HOW DID THIS HAPPEN?
How 'Animal Spirits' Wrecked the Housing Market
By GEORGE A. AKERLOF and ROBERT J. SHILLER
Real-estate markets are almost as volatile as stock markets. Prices of agricultural land, of commercial real estate, and of homes and condominiums have gone through a series of huge bubbles, as if people never learned from the previous ones.
Such events in particular the recent housing bubble are driven by what John Maynard Keynes called animal spirits, a naοve optimism at the intersection of overconfidence, corruption, storytelling, and money illusion (another Keynesian term, for views warped by currency's nominal value instead of its purchasing value).
For some reason, in the late 1990s and early 2000s, the idea that homes and apartments were spectacular investments gained a stronghold in the public imagination in the United States, and in many other countries as well. Not only did prices go up, but there was palpable excitement about real-estate investments.
It was the biggest home-price boom in U.S. history. It extended over nearly a decade, beginning in the late 1990s. Prices nearly doubled before the bust began, in 2006. While it lasted, this spectacular boom, mirrored in other countries, too, helped drive the entire world economy and its stock markets. In its wake, it has left the biggest real-estate crisis since the 1930s the so-called subprime crisis as well as a global financial crisis whose full dimensions have yet to be grasped.
What caused such a boom-and-bust event? What really drove people's thinking?
A good place to start is How a Second Home Can Be Your Best Investment, by Tom Kelly (a radio-show host) and John Tuccillo (former chief economist of the National Association of Realtors). It was published in 2004, when home prices were rising the fastest. The book explained:
"Look at it this way: If you think a house is good enough to live in, someone else will too, and they'll pay you for the privilege. The ownership of a real-estate investment, particularly property that you can personally enjoy a vacation home, your retirement residence is the most profitable investment within the reach of the average American."
Despite those assertions, the book is singularly devoid of arguments as to why real estate is the best investment. Kelly and Tuccillo pointed out that real-estate investments are typically leveraged investments. But that is not an argument for high returns; leveraged investments can turn spectacularly bad if prices go down, as homeowners have recently discovered. The possibility of a national home-price decline was not even mentioned.
That kind of thinking is, of course, characteristic of speculative bubbles. In lieu of rational argument, the book was filled with stories. For example, Ken and Nedda Hamilton had lived in Pennsylvania all their lives. They had dreamed about a home in Florida for years, but they took action only after their grown son Fred laid out a case for such an investment and offered to be a co-investor. A real-estate agent allowed them to spend nights in each of several homes near Naples, Fla. They got hooked on one, bought it, and were very happy. A sequence of stories like that one allows the reader to choose the story that is most congenial to him and that best serves as a model for his own behavior.
But even if the authors felt no need to explain why homes were the best investment, why were investors so convinced of that even before they read the book?
It appears that people had acquired a strong intuitive feeling that home prices everywhere can only go up. They seemed really sure of this, so much so that they were ready to dismiss any economist who said otherwise. If pressed for an explanation, they typically said that, because there is only so much land, population pressures and economic growth should inevitably push real-estate prices strongly upward. Those arguments are demonstrably false. Home prices have fallen before. For instance, land prices fell 68 percent in real terms in major Japanese cities from 1991 to 2006. But investors didn't want to hear that sort of talk.
The impression that homes are spectacular investments probably stemmed, in part, from money illusion. People tend to remember the purchase price of their home, even if it was 50 years ago. But they do not compare it with other prices from the same era. One hears statements like "I paid $12,000 for this house when I came home from World War II." That suggests enormous returns on the purchase of the house partly because it fails to factor in the tenfold increase in consumer prices since then. The real value of the home may have only doubled over that interval, which would mean an annual appreciation of only about 1.5 percent a year.
So there is no rational reason to expect real estate to be a generally good investment. It is so only at certain times and in certain places. But the myth can be amplified by a number of factors, and in this most recent boom, it was.
Two feedback cycles that bloated stock prices also bloated realestate prices: Increases in home-selling prices fueled buying prices, and vice versa, in a loop; similarly, increased home prices swelled GDP estimates, which, in turn, appeared to validate the higher home prices. That is, if everyone is ostensibly more productive and richer, then it's seemingly more likely that they'll be able to afford ever more expensive homes. As home prices rose faster and faster, they reinforced the folk wisdom about increasing value and imbued that folk wisdom with a sense of spectacular opportunity. And the 1990s bubble in the stock market apparently set the psychological stage for such contagion by creating in people a view of themselves as smart investors.
