Are We There Yet?

"I am worried that the collapse of home prices might turn out to be the most severe since the Great Depression." -- Robert J. Shiller, September 2007

Speculative bubbles are ultimately a matter of psychology. People develop extravagant expectations about the wealth their investments will bring them, forgetting the valuable lessons of financial crises long past, and a dangerous bubble builds.

But the psychology of the ride down can be just as perilous. As asset prices now decline, markets might overshoot. Some indicators show that we are already approaching pre-bubble price levels. The price-to-earnings ratio in the U.S. stock market is about at its long-run average. Housing prices are probably more than halfway back down to their late-1990s level, when the bubble began. In some U.S. cities, they are almost completely back down.

No one can say, though, when exactly the market will bottom out. In some sense, the process is a self-fulfilling prophecy. The euphoria ends, and negative expectations lead to plunging asset prices, which in turn seem to justify those expectations. Given the poor outlook on the economy for the next year, housing prices might continue to decline well into 2010, as the futures markets in Chicago suggest.

History tells us there is some precedent for a protracted, weak housing market. After the last housing boom in the United States peaked in 1989, it took a typical city five years to hit bottom. This time, prices have only been going down for two years. We might look with caution to Japan, where urban land prices fell for 15 consecutive years, from 1991 to 2006.

When the market does reach bottom, it may be with a whimper, not a thud. Generally, there are no sharp turning points. Home prices might remain flat for a few years before they start rising again. Along the way, it will be hard to identify the road markers with any certainty until we have spotted them in the rearview mirror.

So far, the measures we’ve taken to resolve this crisis have thrown the rational principles of finance out the window. We are going on a crash diet — contradicting mortgage contracts on an ad hoc basis and giving away handfuls of money — when we should be coming up with an eating regime we can live on indefinitely. Instead of making whatever short-term patches seem necessary, we might take a more systemic, market-based approach, such as stipulating that mortgage values always be linked to housing prices and adjusted each month.

Speculative excesses are an endemic problem of the market system, but capitalism also provides its own self-correcting mechanisms. There’s no reason to abandon those tools now.

Robert J. Shiller is a professor of economics at Yale University, winner of the 2013 Nobel Memorial Prize in economics, and the author of Narrative Economics: How Stories Go Viral and Drive Major Economic Events. Twitter: @RobertJShiller

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