially modeled the impact of a price decline of up to 13.4 percent. When I asked him about the possibility of a bigger drop, he replied that such a drop had never happened (at least not since the Great Depression)—and he seemed unable to imagine that it could.

There's a name for this collectivist thinking—Social Proof.

Shiller provides a rational view of the housing bubble:

Since the 2006 peak, housing prices, adjusted for inflation, have fallen nearly 15 percent. Where they’ll go from here is uncertain; we are in uncharted territory. Between 1997 and 2006, real home prices in the United States rose 85 percent; this run-up was historically unprecedented. There was no rational basis for it: fundamental indicators such as the ratio of home prices to building costs, or to rents, or to personal income, also soared, suggesting unsustainable price levels. (The idea that the country is running out of residential space is no more true now than it was during the manias of the 18th and 19th centuries.)

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