People had learned the vocabulary and habits of investors, they had increasingly begun subscribing to investment periodicals, and they watched television shows about investing. When the stock market soured, many people thought that they had to transfer their investments into another sector. Real estate looked appealing. The accounting scandals accompanying the stock-market correction after 2002 caused many to mistrust Wall Street. But homes, especially their own, were something tangible that they could understand, see, and touch.
As the boom progressed after 2000, the way in which we thought about housing changed. Newspaper articles about houses as investments proliferated. Even our language changed. New phrases like "flip that house" or "property ladder" became popular. (Those two were even used as the titles of popular television shows.) The old phrase "safe as houses" acquired a new currency. The phrase actually dates back to the 19th century, when it seems ships were compared to houses. A sailor might try to reassure a terrified passenger during a violent storm: "Don't worry, these ships are as safe as houses." But in the 21st century the term moved into the investment context, with the meaning "Don't worry, these investments are as safe as investments in houses." And the boom seemed to connect this phrase with the further thought "and so a highly leveraged investment in houses is a sure winner."
Why was the home-price boom after 2000 so much bigger than any other before it? Partly because of the evolution of economic institutions related to housing.
Institutions changed because of the belief that the opportunities to take part in the housing boom were not being shared fairly among all elements of the population. Martin Luther King III, the son of the great civil-rights leader, lamented in a 1999 editorial titled "Minority Housing Gap; Fannie Mae, Freddie Mac Fall Short" that minorities were being left out of the boom. He wrote, "Nearly 90 percent of all Americans, according to surveys by HUD, believe that owning a home is better than renting one." Like everyone else, minorities deserved this opportunity for wealth.
The allegation of unfairness led to an almost immediate, and uncritical, government reaction. Andrew M. Cuomo, secretary of the Department of Housing and Urban Development, responded by aggressively increasing the mandated lending by Fannie Mae and Freddie Mac to underserved communities, even if that meant lowering credit standards and relaxing the requirements for documentation from borrowers. He wanted results. The possibility of a future decline in home prices was not his concern. He was a political appointee. His charge was to secure economic justice for minorities, not to opine on the future of home prices.
There was never any serious examination of the premise that this policy was in the best interest of minorities. In the overheated atmosphere, it was easy for mortgage lenders to justify loosening their own lending standards. A number of those new mortgage institutions became corrupt at the core. Some mortgage originators were willing to lend to anyone, without regard to their suitability for the loan. Corruption of that sort tends to flourish at times when people have high expectations for the future.
Or maybe corruption is too strong a word. Is making a loan that you suspect will eventually default corrupt? After all, you didn't force the mortgagor to take out the loan. You didn't force the investor to whom you were selling the securitized mortgages to buy the investment. And who really knows the future anyway? There was money to be made giving all these people what they thought they wanted. No regulator was telling you not to do it. As we have already seen, there was an economic equilibrium that linked the purchasers of snake-oil houses with the purchasers of the snake-oil mortgages that financed them.
For evidence of the effect of subprime lenders on the housing boom of the 2000s, consider that low-price homes appreciated faster than high-price homes. And then after 2006, when prices fell, the prices of low-price homes fell faster.
Residential investment (mostly construction of new homes and apartment buildings, as well as improvements in existing homes) rose from 4.2 percent of U.S. GDP in the third quarter of 1997 to 6.3 percent in the fourth quarter of 2005, then fell to 3.1 percent by the fourth quarter of 2008, making it a significant factor in the recent U.S. boom and bust.
The housing market touched on all aspects of the animal spirits identified by Keynes confidence, fairness, corruption, storytelling, and money illusion. It's clear, in this market and many others, that those animal spirits help drive the economy and that, to steer it safely, economists and policy makers will have to study such behaviors further and take careful account of them in devising new incentives and reforms.
George A. Akerlof is a professor of economics at the University of California at Berkeley and winner of the 2001 Nobel Memorial Prize in Economic Science. Robert J. Shiller is a professor of economics at Yale University and author of the Princeton University Press books Irrational Exuberance (2000) and The Subprime Solution (2008). This essay is adapted from their new book, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Princeton University Press, 2009).