“Bubbles only burst after the critics of the bubble have been discredited by years of rising prices”
The Case-Shiller Index is the last word on US home prices. Now, how many modern day economists can boast of having an index named after them? However, Robert Shiller is not the bragging type for he knows financial history inside out. Charles Dow managed that distinction along with Edward Jones, but that was over a century ago and they were both financial journalists who went on to create
The Wall Street Journal. Not that Shiller had a smooth run. After calling the top of the dot-com boom, he was in danger of looking like a one-trick pony as his prediction in 2005 about a housing crisis took its own time coming. The crisis did come and it’s after effects are still being felt. Hence investors made a beeline when he visited India for the first time. When we finally meet him, Shiller mentions that he is as jetlagged and groggy when he arrived as he has been rushing into “meeting after meeting”. His sleepy demeanor belies his prescient understanding of market bubbles, but during our interaction, he lets it slip that Mumbai’s real estate market has him foxed. Well then, Professor Shiller, welcome to the club.
How do you define a bubble?
A bubble is a period of temporarily rising asset prices due to a sort of feedback that price rises generate investor interest and, therefore, price continues to rise for a while till it reaches a level where it becomes unsustainable without further price rises, because people wouldn’t buy such an expensive thing unless they thought it was going to keep going up. It is a time of rapidly growing public attention. There is a sense of envy of other people that plays into the suspension of disbelief about a bubble. Because they see other people who have made so much money and they feel a sense of regret in not having participated in that, people decide to participate in the bubble — not based on strong conviction but almost a sense of community with others who are in the bubble. So people go in tentatively, their doubts amplify and at the end leads to an abrupt turnaround.
How do you know a bubble is about to burst? You called the housing bubble way back in 2006.
I have been working hard on this, but that is not to say that I have a very good answer. Bubbles go on for far longer than you think. They turn after the critics of the bubble have been discredited by many years of rising prices! The news media plays a role in this. They tend to note when people are reacting to news stories. So when there is doubt in the minds of people about a bubble, you have a series of bubble stories that leads to public recognition of the bubble. The news stories don’t convince people but there comes a point when contagion follows and gives it legitimacy.
Every other indicator relating to housing sales in the US has been improving over the last two to three quarters but you don’t seem to be convinced that they have seen the bottom...
Yes, home prices are going up modestly. Housing starts, housing permits are improving and the National Association of Homebuilders survey is also showing a sharp improvement. I do think this could be a turning point, but am less convinced than other people because I know how rare turning points are. I have been doing a questionnaire-based survey on home buyer expectations and that shows that, as of June 2012, expectations continued to decline.
|Foreclosure sales may come back because [in the US] we still have over 10 million households under water|
People are getting optimistic by seeing the decline in foreclosure numbers but I think that the decline is because of some timing issues. Foreclosure sales may come back because we still have over 10 million households under water and their homes are worth much less than their mortgage by a wide margin. Even if home prices go up, we will still be under water. The US government is supporting 90% of our mortgages through Fannie Mae, Freddie Mac and FHA. We see an austerity mood in the US Congress and the pulling back of home mortgage interest rate deduction. With these things on the horizon, there could well be a sudden turndown.
Incidentally, this is the fourth upturn since the crisis. Yet, this is the most convincing upturn of them all because it comes at a time when recession is weakening and unemployment is down to 7.7%.
Would you then say that people are underestimating the risk in US housing at this point?
I think that people have trouble understanding risk in the housing market. It is because the housing market, unlike the stock market, has a trend component that lasts for a while and then the trend reverses. So they tend to see it as very little risk. In our survey, some people did say they see risk but there is greater sense of optimism when markets are going up. In fact, some years ago, an insurance company did a focus group survey and asked people if they would buy insurance against a price decline and the feedback was they wouldn’t because they didn’t see any risk.
Do you see more downside for US housing prices? Where could it settle?
