Robert Shiller
This column was written by Robert Shiller, author of the new book 'The Subprime Solution: How the Current Global Financial Crisis Happened and What to Do about It.'
There was very poor understanding of the housing and mortgage lending boom of 1997 to 2006 as it was happening. As home prices continued to escalate, national leaders issued virtually no warnings. Instead, many of them congratulated homeowners and the firms that put them into their investments. Because they did not understand the boom, they did not see the end coming. Now that the end of the boom is a matter of history, it is widely accepted that something was wrong. Still, there is little understanding.
Most financial experts didn't get it then, because they had the wrong model of the economy. They haven't changed their fundamental model, so they still don't get it. As a result, experts underestimate the extent of the damage. Moreover, survey evidence shows, most home buyers today just assume that the current subprime crisis is just a minor interruption in a continuing boom.
The problem is that the canonical model does not recognize that investor psychology drives markets. Investors are seen as reacting rationally to new information -- like Fed policy -- when, in fact, many have been acting consistently irrationally based on misunderstandings.
The boom years were driven by major investor misperceptions of the fundamentals of the housing and mortgage market. A real estate myth developed, that because of the relentless pressure of fundamentals, investments in real estate are guaranteed to provide high returns. Real estate was viewed as a magic money machine.
The rapid appreciation of home prices was seen as just the consequence of these fundamentals. This myth encouraged people to make highly aggressive and leveraged real estate investments, feeling that they could not go wrong, that there was no need to hedge their risks. The myth accounts for all manner of errors -- errors made by mortgage lenders, mortgage insurers, mortgage packagers, investors including banks and hedge funds, rating agencies and government regulators.
Part of the reason that the crisis drags on so long is that we part with our myths only slowly. The gradual changes in our beliefs have profound effects on the markets over time. Market prices are not so much moved by changes in government policy as they are with fundamental changes in public confidence and trust -- the social fabric.
Because our national leaders did not warn anyone of this crisis, and those homeowners whose homes are worth less than their mortgage are in trouble, we are naturally bitter. This is a problem that won't go away soon.
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