The Joe Walker Podcast - Rational Minds Part 1: A Nation Of Gamblers - Ed Glaeser

Episode Date: December 15, 2020

Ed Glaeser is the Fred and Eleanor Glimp Professor of Economics at Harvard University.Show notesSelected links Follow Ed: Website 'A Nation Of Gamblers: Real Estate Speculation And American History', 2013 Ely Lecture by Ed Glaeser One Hundred Years Of Land Values In Chicago, by Homer Hoyt The Land Boomers, by Michael Cannon '25 years of housing trends' report by Aussie Home Loans Topics discussed A potted history of real estate speculation in the United States. 8:51 How would Ed describe the Great Convulsion of the 2000s to an alien observer? 13:40 Why is real estate well-suited to being a speculative asset? 16:04 If speculators aren't crazy, what are they? 17:00 Was the Great Convulsion primarily driven by credit availability? 20:44 What would a good Bayesian have thought in response to the 2000s housing market in the US? 22:23 Radical uncertainty and its implications for rationality in the context of housing markets. 24:06 Are extrapolative beliefs rational? 26:22 Are housing bubbles irrational? 29:51 See omnystudio.com/listener for privacy information.

Men, wrote the Scottish journalist Charles Mackay, think in herds. It will be seen that they go mad in herds, while they only recover their senses slowly and one by one. My name is Joe Walker and three years ago, trying to understand Australia's obsession with residential real estate, I began researching housing bubbles. I read almost everything I could find. Increasingly, I came to view the question of bubbles as not just a topic of interest to the fortunes of my country, but a vehicle to explore deep questions of human nature. There's a long literature that gleefully lays bare the madness of crowds, from Mackay to Galbraith, Minsky and Kindleberger to Schiller and Chancellor. But it left me with a nagging question. No one in a bubble ever thought she was crazy. So what is going on here? In this series, I'm using the prism of financial bubbles to tackle an eternal question. What does

it mean to be a rational person? I'll be guided by five world experts who will show me that we're not quite so befuddled as popular narratives would have us believe. I'm inviting you to come with me on this journey, to reconsider what you might have been told, and to give rational minds a second chance. I couldn't complain Now it's never the same I found myself Peaking pieces And that's getting great This series is proudly sponsored

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Ladies and gentlemen, boys and girls, swagmen and swagettes, welcome to part one of this series on rational minds. Built into the speculative episode, opined John Kenneth Galbraith, is the euphoria, the mass escape from reality that excludes any serious contemplation of the true nature of what is taking place. Euphoria, mania, madness, frenzies, irrational exuberance, speculative orgy, mass escape from reality. These terms are weapons in the war of words over financial bubbles. And in finance, as much as in war, history is written by the victors. Charles Mackay, the author of Extraordinary Popular Delusions and the Madness of Crowds, nearly gives the game away when he writes about speculation. The subject is capable

of inspiring as much interest as even a novelist can desire. Is it a dull or uninstructive picture to see a whole people shaking suddenly off the trammels of reason and running wild after a golden vision, refusing obstinately to believe that it is not real till, like a deluded hind running after an ignis fatuus, they are plunged into a quagmire? The irrationality account of bubbles enables pundits, financial historians, and behavioralal economists to sagely tut-tut from the vantage point of hindsight while signalling their own rationality. But is it true? Is there a chance that the fabled paroxysms of irrational exuberance in their time looked little different to an average day in a pit of the board of trade?

I ask you to keep an open mind. As this series evolves, you're going to learn which parts of the irrationality story to hold onto, and which parts are little more than propaganda. Our quest begins in America, a nation built on real estate speculation. Were I to characterize the United States, wrote William Priest in 1796, it would be by the title of the land of speculations. Indeed, founding fathers like Ben Franklin and George Washington moonlighted as enthusiastic real estate investors. America is, to borrow a phrase from this episode's guest, a nation of gamblers. And this makes it the perfect starting point for our inquiry. A cursory glance at American history reveals a conga line of land and housing bubbles,

from Robert Morris's 18th century speculations in New York State, to the Chicago boom and bust of the 1830s, to the Florida land bubble of the 1920s, and the Great Convulsion of the 2000s. Popular accounts of such events were, of course, quick to see madness. Joseph Balestier describes the 1830s boom in Chicago like this. So utterly reckless had the community grown that they chased every bubble that floated in the speculative atmosphere. Madness increased in proportion to the foulness of its ailment. The more absurd the project, the more remote the object, the more madly they pursued. In 2008, LA Times journalist Peter Hong gloated about selling his home in Southern California

