Near rational agents and house price booms

House price run-ups, especially when they appear excessive, are difficult to explain. It is it even more difficult to explain how they are not coordinated across countries in a globalized world. Indeed, right now house prices are severely depressed in the United States, while you can have strong suspicions of bubbles in China, Norway and Switzerland. Bubbles are substantial deviations from fundamentals that could be due to some deviations from rationality or herd behavior, or both. But "rationalizing" this is a major challenge because of the apparent randomness of the occurrence of such house price booms.

Klaus Adam, Pei Kuang and Albert Marcet think they have a way to explain this using the concept of internally rationally agent. Such a agent, like the economist, does not know the true process of prices but tries to infer it from past observation using Bayes' rule. The belief about prices then becomes part of the state space and leads to some sort of path dependence. With shocks that are not perfectly correlated, it is then possible for different countries to experience different paths for house prices.

Teenage achievement and the house price bubble

The general economic context of where and when you grow up matters. Think, for example, of those raised during the Great Depression in the US or World War II in Europe who are likely to be very careful with their spending, never through anything away and finish their plates. In this regard, what should we expect from those reaching adulthood in the past years?



Daniel Cooper and María José Luengo-Prado study the impact on teenagers of the house price boom before the current crisis in the United States on educational outcomes. Using the Panel Study of Income Dynamics (PSID), they find that a 1% higher house price at age 17 leads to a 0.8% higher income as adult if the parents owned the home, 1.2% lower if they were tenants, after conditioning for socio-economic characteristics. These are big numbers. They can be justified by the observation that higher house prices allows more collateral to borrow for education. Indeed households with a below median non-housing wealth saw even a 1.6% boost in their child's future income. To explain the impact on tenants, I suppose one can explain it with higher tuition in reaction to larger loans, which tenants cannot afford as well.



The consequences from the recent house price crash are daunting in this context. And given that state are disengaging themselves from financing their public colleges, leading to even higher tuition, the outlook is even worse.

Compartmentalized thinking in personal finances

Even before the crisis hit in the United States, there was talk about how foolish it is to get balloon mortgages, with low teaser rates for a few years. Yet people where going for them, either because they had expectations of strong income growth, or because they were time inconsistent or very impatient. Or people do not understand the true cost of the loan.

Johan Almenberg and Artashes Karapetyan document a phenomenon that is in some ways similar in Sweden. Mortgage interest is deductible from taxes for personal loans, but not when a co=op takes a loan. Yet people seem to favor financial situations that shift debt from personal to co-op loans. On average, the equivalent of US$540 a year are left on table. This can be explained by what is termed salience of debt. People only care about the costs they directly see, and the interest payments of the co-op are not itemized in the fees. The authors survey co-op apartment owners on how they think about their finances. It turns out people a very aware of their personal finances, but completely ignorant of the co-op finances. They never considered the trade-off between personal and co-op debt. That last point may indicate that ignorance may be more important than salience, though. This is reinforced by the fact that market price do not seem to reflect the tax difference.

Economists did see the bubble coming

Economists have been lambasted for not alerting the public that a bubble was in the making in US real state, except for a few oddballs. Of course everyone is wiser in hindsight, but what did economists actually say? It never hurts to look at the facts.

Martha Starr analyzes statements in 24 California newspapers from 2002 to 2007. From 1998 to 2005, the state's house prices increased by more than 10% each year. This prompted the newspaper to run 379 stories with 688 statements by economists on house prices. Academics were clearly warning that house prices were not sustainable. Economists employed in the real-industry, however, were resolutely optimistic. What emerges is a mixed message that gave no guidance to the public, which was even reassured by positive messages from the Federal Reserve.

It is entirely possible opinions could have diverged based on the same evidence. But it seems more likely the professionals were not acting in good faith. They had everything to lose from predicting an end of house price growth. The media should have learned not to trust such biased speakers, yet they continue to be interviewed. Now as to why Greenspan and then Bernanke were so optimistic is beyond me. There speeches are definitively strategic and while they may have realized there was a problem, they may have tried to prevent a bubble from bursting too brutally. Then all the credit to them for trying. But one cannot postpone indefinitely a bubble from bursting, and they knew that.

Latin American home owners are happier, unlike US ones

There is a myth saying that owning a home makes people happier and leads them to contribute more to their community. In an earlier report, I pointed out that this idea is a myth for the US homeowner. What about elsewhere?

Inder Ruprah finds that Latin American house owners are indeed happier. This is obtained from a survey where people declare how happy they are, the reliance of which many researchers have called into question. But happiness studies slowly get more acceptance, especially when results are clear cut, like here. Of course, homeownership could be correlated with some unobservables that matter a lot for happiness, for example economic and social standing. There is a variable that could capture this in the regression, "Interviewer assessment of economic situation of the household," but I have no idea how reliable it is.

PS: The pdf file is 7.3MB large. It took me five attempts to download it. There are a few very simple graphs and histograms in the paper, in other words no reason to have such a large file, but for unnecessary front and back covers. But if the IADB is willing to waste bandwidth that way, especially as its target audience in Latin America may not necessarily enjoy fast internet.

How to finance housing in Islamic economies

Financial markets in Islamic countries face large challenges, as the law prohibits, in principle, interest. Lenders and creditors need to go through all sorts of hoops to find a legal way to allow for something that is interest in spirit but not in fact. One consequence of these hurdles is that the mortgage market is almost non-existent, and this has translated into an absolutely desolate residential stock in many Islamic countries. Clearly, improving the lives of people goes through an proper and active mortgage market. How could this be achieved in an economically and legally reasonable way?

Zubair Hasan claims to have solved this problem. The current practice is to sell the house to a bank and then buy it back with a mark-up added. This margin corresponds of course to interest, but this practice seems very controversial in case of default, as banks insist on full payment of the debt disregarding any installments already paid. This trouble arises because of the ownership structure and this is why the idea is to propose joint ownership between the "landlord" and the bank. The latter gets gradually reimbursed for the amount of the debt and also receives rent for the share of the house it owns. This solution boils down to the same outcome as for a classic, western mortgage. The trouble is that it involves three separate contracts (joint ownership, lease and buyback), and Islamic law prohibits making a contract conditional on another one. This is very constraining.

Hasan's idea is to replace the full ownership of a share of the house by the bank by a constructive ownership, much like a stock broker possesses the stocks his clients really own. The author thinks, without being certain, that this should satisfy Islamic law. But what this highlights is that Islamic law seems to put absurd hurdles on economic activity and that, maybe, it could be adapted to modern circumstances.