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I recently wrote about Robert Shiller’s unusual, for an establishment economist, ability to see the forces that influence market prices. He is also an expert on housing prices, as co-creator of the Case-Shiller index of housing prices. In an article in the June 6, 2008 New York Times, “Why Home Prices May Keep Falling”, he explains why the “efficient market theory”, which says prices should adjust immediately to the “rational value”, doesn’t apply to housing prices. He expects housing prices to continue decline, even if the economy begins to improve. His thought process is worth considering. Here are a few quotes. The whole article is worthwhile.

[Long], steady housing price declines seem to defy both common sense and the traditional laws of  economics, which assume that people act rationally and that markets are efficient. Why would a sensible person watch the value of his home fall for years, only to sell for a big loss? Why not sell early in the cycle? If people acted as the efficient-market theory says they should, prices would come down right away, not gradually over years, and these cycles would be much shorter.

But something is definitely different about real estate. Long declines do happen with some regularity. And despite the uptick last week in pending home sales and recent improvement in consumer confidence, we still appear to be in a continuing price decline.

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Several factors can explain the snail-like behavior of the real estate market. An important one is that sales of existing homes are mainly by people who are planning to buy other homes. So even if sellers think that home prices are in decline, most have no reason to hurry because they are not really leaving the market.

Furthermore, few homeowners consider exiting the housing market for purely speculative reasons. First, many owners don’t have a speculator’s sense of urgency. And they don’t like shifting from being owners to renters, a process entailing lifestyle changes that can take years to effect.

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In fact, most decisions to exit the market in favor of renting are not market-timing moves. Instead, they reflect the growing pressures of economic necessity. This may involve foreclosure or just difficulty paying bills, or gradual changes in opinion about how to live in an economic downturn.

This dynamic helps to explain why, at a time of high unemployment, declines in home prices may be long-lasting and predictable.

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Even if there is a quick end to the recession, the housing market’s poor performance may linger. After the last home price boom, which ended about the time of the 1990-91 recession, home prices did not start moving upward, even incrementally, until 1997.

Full Article

It is refreshing to read an economist who thinks about the underlying individual decisions and behaviors that make up a market, rather than merely doing regressions on past economic data.