in 2005 before the market crashed. When we held our one open house, the frenzied strangers who poured into our living room only deepened my sense that reason had given way to something like mania. I wondered what it would have taken to deter those eager buyers. Asbestos? Rats? By the time the excited throngs cleared at the end of the first day, I no longer doubted my belief that the bubble was about to burst. My first guest in this series is here to tell you to doubt the belief that participants in a housing bubble are necessarily crazy. Ed Glazer is the Fred and Eleanor Glimp Professor of Economics at Harvard University, where he has taught since 1992. He is one of the world's foremost urban

economists, and he has thought deeply about the question of rationality in the context of housing bubbles. Without much further ado, please enjoy this chat with the brilliant Ed Glazer. Ed Glazer, welcome to the show. It's wonderful to be here. Thank you for having me on. And I'm so excited to speak with you because I think you're uniquely placed to answer a question that I have been wrestling with for some years now. I recently had an email exchange with the great Ken Binmore and I asked Ken whether he thought that anybody had made a serious attempt to grapple with the issue of rationality in the context of speculative bubbles. And somewhat ominously, he said, I don't think anybody at all too big to take on. So I'd like to try and take on this too big to take on topic with you today.

And I thought we'd begin just with a very quick and potted history of real estate speculation in the United States. Great. So I did a survey of this about four years ago for the Eli Lecture for the American Economics Association. And I started in the days of the early republic, when the man who had been the chief of finances in America at the very beginning, a man named Morris, went bankrupt because he had been speculating on the American frontier, unbelievably vast amounts of land that he had been buying. It reminds us that, you know, in some sense, America from the beginning was a great piece of land speculation, right? The Europeans who were coming over were, you know, risking everything in the hope that somehow or other this vast continent, which was underpopulated from their perspective, would somehow or other turn out well. And in the

early days, it was basically about trying to figure out some way to expropriate the Native Americans or, you know, convince the powers that be in London to give them vast tracts of land, as indeed William Penn did. And at that point in time, because land ownership is by the powerful, it really was centered on people like George Washington, like Benjamin Franklin, like Morris. And sometimes, of course, it went awry, as it did in the crash of 1797. Now, I then move forward, and gradually over the course of the 19th century, land speculation becomes much more democratic in the U.S.

It becomes a widespread phenomenon. And you have farmers throughout the U.S. who are constantly swapping parcels of land on the frontier. of Alabama in 1819, where, you know, the prices that were paid rose to dizzying heights at its, you know, at the peak of the bubble, only to crash down shortly thereafter. And the point that I tried to make in the article is that, in fact, the prices paid at the peak didn't look that crazy, given the prevalent prices of cotton. That, in fact, you know, given what cotton was selling for in that post-Napoleonic era, given what it cost to farm the land, it looked pretty good. But in fact, by the mid-1820s, the price of cotton had crashed down to earth. And the reason for that is that cotton's pretty

easy to grow in lots of parts of the world. And you can't sustain a price of land that's vastly over, you know, the price of land everywhere else that you can grow cotton. And that just suggests this mistake that's made over and over again in land bubbles. And that's really sort of the central message that speculators forget the power of supply to set the market. There's a lot of land in this world. And you can duplicate things that are being done in one area somewhere else. This was true in cotton in Huntsville, Alabama, where cotton could be grown in Egypt. Cotton could be grown in India. Cotton can be grown in many other places.

In 1919, flash forward a century, there's a huge land speculation around agricultural land in Iowa and Illinois. Once again, it's about agricultural products that can be grown lots of places throughout the world. Because of the dislocations of World War I, because of the influenza perhaps as well, it maybe seemed as if those trade routes were disrupted. But by the mid 1920s, Russia's coming back online, the world is awash with wheat, the wheat prices drop and the land prices drop. It's exactly the same point in Las Vegas in 2006. OK, for 40 years before the land bubble, Las Vegas prices had hewed closely to the cost of building homes. After all, America is lousy with desert land. There's nothing special

