Can economists warn us of housing bubbles – and crashes – ahead of time?
It's a question that becomes ever more fascinating as Canada's real estate market scales new heights. The reaction from most Canadian bank economists has been largely a shrug. Yes, activity may be overheated in certain cities, they acknowledge, and prices may have to back off a little, but there's little reason to worry about anything serious.
It all sounds very reassuring – until you look at the dismal record among U.S. economists in diagnosing the state of their housing market. The lack of general alarm about the state of American housing circa 2005 points out the problem that most economists have in disagreeing with the wisdom of the market.
It's an understandable blindness. To label something a bubble is equivalent to saying that buyers have turned irrational – and that's not a comfortable assumption for anyone trained to assume that buyers and sellers are utility-maximizing economic agents with a collective intelligence greater than that of any single individual.
Where specifically do economists go wrong? Among other things, they tend to assume that trends that have proven true in the past will continue to play out.
Notable in that area is a 1990 paper by Gregory Mankiw, a Harvard professor, and David Weil, a Brown University economist. The two prestigious authors – Prof. Mankiw would later become chairman of the President's Council of Economic Advisers – argued that as baby boomers aged and moved out of their prime house-buying years, housing demand in the 1990s would grow more slowly than at any time in the past 40 years and "real housing prices will fall substantially over the next two decades."
That prediction, as you may have noted, didn't really work out. But Prof. Mankiw and Prof. Weil have lots of company in the forecasters' hall of shame.
In their paper, "Bubble, bubble, where's the housing bubble?" published in 2006 just as the U.S. housing market was entering its frothiest stage, Margaret Hwang Smith and Gary Smith, married professors of economics at Pomona College, argued that "under a variety of plausible assumptions about fundamentals, buying a home at current market prices still appears to be an attractive long-term investment."
It wasn't any lack of fact-finding enterprise that sabotaged the Profs. Smith. They went to extraordinary lengths to estimate the fundamental value of home ownership from information they painstakingly collected on rent of near-equivalent properties.
Unlike Prof. Mankiw and Prof. Weil, they didn't assume that past was necessarily prologue. In fact, they did the opposite. They pointed out that people who were concerned about the rapid rise in real estate values in recent years were assuming that prices were close to fundamentals in the past. "But maybe prices were below fundamentals in the past and the 2001-05 run-up pushed prices closer to fundamentals," they argued.
Just like ordinary humans, economists seem susceptible to being swept away by bullish sentiment. In fact, anyone who reads academic papers from the pre-crash period comes away with a grudging admiration for economists' ability to claim that a flashing red alarm light is really green if you just squint at it the right way.
In a 2005 paper, Charles Himmelberg of the Federal Reserve Bank of New York, Christopher Mayer of Columbia University and Todd Sinai of the University of Pennsylvania cheerfully acknowledged that home prices were expensive in relation to rents and income – but then argued that those indicators didn't really matter anyway, since they failed to reflect the effects of other factors such as real interest rates or the ability of people to correctly predict future house-price appreciation.
Right now, of course, both the home-price-to-rent and home-price-to-income indicators suggest Canadian real estate is overvalued. Maybe this time the economists will be right and there's no reason to worry. Just don't count on it.