US house prices: you thought we had a problem?
Reading my US professional body’s reports of conference proceedings I was struck by a piece from Robert Schiller, author of the book ‘Irrational Exuberance’ about the stockmarket bubble at the end of the 90’s. Speaking at a presentation in New York in February, he contrasted the bubble correction in stocks with the new irrational exuberance in the US housing market.
Prof Schiller doesn’t use the term bubble lightly. He is always hungry for a long historical context of relevant data. Not finding it for house prices, he created an index, going back to 1890. It appears comparable in principle with the Nationwide index for UK prices since 1957 that I frequently refer to.
Both indices have jumped by about 50% in real terms since 1997. But there is a striking difference. There was no steady real growth trend in the US to compare with the 2% trend in the UK and no big cycles like we experienced. Was the anomaly the flat real price between 1945 and 1997 or the dramatic rise since? Schiller opts for the latter, pointing to easier access to land that suppressed real growth before, easier access to credit that sparked the boom and wildly unrealistic expectations that then fed it.
Robert Schiller’s index is clearly a serious piece of research, as it is used as the basis of derivative contracts. I reproduce it below. The index is in real terms, adjusted for general inflation, as is the index in my article earlier this month. The comparisons he offers are with deflated (ie relative) building costs, population and real long term interest rates.
It is clearly tricky to fit a trend either to the whole period, since there are distinctly different phases, or the last 50 years (that corresponds to the Nationwide UK index). Schiller’s view is that there has been essentially no growth trend.
Schiller answers as follows his own question: ‘Why haven’t home prices gone up? The price of a house relates most to its structure. And houses are getting cheaper to build, not more expensive, because of technical progress… Land has been getting more expensive, but if a person wants a house and does not care where it is, land can cost almost nothing. The population spreads out into formerly rural areas, taking the pressure of prices in city centres.’
Does this explain the flatness of real prices between 1945 and 1997? Maybe. It does seem realistic that land scarcity might explain a difference in profile of real property values between the two countries.
Turning to the recent period, Schiller warns that credit has fuelled this boom. ‘We have seen a deterioration in lending standards and a proliferation of adjustable-rate mortgages (ARMs) and option ARMs. People with very small downpayments are buying houses, and too many of them are considered lower income or have poor credit histories.’ Sounds familiar, but evidently it is not a regular feature of American business cycles.
Anecdotally, I hear that a reason for prices weakening recently is that many homeowners were cushioned from the early stage of rising interest rates by short-period fixes, which are now maturing – also a new feature of the US market.
His argument that the house price rise is psychological rather than fundamental is supported by surveys of expectations about future house price growth. The respondents don’t look at long-term real price charts like I show and Professor Schiller shows. They have unrealistic views about past growth, confused by inflation, let alone future growth. Respondents in Los Angles, for instance, thought in 1988 that prices over 10 years would rise by 14% pa (taking the mean expectation) and by 2005 that had jumped to 23%. Price inflation in the meantime has fallen, not risen, so the implied change in expected real prices is probably even greater.
The confusion caused by money illusion I recognise as common to both countries. But the difference in land price inflation might lead us to be more surprised that such a change in psychology took hold in the US.
I believe credit is the proximate cause of the boom in both countries. Ignorance of home economics, sadly, is the necesary condition. The education is surely coming.
If there is a moral, here, it is to use everybody’s experience of history – it can be expensive to limit your education to your own brief and narrow history. That’s what this site is here for.