about Las Vegas, right? There's no regulations that make it difficult to build. For 40 years, it cost $80 a square foot or so to build housing, and that's what housing was sold for. Then all of a sudden, the prices doubled, and then they tripled, right? Because people somehow or other thought that there was some magic that was going to happen. But, of course, it wasn't as if it had become difficult to build in Las Vegas. All of a sudden, you know, somehow or other, the rules had been changed. No, it was still easy to build. And by 2007, it was obvious that they were building far too many housing that could support

such high prices. And once again, the prices came down to earth. So the lesson is, you know, land bubbles are ubiquitous in a country that was built on land speculation. But ultimately, you know, and sometimes some of the buyers of urban real estate have done extraordinarily well. But you must never forget the fact that there's a huge amount of land in this world. And there's a huge amount of land in the United States. And over and over again, speculators have gotten it wrong because they've underestimated the power of that abundant supply to determine the long-run price. How would you describe the great convulsion that rippled across the United States in the 2000s to an alien observer coming to Earth for the very first time? So there was a boom in the late 1980s. And in fact, when I started as an economist,

we were just recovering from what we thought was a big boom. By historical standards, it was a pretty big boom. And so for much of the 1990s, prices were pretty flat. And then all of a sudden, prices ticked up. And they ticked up at first in totally sensible ways. New York had come back. Boston had come back. California was always pretty nice, but it had experienced a big drop in the early 1990s.

It had come back. And so that seemed sensible. Interest rates were low. And then all of a sudden, people started bidding up prices in places that, you know, didn't seem to have come back, didn't have anything special about them. You know, they just seemed a little bit cheaper than Los Angeles. And, you know, a washing credit, people forgot the basic rules of housing. And all of a sudden, we're building up totally ordinary, buying up ordinary homes for prices that were totally unlike anything in the past. It's, you know, one of these things that happened.

And it's, I agree with Ken Binmore, that it's very hard to understand how this matches with any of our rational models of prices. But it was was enthusiasm. And, you know, one of the things that's interesting is that the big, great housing convulsion was particularly centered in warmer parts of the country, maybe because speculators thought that the general movement of America to warmer places would somehow or other cause a housing price bubble, a housing price growth. But the strange thing about that, of course, is that one of the reasons Americans move to warmer areas is those are the areas that it's easy to build in. Those are the areas in which you don't have regulations that fetter housing, housing price growth. And so consequently, they're the last places that you would expect to have

permanently higher prices. So in some sense, it was a bunch of people acting close to rationally, looking at things that seemed like they were making the buyer smart. But of course, they didn't seem to think about the whole market. And eventually, this big ball of credit and hope collided and ended in a colossal amount of flames. I don't know how that would work with the alien, but it was a triumph of hope over reality. Why is real estate well suited to being a speculative asset? One reason is it's easy to borrow one. So real estate is something which you can get a mortgage on, you can put very little money down, and you can bet on because the bank thinks that they can get the value back.

If you and I borrow money to start a restaurant, if that restaurant fails, a huge amount of money the bank has invested in this is just gone. If we buy a plot of land, the land's still there. And so because of that, since the beginning, banks have been willing to, you know, lend. Look, Morris in the 1790s was coming over to the Netherlands and getting Dutch bankers to back his purchases, right? Credit was there from the beginning. You can't get a housing bubble, you can't get a land bubble just with credit. But the fact that there's credit available then combines with the human capacity for optimism, for over-optimism, and makes it possible. I think that's the most important thing. It also is democratic. It is also a thing that everyone can understand. So there's a long tradition of literature which portrays speculators during

bubbles as like frothing at the mouth, bug-eyed, mad and exuberant, stretching from Charles McKay to Galbraith, Kindleberger to Chancellor. And we also see this in the context of real estate bubbles as well. We got homer hoyt's 100 years of land values in chicago i've just got it open here to the the famous quotation which everybody likes to quote of harriet martineau the great harriet martineau i thought you were going there absolutely the uh sure let's let's hear it that's right so she she writes i never saw a busier place than chicago was at the time of our arrival which was 1836 the streets were That's right. So she writes, the whole people. As the gentlemen of our party walked the street, storekeepers hailed them from their doors with offers of farms and all manner of landlots advising them to speculate before the price of land rose higher. And in the Australian context, we have similar visions from the famous,

fabulous land boom in Melbourne in the 1880s. Michael Cannon's book, The Land Boomers, kind of salaciously covers some of those events. But here, for example, we have a cartoon of auctioneers offering free champagne at lunches to provoke buyers into a reckless mood. Now, the question for you, Ed, is no one in a bubble ever thought he was crazy. So what is going on here? in Chicago. And we asked, what do you have to believe to pay what they were paying? And we luckily, we know exactly what they were paying. They were paying less than you pay for comparable property in New York. Maybe not enough less, but not something which if you really thought that this place, which was seemed poised to be the linchpin of a great watery arc of American transportation that went all the way from New Orleans up to New York City, if you thought that this city was really going to replace Cincinnati or St. Louis as being the queen of the West, that it may very well work out.

