Robert Shiller vs My Mom

Robert Waldmann

Now that the crash has come, Robert Shiller’s editor convinced him to write another book to cash in on the fact that he predicted the crash in the second edition of Irrational Exuberance so he wrote “The Subprime Solution”. Smart move. A less comprehensible part of the Princeton University Press publishing strategy was to send me, your humble blogger, a review copy.

I haven’t even read the first edition of “Irrational Exuberance” so I found the graph, which is old news for Shiller fans, the most interesting part of the book. Shiller et al have constructed the first long US wide price series for houses which starts around 1900.
If people had seen (and believed) this graph, the world would be a better place.

The amazing thing is that the relative price of houses (price deflated by CPI) did not have an upward trend in the 20th century. It was really at about the same level in 2000 as around 1900. The series shows two dramatic events — shortly after WWI the US price level roughly doubled (weak tea for about then for the German price level rose 1 billion fold). House prices did not respond much, so the relative price fell sharply. Then during WWII, when most prices were controlled, the relative price of houses returned to the pre WWI level.

That’s it. Nothing huge happening during the depression. Nothing else happening on the scale of the nationwide housing bubble in the 20th century.

The new graph has a very impressive line dividing the series up up up until the publication of “Irrational Exuberance ed 2” and the series down down down from Shiller’s prediction of the crash.

Shiller has an interesting explanation of the almost universal illusion that the relative price of houses trends up.

OK, first a boring explanation — people know the price of the average house, not of a house of fixed characteristics. Houses have gotten larger so the price has increased even though the relative price of a unit of housing has not increased compared to the price of, say, a loaf of bread.

But second, he argues that people remember how much they paid for their house (it is a big event) and any houses they previously owned. However, he claims, most people don’t remember how much they paid for a loaf of bread the week they bought their house.

Why yes indeed, people are regularly stumped by compounding and amazed at how cheap things used to be.

I’m at my parents’ for Christmas in a house which is one year older than I am. So I ask my mom how much it cost in 1959. After hearing $ 23,000 I picked my jaw off the floor (I had heard the price many times but it slipped up to $ 30,000 in my mind). The I asked how much a loaf of bread cost back then. She said about 8 cents !?!

OK now bread is about $2.80 so 35 times so the house should be $805,000, which is about right. OK, but that’s my mom and besides I think she was on to me.