Here Is What You Need To Know About Economics!!

When Adam Smith started the whole thing with his "Wealth of Nations", he used words to explain what he saw happening.

When David Ricardo understood why it was better for everyone if countries specialized in what they produced, he described it words.

When John Maynard Keynes wrote his monumental tome on economics, he used words.

But after WWII, some macro economists decided they could build a mathematical model of the economy.  The idea swept the entire profession.  Now you cannot get a degree in economics without mastering the arcane mathematics, and you cannot get tenure without publishing some kind of mathematical research.

The problem is that mathematical models of the economy don't work!!  Period!!  A couple of months ago, the Dean of the Economics School at the University of Athens stated the problem perfectly.  He said he had an impossible job.  On one hand he had to teach PhD candidates arcane mathematical models, but on the other hand he had to teach them that the models are worthless.

Here is the heart of the problem, and it is a very, very serious problem with huge consequences for all of us.  The economy is driven by psychology, not finance, and nobody has been able to model psychology.

That behavior drives the Business Cycle.  For awhile, everybody thinks things will get better, and so they do.  Then, for some reason, people decide things are going to get worse, so they do.

I wrote a brief description of this reality in "The Great Recession Conspiracy" and Reinhard and Rogoff wrote an extensive description in "This Time Is Different".

Now a few economist are taking a first few, tentative steps to recognize the ultimate importance of psychology.  This article appears in today's New York Times.  Notice how Shiller dances around this argument before he makes his final position clear.  He reminds me of the Dean at the University of Athens.

Housing Fever Can Work Both Ways

By ROBERT J. SHILLER

THE boom and bust in the housing market was a dual social epidemic. First, there was an epidemic of positive thinking that led to high expectations for long-term home price appreciation — and for the economy, too. Then, after 2005, an epidemic of negative thinking discouraged many people from buying a house or from spending in general, and kept many employers from hiring. 

We would all like to think that our economy makes more sense than that, and, in some ways, it does.

Certainly, there were other factors behind this boom and bust. But many of them — for example, Federal Reserve actions, government policies toward housing, even the effects on the United States of developments in other countries’ economies — were arguably driven by this same social epidemic.

In 2004, there was little about the economic climate that would explain why a housing peak should be coming soon. The world was widely believed to be slowly emerging from the early-2000s recession, which had been associated with the bursting of the stock market bubble of the 1990s. The stock market was just starting to recover. It seemed a time of healing. But something else, hard to discern, was driving things.

Recognizing when you are being caught up in a social epidemic is often difficult. As a first-time father, 30 years ago, I wanted to give my son a name that was less common than mine. There were far too many other “Bobbies” and “Bobs” when I was growing up. My wife, Virginia, and I settled upon the name Benjamin, which was my father’s name, and which seemed a rarer choice. 

But when Ben got to kindergarten, there was another Ben in his class, and we soon realized that we had somehow chosen a common and trendy name. In fact, according to Popular Baby Names by Decades, a Web page from the Social Security Administration, the name Benjamin rose from a ranking of 130th in the 1960s to 31st in the 1980s. (It moved up to 25 in the 2000s.) Its popularity probably grew even faster in our own circles. Others were giving this name to their wee ones in a slow contagion. How we were influenced still mystifies us, though my wife does recall meeting one other baby Ben in the months before our son was born. 

Most people seem to know that social epidemics are occurring, at least at some level. In fact, the term “going viral” has been going viral itself. A Google Trends search confirms that the phrase has taken off in the last few years. It is possible to go deeper — to ask what people are thinking, and infer something about the social epidemics that drive the economy

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KARL CASE, of Wellesley College, and I have been trying to do that for over a decade. We have conducted an annual mail survey of home buyers for years, with a total now of nearly 5,000 completed questionnaires. The survey, supported by the Yale School of Management, has covered the years leading up to the 2006 peak in home prices, and the years of disappointment thereafter. 

The mailed questionnaire survey posed multiple-choice questions and a number of open-ended essay questions, where respondents could fill in their answers in their own words. Anne Thompson of McGraw-Hill Construction joined us in analyzing the data we collected, and we presented our paper “What Have People Been Thinking?” last month at the Brookings Institution. 

We found that those who filled out our questionnaires were generally well informed about recent home price trends, and that their expectations for the next year’s home price appreciation were actually on the sober side. There were no signs of bubble thinking in these short-run expectations.

But expectations about long-term price appreciation — for what home prices would do over the next 10 years — were less sober. The data showed some odd patterns, not easily tied to any objective data. How does anyone know where home prices will go over 10 years? Somehow, people form opinions about the vague and distant future — just as they form opinions about baby names — and these opinions are crucial in their home-buying decisions. 

Notably, in 2004, when the housing boom was going gangbusters, even though the 30-year mortgage rate was above 6 percent, our survey tells us that people expected long-term home price growth of over 12 percent a year. In other words, if you borrowed 90 percent of the money to buy a $100,000 house, you would expect to make $12,000 on the house’s appreciation, and pay $5,400 interest, for a one-year profit of $6,600 — a return of 66 percent in just one year on the down payment of $10,000. 

(How many people do you think made these calculations before buying a house?  Economists just have a hard time giving up their mathematical models!!)

So you can see why people were excited about real estate back then. It’s not that they were sure that home prices could never fall. Rather, they thought that the long-term trend was so strongly upward that any conceivable short-run price falls would surely be reversed, and then some.

Since then, the mortgage rate has fallen to well under 4 percent, but long-term expectations, as we measured them, have fallen faster, so that the earlier 6 percent spread is undeniably gone. That does a lot to explain the slow markets we have been observing lately. 

BUT why did people have such extravagant expectations, and why did they change so abruptly?

We don’t really know. But in our 2004 survey, when the rate of home price increase was highest, people wrote that they were thinking about ever-growing population and limited land, about economic growth and eager Asian investors, about “flippers” making hot trades. All of these ideas suggested that it was important to dive in sooner rather than later. If Cousin Bill’s housing investment looked enviable, you might not hesitate to buy a home, even at a price that seemed a bit high. 

No respondents volunteered the phrase “housing bubble” on our questionnaires that year, as if it never crossed their minds that housing booms could come to an ugly end. That’s remarkable, given people’s recent experience with stock market losses. They all apparently thought that housing was different back then.

After 2004, the use of “housing bubble” grew among our survey participants. And a Google Trends search confirms that there was a huge burst in Web searches for “housing bubble” in 2005. That seems to be when many people were thinking, “Just what is a housing bubble, anyway?” and had to learn once and for all what it meant. 

People waiting to buy a home may be waiting for a sense that prices have a rosy long-term future. Home prices in the United States have been rising for several months, and that is generating some optimism that now is the time to buy. However, the social waves also carry other, less encouraging stories that compete with such optimism — for example, foreclosures, unemployment, Europe’s troubles and the Asian slowdown.

Will optimism about real estate emerge as a leading story? If this is a major upturning point for the housing market, it is still sociologically opaque.