Ready, Fire, Aim! - Mihail's Public Blog: When talk bursts bubbles

Thursday, June 2, 2005

When talk bursts bubbles

According to this New York Times column by Yale Professor Robert Shiller, the author of Irrational Exuberance, things may be getting shaky for the real-estate bubble that we're seeing in cities like San Francisco. Friends of ours who bought a house in Palo Alto for $2.3M last February couldn't resist flipping it for over $3M last month -- even though they're now having trouble finding a place to live.

The upward pattern is a little less regular but even more striking in some U.S. cities. In Los Angeles, real home prices, after falling 2.7% in 1996, rose 4.1% in 1997, 10.3% in 1998, 4.5% in 1999, 7.7% in 2000, 7.9% in 2001, 16.9% in 2002, 19.2% in 2003, and 23.2% in 2004.

While home price increases have been getting increasingly stronger since the last 1990s, recently there's also increasingly more talk about a bubble amidst record prices.

There is a widespread perception that something big and exogenous has to happen to break the bubble. People say: Sure, after the real-estate boom of the 1980s, Los Angeles home prices fell 41% in real terms between its peak in late 1989 and its bottom in early 1997, but that was a time when the defense and aerospace industries were contracting in Southern California. They say that contraction is the real explanation of the price drop there.

Special factors may help explain the most extreme price declines, but talk and high prices are the main things that end bubbles. The intensity of talk about the high prices right now is enormous, suggesting an emerging change of public thinking that may signal the end of the bubble.

I know I've used the word bubble to describe real estate prices at least fifty times in the last few months and at least three friends are now sitting on the sidelines, renting, and waiting for the bubble to burst before entering the real estate market. Maybe Shiller has a point!

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