In the last century, real home prices went nowhere. There is a different model that is rarely mentioned these days. Except in places like downtown Mumbai, home prices are driven by construction costs mostly. In most places, land is a minority component of home prices and they keep building these cities. Construction costs have two main components. One of them is labour and the other is technology. In a country like India where the wage rate is going up rapidly that would be a hefty component of housing costs. But offsetting that is technological progress in the construction industry. There is more automation and more new materials. That has kind of washed out historically, at least in the US. So there has been a modest increase in construction costs. If we go back 100 years ago it was very expensive to build a house because it was all done by hand and hand tools. But now home prices in real terms are back at the level it was 100 years ago. The question in my mind is that there might be another bubble starting and it could go off again. Or it could overshoot and continue downward. I don’t know what it is going to do. There are too many uncertainties right now.
Do you think based on the cyclically adjusted price earnings (CAPE) ratio; the S&P 500 is still overvalued?
It is modestly overvalued. But I actually favour putting substantial money in equities because there is no alternative right now. The long-term bond market looks even worse. We actually have negative yields on inflation index bonds in the US. A good strategy is to focus on low CAPE sectors. This is what I have done with Barclays. In September, we launched a product in the US that invests in low CAPE sectors. It has pretty much the historical average expected return because of what it does. So, the overall market might be going up at 4% and ours might be going up at 7%. I can’t say with any assurance that it indeed will.
What do you think is a sustainable PE for the S&P 500?
Historically, it has averaged at something like 16. Now, there is a question of whether there is a trend in the PE. In 1929, Irving Fisher, an economist at Yale University, said that he thought PE should be uniformly higher going forward because investors have learnt that the stock market outperforms other investments at the old PE; so, it has to reach a new level. That same theme was resurrected in the 1990s. There was a book, Dow 36,000, by Kevin Hassett and James Glassman, written in 1999, that made the same argument. They were both catastrophically wrong. I think it is a little hard to know what the PE will be but my guess is, it will be what it has been historically, which is 16. Right now it is a little over 20, which is high but not alarmingly high.
What factors could drive the next downturn in the housing market? On the flipside, will the continuous QE trigger yet another bubble?
|Before 1913 in the US we didn’t have a central bank or a stabilisation policy|
It is largely uncertain now. I wrote my book Irrational Exuberance
in 2000 because I had a sense — and it was not just my intuition, the CAPE was very high at 45 then. Right now, we are on an uptrend but I do not see any extremes. But in stockmarkets, you can have booms even in depression times. So, for example, between 1933 and 1937, we had a booming stockmarket even though unemployment rate was in the high teens. This happens because people want to beat the market — when things are bad they are willing to pile into markets sensing that a bottom will come soon. So it’s possible that the current uptrend will continue, but we can’t guarantee it because there are other problems like the weakening world economy and a mood of austerity.
When do you see US unemployment easing off?
Unemployment has been going down since 2010 but a lot of that is due to people dropping out of the labour force and switching to retirement. If you look at the employment-population ratio, it is quite low. By that measure, we are seeing a very low and slow recovery. I suspect that the unemployment picture may not improve for a long time. [Ben] Bernanke said the Fed would keep quantitative easing till unemployment fell below 6.5% — that might be a few years away.
Are there any factors that could result in a possible uptick in US employment?
Well, there is always the animal spirit that comes back. To give you an analogy, psychiatrists tell their depressed patients, “You should know before you get suicidal that most episodes of depression don’t last for more than a year. Even if we do nothing, you will get better in a year for no reason.” There is something like that in the economy, too. Before 1913 in the US we didn’t have a central bank or a stabilisation policy. Yet we had a number of recessions and they all ended on their own. So there is a natural process at play. What tends to end recession is that if people postpone buying a washing machine or new car, it starts to wear out on them. There is a pent-up demand that brings the economy back on track. That is probably a factor now. Automobile sales are coming back.
You seem to believe that austerity isn’t good. How do we get rid of the excess if we do not resort to austerity?
