Neither Irrational Behavior Nor Animal Spirits Caused Home Prices To Rise

Many believe that house prices were in a bubble that eventually burst. The drop in home values, with its tremendous wealth losses and foreclosures, caused politicians and the public to look for scapegoats in the financial services industry, including the Federal Reserve. Investigators will need the passage of time from the current crisis to understand its likely causes, but neither irrational behavior nor animal spirits, as some economist claim, caused home prices to rise prior to the significant nation-wide decline.

Use of the terms "animal spirits" and "irrational behavior" as economic explanations reminds me of the patient with a red rash who goes to the doctor and is diagnosed with an ailment that is the Latin phrase for red rash. In both the economic and medical cases, the new terms do not contribute to our understanding and do not assist us in finding preventive or corrective measures. They are just linguistic placeholders until we learn more.

Furthermore, the spirits and irrationality are as likely to be coincident or lagging as leading, and if correlated, not causative. If my neighbors sell their house for a price that surprises me and makes me feel paper wealthy, am I irrational to think that at a future date, I could also sell for that or a higher price. If so, which caused which? If unexpectedly I must relocate and sell my home, am I relying on animal spirits when I buy my new home?

Furthermore, controlled laboratory behavioral pricing and trading experiments may show irrational pricing among the participants, but the lab situation tends to give equal weighting to all participants. It is comparable to going to a party and finding out that everyone there thinks the price of a certain company's stock is going to double, but nobody has either enough money or insight to be a price setter as opposed to a price taker. In the world outside of the experiment, there are many pools of available funds ready to take advantage of over or under pricing of investment opportunities and shrink the mispricing. Additionally, there are real world pricing constraints, such as short selling and signaling from informed sellers or buyers, and other equivalent markets, such as derivatives, etc.

For example, during tender offers, shares become unavailable and on occasion Put Call Parity will break down because shares are unobtainable for shorting or purchasing. In investing and trading markets even in time of "animal spirits," arbitrage relationships do not break down.

In 2005, residential housing was 15.6 percent of GDP. In 20091Q, it was 13 percent. Clearly, the decline in the residential housing sector is contributing to the decline in GDP. If we understood the decline in home prices, which caused the decline on housing related activities, we would understand a lot about our current economic downturn.

Residential housing is composed of two assets, the structure and the land. During the recent housing price run up and collapse, the price to rent ratio increased about 60 percent from 1999 to 2005. From 2005 to 2009, the price to rent ratio declined about 20 percent, so that it is still about 30 percent higher than 1999. Home prices rose faster than rents.

A renter does not have the legal rights of the owner to the land, but both have rights to the occupation of the structure. Since owners did not raise rents in line with residential value increases, is it illogical to conclude that home price increases were either in the land or in the cost of developing and regulatory approvals of a building lot, and not in the structure?

Furthermore, since homes are durable goods with an intergenerational life, expectations about future events that would significantly influence house prices can change and affect prices, both upwardly and then downwardly, before the events reveal themselves to the participants. Home prices would appear to be irrational unless one looked for economic or governmental signals that would modify expectations about events affecting future land prices. Expectations about future regulatory development restrictions, expensive government mandated costs associated with development, such as schools, sewers, roads, etc., or changes in estimates of developing high cost land, such as steep slopes, etc. would modify home prices without the occurrence of any direct home price related event. The fact that expectations about a future event change affects home prices and then reverts prior to that event actually happening, does not indicate irrationality or animal spirits. It could be rational response to anticipated events, still anticipated.

We will need time for events to unfold to show us the causes of the decline in house value. It could be many future factors, such as lower population growth, lower rate of household formations, lower household income growth, deflation, changes in the cost of home building, and many others.