In this compelling short book, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to do About It, Professor of Economics at Yale University Robert J. Shiller examines the US housing bubble that began in the late 1990s and which eventually led to the subprime crisis.
Shiller is well known for his best seller Irrational Exuberance, which looked at economic behaviour from a psychological perspective. In particular Shiller examined why markets become irrationally over optimistic.
In this study of recent irrational economic behaviour, Shiller finds a self-reinforcing culture of positive economic stories that create their own feedback loops. Suddenly no one can think outside the received wisdom of media stories and positive hype that house prices will boom forever.
The History of Housing Prices
To discover why prices in the US boomed the author examines the history of housing prices from 1890 to the present day, and finds no underlying factors for increasing prices. In fact, boom and bust cycles aside, housing prices have stayed stable over the period.
Then between 1997 and 2006, housing prices in the US rose by 85 percent. During this period, the economic fundamentals underlying housing – interest rates, population, building costs, rents and personal incomes – did not increase anywhere near what housing prices did.
Writes Shiller:
“The misalignment of home prices with economic fundamentals is strongly suggestive of economic instability.”
What Caused House Prices to Soar Dramatically?
The subprime phenomenon was not responsible for the overall boom in prices, and can claim only a minor part of the boom for prices at the lower end of the market.
What caused the boom in housing prices from 1997-2006 was what Shiller calls the “contagion of market psychology” or “boom thinking”. What this phenomenon entails is the constant circulation of positive stories from the media, business leaders, government bureaucrats and politicians, that reinforce the thinking that a boom in housing with spectacular returns is now a normal condition of the economy.
With so many positive stories circulating, a new narrative is created that becomes legitimised. This irrational optimism is reinforced with feedback loops. Soon everyone believes it as a self-evident truth.
The Momentum of Housing Booms
Housing booms also have a steady momentum. Unlike stock market prices, which can be volatile, housing prices during a boom steadily and inexorably rise – until the bubble bursts. Therefore it is possible to make money during a boom, yet the investor needs to know when to get out.
How to Fix the Subprime Problem
Having described the psychological underpinnings for the housing boom, Shiller then spends the last couple of chapters of his book outlining a program to fix America’s economic problems. His solution is to ‘democratise’ finance. In essence this means spreading financial knowledge to those who have poor literacy in this area. The key reform ideas can be summarised thus:
- Improved information infrastructure.
- Financial planners to be subsidised by the government to give advice to those on low incomes.
- A new financial watchdog.
- Improved financial disclosure.
- Improved financial databases.
- Streamlining units of measurement and making them more understandable.
In closing his book, Shiller argues that citizens should avoid getting angry with financial markets. When they work well, they have done much to improve people’s lives. By expanding knowledge and financial literacy, by creating a “financial democracy”, markets will run more smoothly and will work as they should, serving the community.
In The Subprime Solution, Shiller makes a cogent, clear argument for common sense thinking and transparency in finance. Whether society can learn the lessons of the irrational boom in house prices is another matter.
The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to do About It, by Robert J. Shiller is published by Princeton University Press (2008). ISBN:978-691-13929-6
Chris Saliba - Chris Saliba is a freelance writer. Read more of his workplace articles at chrissalibafreelancewriter.blogspot.com
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