August 11, 2022

Economic View: The Sickness Beneath the Slump

News accounts of the economic crisis rarely put it in these terms. They tend to focus on distinct short-term developments or on the roles of prominent people like Federal Reserve governors, members of Congress or Wall Street financiers. These stories grab attention and may be supported by some of the economic statistics that the government and private institutions collect.

But the economic situation is primarily driven by hard-to-quantify sociological factors that play out over many years.

The uptick in the unemployment rate, to 9.1 percent from 8.8 percent two months earlier and the drop in stock prices over the last month have attracted notice, yet in a sense they are symptoms of a deeper economic sickness.

Real estate prices have been a significant indicator of this ailment. An unprecedented bubble in American home prices started in 1997 and ended five years ago. Home prices rose 131 percent in that time, or 85 percent in real inflation-corrected terms, according to the S. P./Case-Shiller National Home Price index. (I helped to develop that index, along with Karl Case of Wellesley College.)

Around the same time, there were bubbles in the nation’s commercial real estate and farmland. And there were real estate bubbles in many other countries, too.

Consider this: Home prices rose nearly 10 percent a year on average in the United States from 1997 to 2006, long enough for many people to become accustomed to the pace and to view it as normal. The conventional 30-year fixed mortgage rate averaged 6.8 percent over those years, far below the appreciation rate on housing, so even if you had a substantial mortgage, you were becoming wealthier by the day, at least on paper. People who owned a home over that period had reason to feel pretty well off and proud of their investment acumen. That fed a contagion of optimism and helped to drive the speculative bubble, propelling the economy and the stock market in a feedback loop that repeated year after year.

Professor Case and I have conducted annual spring surveys of home-buyer attitudes for many years. We ask about long-term expectations: “On average over the next 10 years how much do you expect the value of your property to change each year?”

The survey we conducted in spring 2005, near the end of the bubble, included 407 home buyers. In it, the median expectation for home price appreciation over the next decade — until 2015 — was 7 percent a year. That is substantially less than the 10 percent a year that Americans had recently experienced.

But expected increases of 7 percent a year still implied another doubling of home prices by 2015. And about a quarter of our respondents in 2005 anticipated increases of at least 15 percent a year for the next decade. Something was very wrong with this picture, but few noticed it.

As it turned out, of course, those expected increases didn’t happen. Instead, home prices tumbled 34 percent nationally from the peak in the first quarter of 2006 to the first quarter of 2011 — or 40 percent in real terms — and they still appear to be falling. The brief “recovery” in home prices of 2009 and 2010 was most likely spurred by federal housing stimulus measures like the home buyer tax credit. After that stimulus ended, prices resumed their downward trend.

During the bubble, the sense of rising wealth and high expectations gave people a good reason to spend and a greater willingness to plunge into investment, too. Government policy makers breathed in the same optimism, which no doubt encouraged them to be lax on regulatory restraint.

The mood is far different now. Our latest survey, covering April and May of this year, included 296 home buyers, and their median expectation for annual home price appreciation over the next decade was down sharply, to just 3 percent. And, in comparison with the 2005 results, few people had extravagant expectations.

The 3 percent figure is well below prevailing rates for 30-year mortgages, now hovering between 4.5 and 5 percent. Amid such low expectations, buying a home with a mortgage certainly isn’t being viewed as a way to get rich.

Even for people who have other reasons to buy a house, there may be little urgency to do so. Our 2011 survey found that the median expectation for home price appreciation next year is just 1 percent. So it won’t be surprising if new home sales remain abysmally low and few jobs are created in the hard-hit construction industry. And it shouldn’t be a shock if the personal savings rate stays at around 5 percent, as it has recently, up from around 1 percent in 2005. This would mean that consumer spending will not drive a strong recovery.

A half-century ago, there was a lively discussion among economists about the dynamics of price expectations. For example, Alain C. Enthoven, then of the Massachusetts Institute of Technology, and Kenneth J. Arrow of Stanford wrote in 1956 that expectations that extrapolate past price increases can produce economic instability. But that thinking was largely cast aside in the 1960s, when my profession embraced the theory that efficient markets formed by people holding rational expectations could explain virtually all economic activity.

As a result, economists in recent decades have not developed expectations theory much further. That needs to be corrected in coming years. In the meantime, this failing helps explain why the current crisis was generally unpredicted, and why its future course is so poorly understood.

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets.

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