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The Perils of Predicting Financial Bubbles

The New York Times
July 25, 2004

HOUSING prices will plunge. Now. This is the conclusion of a growing troupe of economists, who warn that the surge in home prices over the past few years is pumping up a housing bubble that is doomed to implode, prompting a dramatic decline that could cost the economy trillions of dollars in lost wealth.

"The end result will be a loss of $2 to $3 trillion in housing wealth, and a downturn that is even worse than the fallout from the stock market crash," wrote Dean Baker, co-director of the liberal Center for Economic Policy Research.

But maybe not.

Even as the housing market has set more warning bells a-clang, some bubble-skeptic economists dismiss the idea that housing prices are due for a pop. Sure, home prices are high, they say. They might decline somewhat to adjust to rising interest rates. But nothing justifies an uncontrolled plunge.

The argument is likely to continue - regardless of what actually happens to the price of homes - because the argument doesn't really have much to do with housing prices. It is about fundamentally different views of how markets operate.

Housing prices have indeed soared. Stoked by some of the lowest interest rates in history, home prices in Los Angeles rose 18 percent in the last year. In Miami, they jumped 14 percent. But do these amount to bubbles?

Robert Shiller, the famed Yale economist and bubble-ologist who predicted the end of the dot-com stock boom in his book "Irrational Exuberance," argues that they do. He explains that bubbles are created when the prices of assets are fueled by psychological rather than economic considerations.

From apartments in New York to tulips in 17th-century Holland, a bubble is born when people lose sight of the fundamental value of an asset and are willing to pay whatever it takes because they see that prices have risen like crazy and assume they will continue to do so.

"People get excited about price increases and start behaving differently," Mr. Shiller says.

After all, he says, bubbles always pop. Like a Ponzi scheme, a bubble will survive only as long as the herd believes in ever-rising prices. If something pricks this faith, if no next buyer is willing to pay more, the herd will run and the bubble will deflate catastrophically.

Take the stock market. From 1996 and to 1999 the price of tech stocks in the Standard & Poor's index rose nearly sevenfold, goaded by dot-com enthusiasts who claimed that a new economy with much improved qualities justified prices previously believed to be impossible.

Then the herd turned around. By mid-2001, tech stocks had fallen back by 70 percent.

But despite these dramatic upheavals, not everybody is convinced that bubbles even exist. Peter Garber, a global strategist at Deutsche Bank, believes that psychological explanations like herd behavior are a deus ex machina invoked by economists who do not properly understand the economic underpinnings of the market.

Mr. Garber argues that from the Dutch tulip craze to the stock market boom of a few years ago, soaring prices have been justified by economic fundamentals - be it the earning potential of rare tulips or stocks.

Some of the arguments backing the tech boom ultimately proved to be flawed, he acknowledges, but the analysis holding stock prices up - that productivity had reached a new level and companies would be able to capture this in higher profits - was reasonable. When stock prices fell, it was because of changes in this underlying business landscape.

Another bubble-skeptic is Kevin Hassett, director of economic policy studies at the American Enterprise Institute and co-author of the fabled "Dow 36,000," which was published in 1999 when the Dow Jones index was around 11,000. Mr. Hassett says there is an ideological component to the belief in bubbles. Liberals, who tend to believe that government must step in to protect people from market imperfections, will likely see more of them. Conservatives, who like their markets unfettered, will see less.

In any case, it's difficult to predict when bubbles may burst. The Fed chairman, Alan Greenspan, was three years early when he said stocks were irrationally exuberant in 1996. According to Laurence H. Meyer, a governor at the Fed during the rise and pop of the dot-com bubble, Mr. Greenspan gleaned from the experience an undisputable rule to spot asset price effervescence: if stock prices come crashing down by 40 percent or more, it means there was indeed a bubble, and it just burst.

"You don't know until its over," Mr. Meyer says. "Or at least until it's too late to intervene and avoid it."

Mr. Hassett of the conservative American Enterprise Institute thinks housing prices will be pretty much O.K. He acknowledges there might be some bubble dynamics at play in some regions. But he argues that for the most part people are paying more for homes because their incomes are higher and interest rates are lower, reducing the cost to own a home.

Mr. Hassett expects that rising interest rates would raise this cost and home prices would then decline proportionately. But he sees no reason to expect a catastrophic decline. "I don't think a catastrophe is very likely," he says.

But Mr. Baker argues that house prices have been running faster than inflation since 1995 - the first time they have done so since World War II. Meanwhile, rental prices are falling in real terms, indicating that demand for housing is weak. And builders are rushing to add new units - threatening to glut the market.

Mr. Baker thinks that Mr. Greenspan has been too supportive of the boom in housing prices, and could have made the case that housing prices were starting to behave irrationally.

Mr. Baker is so convinced that the bubble will burst that two months ago he sold his condo in Washington.

"I would be a fool to hang onto a place through the collapse of a bubble," he says.



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