The Great Real Estate Bust of 2008

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Project SyndicateWhat brought on the collapse of home prices in 2008 that is the root of the financial crisis now enveloping much of the world?

Home prices in the United States, as measured by the Standard & Poor’s/Case-Shiller Home Price Indices, have plummeted more than 40% in real inflation-adjusted terms in some major cities since the peak around the beginning of 2006. Nationally, including all cities, the fall is over 25%.

The futures market at the Chicago Mercantile Exchange is now predicting declines of around 15% more before the prices bottom out in 2010. These are the market’s forecasts – and it is not a very liquid market. But those who make these forecasts are implying real declines, from peak to trough, of more than 50% in some places.

Why are we seeing such big price drops? And why does the housing market in so many other countries now reflect similar conditions? The answer has both proximate and underlying causes.

The proximate answer for the US is that a decline in lending standards helped people buy houses at ever-increasing prices before 2006. Freer lending meant that people were freer to bid up prices of homes to ridiculous levels. Shacks were selling for a million dollars.

After the peak, lenders tightened their standards. When buyers find it difficult to finance home purchases, sellers have to cut the asking price.

The up and down of lending represents a credit cycle, and credit cycles have played a major role in economic fluctuations for centuries. In his 1873 book Lombard Street , Walter Bagehot, the British businessman and editor of The Economist , described these cycles perfectly. The boom just before the depression of the 1870’s that he described sounds a lot like what happened just before the current crisis. When credit expands, he wrote, “The certain result is a bound of national prosperity; the country leaps forward as if by magic. But only part of that prosperity has a solid reason…this prosperity is precarious.”

But the credit cycle was not the ultimate cause of the 1870’s depression or the crisis we are seeing today. Ultimately, one must always ask why lending standards were loosened and then tightened. The credit cycle is an amplification mechanism. The instability in the lending sector is always there, and the crisis manifests itself only if some precipitating factor triggers it.

Moreover, the extreme weakening and then tightening of credit standards seems particularly prominent only in the US, while the housing boom-bust cycle is prevalent throughout much of the world.

The precipitating factor that led to the current situation has to do with our evolving world culture, spread rapidly through enhanced media outlets and the Internet, and its perceptions of the markets.

It has to do with the deep admiration of markets that has developed during the boom, in line with the “efficient markets theory” in academic finance. It became widely believed that financial markets are such sublime poolers of information that they represent a collective judgment that transcends that of any mere mortal. James Surowiecki’s bestselling 2004 book, with the outrageous title The Wisdom of Crowds , pressed this idea forward at the very height of the real estate boom.

The boom in the world’s housing markets and stock markets between 2003 and 2006 was caused by this faulty idea, and the idea that investments in homes and equities are a sure route to wealth. It had become an article of faith that the value of both types of assets only goes up in the long run, and that it is foolish to try to “time the market.” It was sincerely believed, and supported by deep intuitive judgment, that interruptions in this upward trajectory could only be small and transient. People seemed to think that rapid appreciation in these markets had become a universal constant, like the speed of light.

Nothing else ultimately explains lenders’ immense willingness, in the boom up to 2006, to lower their credit standards on home mortgages, regulators’ willingness to let them do it, rating agencies’ willingness to rate mortgage securities highly, and investors’ willingness to gobble them up.

There is no theory in economics that provides a reason to think that prices in these markets can only go up. On the contrary, economic theorists have been puzzled by the historical rate of increase in the stock market, which they call “the equity premium puzzle.” They do not have a corresponding name for the behavior of the housing market, because, historically, its prices (correcting for inflation) have not generally gone up very much on average, until the post-2000 bubble.

The booms in these markets can be traced substantially to the growth of the idea that one should always continually hold as many of these assets as possible, just as that you should drink green tea or eat dark chocolate every day for antioxidants. Such ideas create artificial demand – but only for a while. After all, we no longer smoke cigarettes to prevent infections.

People will believe many things if they have the impression that the rich and famous believe them, too. But their belief can suddenly be disrupted if plainly visible events contradict it. That is what is happening now, and 2009 will shape up as a year of even more profound disenchantment.

Robert Shiller is professor of economics at Yale University, chief economist at MacroMarkets LLC and author of 'Subprime Solution: How The Global Financial Crisis Happened and What To Do About It'.

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