Housing Bubbles and Expectations – The Power of a Feeling!

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By Shahar Rotberg

From 2001 to 2006 the Case-Shiller index, a measure of housing prices, rose by a staggering 82%, only to plummet 25% between 2007 and 2011. What could explain such strong fluctuations in housing prices? In turns out that low interest rates, low minimum down-payments, rising incomes, and other fundamentals can only account for 50% of the boom-bust in U.S. housing prices. What could account for the other 50%?

In a paper I started writing for my dissertation in 2015, I explored the role of expectations in generating house price fluctuations. I started my work after observing that during years in which income was above its long-run trend, housing prices were going up, while during years in which income was below its long-run trend, housing prices were declining. It seemed that a plausible explanation is that during good years people felt increasingly richer, and increased their demand for housing, which pushed house prices up. Since they only felt richer, the demand for housing was only artificially and temporarily raised. In contrast, during bad years people felt poorer than they really were, and thus, overly reacted by reducing their purchases, causing a severe drop in housing prices.

In my paper, I compared house prices between two models: In the first model, people did not change their perception about their income (this is what economists call “rational expectations”), while in the second model people felt richer whenever their incomes went up and poorer whenever their incomes dropped. The second model was consistent with many findings by high-caliber academics, such as Noble laureate Daniel Kahneman, who provided experimental evidence showing that people adjust their expectations up after observing good outcomes and down after observing bad outcomes.

I found that including people’s changing expectations about their income in my model could explain around 20% of the rise and the fall in housing prices. This means that demand is sometimes driven, quite aggressively, up and down purely due to people’s perceptions. Thus, policy makers should think of ways to “chill” people’s rapidly changing beliefs if they wish to avoid severe housing price fluctuations.

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