When it comes to housing, Yale University economist Robert J. Shiller is the man of the hour. Not only is the author of Irrational Exuberance among the most prominent believers that there's a U.S. housing bubble, but he recently helped launch a system that will let people speculate or hedge on housing prices in 10 metro areas. The Chicago Mercantile Exchange is about to begin trading futures and options based on Standard & Poor's-branded indexes that were invented by Shiller and several colleagues.
The metro areas covered by indexes are Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco and Washington, D.C. BusinessWeek Economics Editor Peter Coy had this e-mail exchange with Shiller:
What's the most important mental mistake that people make as buyers or sellers of homes?
At the present time, it is the mistake of thinking that homes will generally be a terrific investment. People typically think that home prices will go up at something like the return on the stock market. If home prices had done this for the last century then their real value today would be roughly a thousand-fold higher, while our real per-capita incomes are only about 6-fold higher. That is clearly not what happened -- it would mean that practically none of us could afford homes today. Quite the contrary, we are able to afford much bigger and better homes. Homes are a manufactured good, and in the long run construction keeps prices down.
What do you think is the strongest evidence that we're in a housing bubble?
Speculative booms and busts have been in the housing market from time immemorial; the only thing that is new now is the national -- and international -- character of this boom. The pattern of speculation should be well known to people who read history, though most people don't.
We see immense public excitement, scrambles to invest in homes amidst rising prices and rising construction activity. The excitement is sure to fade, just as supply comes on line. Of course, speculative booms have not always ended in busts. There have been soft landings as well as busts, and no one can be sure what will happen this time. That is why we need new markets that will help us by delivering market expectations for future dates.
You've written that consumption doesn't fall as much in a housing bust as it rises in an up market. Does that mean we don't have to worry about a big hit to the economy if a housing bubble bursts?
It is true that people will try to maintain their standard of consumption even if home prices fall. This time, however, they are starting out with a personal saving rate that has been very low -- negative in 2005. So, there may be bigger contractions in consumption this time. There is cause for some worry: Housing busts have been a leading indicator of recessions. Monetary policy has improved, though, and with [Fed Chairman] Ben Bernanke at the helm, maybe the economy won't take a big hit even if there is a housing bust.
Housing price indexes haven't caught on in the past. Why do you think they'll catch on this time?
When my colleagues Karl Case and Allan Weiss and I started our campaign for futures markets for housing in 1990, the science of real estate price indexes was in its infancy. Nobody trusted the median home price data that was in the news then because it was so noisy as to be obviously unreliable. Technical progress in index-number construction, as well as technical progress in markets and increasing financial sophistication all point to a day before long when home price risks will be actively traded.
Would instruments like these tend to stabilize the housing market, making bubbles less likely, or fuel speculation and make bubbles more likely?
I believe that creating liquid markets for home prices will have little effect on home prices at first, but eventually will tend to make home prices more efficient. That probably means that home prices will be more volatile from month to month. That is as it should be -- if information can be incorporated into market prices more quickly, prices will react faster.
But greater efficiency probably also means that home prices will be less volatile from year to year or decade to decade. The new futures and options markets will be creating an opportunity for people all over the world who are skeptical of local housing market booms to express their opinions early on by taking short positions -- something that is just not possible today. They will be a beneficial influence on the housing market.