Shiller on Expectations

From an excellent article by Robert Shiller in the NY Times. I've bolded key bits:

The origins of the current economic crisis can be traced to a particular kind of social epidemic: a speculative bubble that generated pervasive optimism and complacency. That epidemic has run its course. But we are now living with the malaise it caused.

News accounts of the economic crisis rarely put it in these terms. They tend to focus on distinct short-term developments or on the roles of prominent people like Federal Reserve governors, members of Congress or Wall Street financiers. These stories grab attention and may be supported by some of the economic statistics that the government and private institutions collect.

But the economic situation is primarily driven by hard-to-quantify sociological factors that play out over many years.

The uptick in the unemployment rate, to 9.1 percent from 8.8 percent two months earlier and the drop in stock prices over the last month have attracted notice, yet in a sense they are symptoms of a deeper economic sickness.

Real estate prices have been a significant indicator of this ailment. An unprecedented bubble in American home prices started in 1997 and ended five years ago. Home prices rose 131 percent in that time, or 85 percent in real inflation-corrected terms, according to the S.& P./Case-Shiller National Home Price index.

...

During the bubble, the sense of rising wealth and high expectations gave people a good reason to spend and a greater willingness to plunge into investment, too. Government policy makers breathed in the same optimism, which no doubt encouraged them to be lax on regulatory restraint.

The mood is far different now. Our latest survey, covering April and May of this year, included 296 home buyers, and their median expectation for annual home price appreciation over the next decade was down sharply, to just 3 percent. And, in comparison with the 2005 results, few people had extravagant expectations.

The 3 percent figure is well below prevailing rates for 30-year mortgages, now hovering between 4.5 and 5 percent. Amid such low expectations, buying a home with a mortgage certainly isn’t being viewed as a way to get rich.

Even for people who have other reasons to buy a house, there may be little urgency to do so. Our 2011 survey found that the median expectation for home price appreciation next year is just 1 percent. So it won’t be surprising if new home sales remain abysmally low and few jobs are created in the hard-hit construction industry. And it shouldn’t be a shock if the personal savings rate stays at around 5 percent, as it has recently, up from around 1 percent in 2005. This would mean that consumer spending will not drive a strong recovery.

A half-century ago, there was a lively discussion among economists about the dynamics of price expectations. For example, Alain C. Enthoven, then of the Massachusetts Institute of Technology, and Kenneth J. Arrow of Stanford wrote in 1956 that expectations that extrapolate past price increases can produce economic instability. But that thinking was largely cast aside in the 1960s, when my profession embraced the theory that efficient markets formed by people holding rational expectations could explain virtually all economic activity.

As a result, economists in recent decades have not developed expectations theory much further. That needs to be corrected in coming years. In the meantime, this failing helps explain why the current crisis was generally unpredicted, and why its future course is so poorly understood.

Go read the whole article to get the details about how expectations have changed over the last few years. This will let you appreciate why the Great Recession won't go away quickly. It also helps explain why economists like Paul Krugman and Brad DeLong have beat the drum for major fiscal stimulus along with monetary easing to get the economy past the dead calm created by a bank panic. Sadly, Obama, the Republicans, the Democrats, the Federal Reserve, big business, etc. all are playing their roles of "little Hoovers" in working hard to ensure that the Great Recession becomes the Great Depression II. Tragic.