Infectious Exuberance

Financial bubbles are like epidemics— and we should treat them both the same way.
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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.

How can we inoculate ourselves against a recurrence of this whole awful cycle? Government officials today are rightly pushing regulatory reform to prevent lending abuses and reckless behavior among financial institutions. But that doesn’t address our psychological vulnerability to bubble thinking, which seems greater than it’s ever been. During the stock-market boom of the 1990s, the national psyche, long infused with a Protestant work ethic, seemed to undergo a transformation, and the idea arose that we could expect to make a lot of money by investing. At the same time, the proportion of Americans owning stocks and homes was increasing. We should be happy that more people are investors and homeowners today, but those latest to the game are often the least sophisticated players, most susceptible to irrational optimism—one reason why the most-recent stock and housing bubbles grew so large.

Irrational exuberance is bound to pop up from time to time; we can’t stop it altogether. But we probably can limit it, preventing some bubbles and keeping others smaller. Boom thinking is carried along by bad arguments and bad information. The key to keeping the transmission rate low and the removal rate high, if you will, is better dissemination of reliable information—something the government should focus on over the coming years.

Many households have access to very little financial insight. In most cases, the only financial professionals they come into contact with are trying to sell them something, whether it’s a mortgage or a stock. Independent financial advisers, who provide more-comprehensive advice, have typically been available only to the relatively wealthy. The questions most people need answered are elementary: How risky is this investment? Have prices ever gone up this fast for this long before? Can I afford this loan if interest rates rise? But they’re not getting straight answers to these questions.

Financial advice is in some respects like medical advice: we need both on an ongoing basis, and failure to obtain either can impose costs on society when our health—physical or financial—suffers. There’s a strong case to be made that the government should subsidize comprehensive financial advice for low- and middle-income Americans to help prevent bubbly thinking and financial overextension. One way to do this would be through co-pay arrangements like those in place for Medicare or for private health insurance. Accredited advisers, charging a flat fee, would be partially reimbursed by the government; the moderate costs to consumers would create a much broader market for their services.

We also need to get better—and more—information to more-sophisticated investors and financial professionals. In real estate, one important way of doing that is by further developing the financial market rather than focusing only on regulating it or reining it in. For instance, real-estate futures markets, which have existed since 2006 but are still in their infancy, have the potential to tame future housing bubbles. Without them, there is no way for skeptical investors who think they see a rising bubble to express that opinion in the market, except by selling their own homes. If futures markets grow, then any skeptic anywhere in the world could profit from a bubble in, say, Las Vegas, by short-selling real estate there. Substantial short-selling would reduce bubbles, and provide information to home builders, ratings agencies, and others. In turn, builders, for instance, might not overbuild if they see that most of the money in the futures markets is being bet on price declines.

Subsidized financial advice and the encouragement of real-estate futures markets are just two examples of the sorts of actions that could limit future bubbles. The larger point is that increasing the amount, accessibility, and reliability of information about investments should be a high priority for policy makers. Epidemiology suggests that even very small changes to the transmission rate of a disease can make the difference between an epidemic and a low-incidence disease. If better information inoculated even relatively few people against boom thinking, that could prevent many bubbles from rising.

There’s another, more urgent reason to focus on the idea of social contagion today. Like booms, many busts are magnified by group thinking. And once busts become severe enough, they prompt changes in the national mood that ramify well beyond economic affairs. Benjamin M. Friedman, in his 2005 book, The Moral Consequences of Economic Growth, cites abundant historical evidence that when economic prospects look bleak—especially for long periods of time—intolerance, racism, and other reactionary impulses flourish. As more people experience hardship, trust between them tends to diminish, and the social fabric itself seems to fray.

If home prices keep dropping, more bailouts of banks and broker-dealers likely will be necessary to prevent the paralysis of the financial system and a severe loss of confidence in our economy and economic institutions. And if we aim to stop foreclosures, with all their ugly consequences, from spreading further, many, many homeowners are going to need loan refinancing—which will need to be provided or backed by the government. Bailouts of investors and prospective bailouts of unwise or unlucky home buyers have stirred a lot of controversy, and indeed, financial bailouts are, for many reasons, unsavory. But given the severity of the current financial seize-up, they are needed—not to prop up Wall Street profits or housing prices, but to prevent a fundamental loss of economic confidence and to maintain a sense of social justice for those of modest means. Losses of confidence and trust can mount with surprising speed, and beyond a certain point they become very difficult to recover from.

We recently lived through two epidemics of excessive financial optimism. I believe that we are close to a third epidemic, only this one would spread irrational pessimism and mistrust—not exuberance. If that happens, our economic problems will become much worse than they need to be, and our social problems will multiply. Only if we heed the lessons of the boom can we keep the bust from causing lasting damage.

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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