Infectious Exuberance

Financial bubbles are like epidemics— and we should treat them both the same way.
subprime real estate
(Photo credit: Tannen Maury/EPA/Corbis)

America, from its inception, was a speculation,” begins the historian Aaron M. Sakolski’s 1932 classic, The Great American Land Bubble. George Washington himself was a land speculator, Sakolski notes, and by Washington’s time it was widely perceived that America would eventually be populated much more densely by vast numbers of immigrants, leading many investors to dream of rapidly rising land prices. Waves of speculative mania swept towns, cities, and regions from the 18th century onward, even along the vast and empty frontier. Up, up went the prices. And then, inevitably, down.

Sakolski was seeking to make sense of the biggest national housing bust in American history—at least so far. It began in 1926 and spread to the stock market in 1929, triggering a severe banking crisis that in turn affected almost all types of businesses. Home prices fell a total of 30 percent from 1925 to 1933, and the unemployment rate reached 25 percent at the depth of the Great Depression.

Many culprits have been fingered for the housing crisis we’re in today: unscrupulous mortgage lenders, dishonest borrowers, underregulated financial institutions. And all of them played a role. But too little attention has been paid to the most fundamental cause, the same one that was at the root of the many booms and busts that Sakolski chronicled years ago: the contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they’re going to keep forming. And unless we apply that understanding to the bubble we’re trying to recover from, we risk calamity.

Bubbles are a lot like epidemics. Every disease has a transmission rate (the rate at which it spreads from person to person) and a removal rate (the rate at which those individuals recover from or succumb to the illness and so are no longer contagious). If the transmission rate exceeds the removal rate by a certain amount, an epidemic begins.

From the archives:

Dow 36,000 (September 1999)
Has the long-running bull market been a contemporary version of tulipmania? In explaining their new theory of stock valuation, the authors argue that in fact stock prices are much too low and are destined to rise dramatically in the coming years. By James K. Glassman and Kevin A. Hassett

Speculative bubbles are fueled by the social contagion of boom thinking, encouraged by rising prices. Sooner or later, some factor boosts the transmission rate high enough above the removal rate for an optimistic view of the market to become widespread. Arguments that this boom is unlike past bubbles—I call them “new era” stories—become more prominent and seemingly credible. In the recent housing boom, such optimism was much in evidence. A survey that Karl Case and I conducted in 2005, for instance, found that on average, San Francisco home buyers expected housing prices to increase by 14 percent a year over the next 10 years. About a quarter of the respondents reported truly extravagant expectations—occasionally more than 50 percent a year.

In this sort of environment, skeptics have a hard time of it. No one has perfect information, and people—quite rationally—infer a great deal from the actions of others. As a bubble expands, some skeptics begin to disregard their own judgment because they feel that everyone else simply couldn’t be wrong. Contrarian voices become softer, which only makes it harder for the remaining skeptics to justify their views. Over time, the quality of information that can be gleaned from the behavior of others becomes worse and worse.

Few people seem immune to boom thinking. The recent bubble grew so large partly because the very people responsible for the financial system’s oversight came to share the general public’s rosy expectations. They may not have believed as fervently in the boom, but they still accepted the idea that it would not end badly. Builders kept building, and ratings agencies did not temper their sunny assessments of mortgage securities until after the crisis had begun. In October 2006, Frank Nothaft, the chief economist at Freddie Mac, a major securitizer of home mortgages, told me that Freddie Mac had financially modeled the impact of a price decline of up to 13.4 percent. When I asked him about the possibility of a bigger drop, he replied that such a drop had never happened (at least not since the Great Depression)—and he seemed unable to imagine that it could.

Since the 2006 peak, housing prices, adjusted for inflation, have fallen nearly 15 percent. Where they’ll go from here is uncertain; we are in uncharted territory. Between 1997 and 2006, real home prices in the United States rose 85 percent; this run-up was historically unprecedented. There was no rational basis for it: fundamental indicators such as the ratio of home prices to building costs, or to rents, or to personal income, also soared, suggesting unsustainable price levels. (The idea that the country is running out of residential space is no more true now than it was during the manias of the 18th and 19th centuries.)

Already, the crisis has infected other sectors besides housing. Credit-card and automobile-loan defaults have been increasing. The credit ratings of municipal- bond insurers are being downgraded, and the market for corporate debt is troubled. If housing prices keep falling, the impact of the crisis on the broader economy will be amplified further. Both Sweden and Mexico experienced severe recessions after profligate mortgage-lending booms in the early 1990s. Japan suffered a “lost decade” after its housing bubble burst in 1991. We may wish to think of the current economic setback as a one-act play, soon to end, but it could be only the first act of a long and complex tragedy.

Presented by

Robert J. Shiller is a professor of economics at Yale University. This article is drawn from his forthcoming book, The Subprime Solution, to be published in August by Princeton University Press.

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