Austerity is still not called for in the US. We are still a weak economy. There is a threat of another downturn. Europe is still on an austerity path. There is this conflict emerging in Europe that is actually alarming. They are talking about countries leaving the European Union and that is disquieting at this time.
I think we need balanced budget expenditures that would raise taxes and raise expenditure. That would stimulate the economy without raising the national debt. In fact, it would tend to lower the debt-to-GDP ratio because you would boost the denominator without changing the numerator. I find it puzzling. Economic theorists have been talking about balanced budget stimulus for half a century, but it doesn’t seem to form part of the discourse. But if you look at President Obama’s American Jobs Act last year, it was a balanced budget stimulus. He couldn’t get it through Congress, though. That is the fundamental problem. You can’t deal with economics without dealing with politics.
Is the Fed missing out on something? Their aim is to prevent deflation. That is why you have series after series of QE. If you look at the Japan experience, are there lessons that the Fed is ignoring?
On the contrary, I think Japan is an interesting example because they had huge bubbles in the real estate and stock markets in the 1980s and both of them peaked around 1990. They have been having disappointing progress ever since, but they have had no depression. They have had 1-2% growth a year which you may not be impressed with, but they are growing. They had deflation but very little deflation because their quantitative easing pretty much stopped it. It is almost a model of price level stability. I think Japan is actually a reasonably good model for surviving an economic bubble. Also, part of the slowdown in Japanese economic growth is because of their having reached the zenith of development and having become an advanced country.
What is your take on real estate prices in India?
|Japan is actually a reasonably good model for surviving an economic bubble|
The thing that is different about India as well as China is that there is this sense of emergence starting from this century. There is a novelty side to this but there is also a possibility that it’s exaggerated. It is the same thing in Russia too. When I was in Moscow, I asked the limousine driver what is going on with housing prices and he said, “There have been all these new expensive constructions and only Arabs can afford these things.” Usually, these are exaggerated stories of the new wealth behind property prices. The general public is more responsive to stories like that than they are about warnings to new construction, which might eventually change the supply situation. They just don’t believe it. So there is a sort of an urban spirit that develops. In a city like Mumbai, which has a long history and is a financial centre, there is a natural shortage of land that can’t be so easily rectified with new construction. There is some truth to that, but the public exaggerates that. They think that home prices are going to rise 10-20% a year here. That is not true at all. There is a certain quantitative judgement that people are not making and they imagine that the profit opportunities are more intense than they really are. That leads to a bubble. If you ask me, buying urban real estate is not a great idea because it is not a productive investment. If you are investing in India, you should be investing in entrepreneurship rather than houses.
How do you think financial innovation will evolve? You have been talking about equity warrants on GDP.
The idea of issuing equity warrants on a GDP is such a marked departure from conventional finance that people are worried about doing this on a large scale. Even Greece, which has been the first to issue these warrants, has not issued very many of them. There is some worry about creating a market for GDP because if it turned badly, what do we do? We tolerate markets for corporations but that is still to be accepted at a country level. I would think that it will happen eventually because most countries are now struggling with very high levels of debt and will soon realise issuing equity will be a better option. Financial innovation takes time to develop. The first inflation-indexed debt was issued in 1780 by the Commonwealth of Massachusetts in the US. That was 230 years ago. It ended up with a lot of inflation and the government paying out a lot more. So the government didn’t do it again until 1997. But now it is well established. So, innovations take a long time but I would like to think that it would happen sooner.
What would be the implication of equity warrants on GDP for the market and the government?
It will help in deleveraging the government. Some governments are functioning like shadow banks that finance things by borrowing short term and investing long term. That creates its own risk and that is why the borrowing needs a more corporate-like structure. Of course, you can deal with it by extending the maturity of bonds but that will be at the expense of higher long term rates. So, it is better to issue shares linked to GDP. The only problem is in pricing it, because there isn’t an established precedent.