So I think these things are not wild irrationalities. And I think the wild irrationality myth is dangerous because it suggests that it couldn't happen to me. I could never be as foolish as one of Harriet Martineau's speculators. I'm not foaming at the mouth. When I make a real estate purchase, it's based on sound logic. It was always based on sound logic, right? I mean America was this country, which in 1816, it cost as much to move goods 30 miles across America as it did to ship them across the entire Atlantic Ocean. And so we sat poised at the edge of this continent like Tantalus in the pit, groping for all this wealth.

And then suddenly these waterways made it all possible. And the cities that took advantage of the waterways, like Buffalo, like Cincinnati, became great hubs. Chicago looked like it was going to become the greatest of them all. And it did, in fact. And in fact, the buyers in 1836, if they'd been able to hold on until 1850, they would have done just fine. But in the short run, you know, their credit came due, they weren't able to spend the money. And of course, the whole thing just got too out of hand, because again, hope exceeded at least short-term reality. Do you buy Atif Meen and Amir Sufi's narrative that the Great Convulsion was triggered by a credit availability shock and then primarily driven by credit availability?

I think the credit is necessary but not sufficient for explaining land bubbles. I can't imagine a land bubble happening if there's no credit. I mean, it's got to be someone borrowing on it. But we have had lots of times in our history, and yours too, where credit has been abundant and there's been no great property value. If you thought that credit was both necessary and sufficient, you would think that the 1950s would have been one of the most amazing land bubble periods in American history. This is a period in which suddenly 30-year mortgages are widely available, not just for veterans, but for everyone through Fannie Mae and Freddie Mac. You would have thought that, you know, there would have been an explosion of prices, and yet prices stayed quite flat. Buyers, I think, correctly got, you know,

understood that supply was relatively abundant. We were building huge numbers of suburbs and, you know, the prices stayed relatively constant. So it's really not enough just to have extra credit. You need to have something which creates a credible narrative that that, in fact, those prices are going to go up for some durable reason. And in fact, those narratives were abundant. Those narratives were even there in Las Vegas. I mean, the Las Vegas story was that the federal government was stopping its sales of land.

Now, there was no real truth to this. There was an abundance of land that was available. But at least it was a credible narrative. So I think easy credit doesn't get it on its own, but it is an important part of the story. Seeing house prices rise in the United States in the mid-2000s, what would a good Bayesian have done? Would they have taken this long history of mean reversion and put it into their prior, and then had a strong degree of skepticism about the United States housing market back then?

I think so. I mean, the prevalent story which seemed to justify it was indeed the lower interest rates. And that was something that as a good Bayesian, you could pretty easily reject. I mean, historically, the relationship between interest rates and prices is something like, you know, a hundred basis point swing in interest rates is associated with about a 6% increase in housing prices. So it's not that they're irrelevant. That's a number that's perfectly compatible with basic economic theory. But that doesn't give you a 50% increase. That gives you over the, let's say there was 150 point basis point reduction in interest rates over that earlier time period.

That would have given you a 9% or 10% increase in prices. You could look at the fact that historically, housing prices mean revert pretty substantially over the past 30 years. For every dollar, housing prices go up in one metropolitan area in the US. They go down by 32 cents over the next five years. So there's a pretty regular feature of mean reversion, which would have told you to be cautious. And of course, the next thing that gets you to caution is just this fact that you look at conditions of supply and demand. And I think that's the most, you know, that's the most reliable one, that you just can't imagine that in Las Vegas, in Phoenix, in the cities that are built on sand, that high prices can be sustained in the presence of essentially perfectly elastic supply. Of course, the other thing to note is that

departures from Bayesian inference are not irrational in a world of radical uncertainty. And a question that I've been wrestling with is just how uncertain are housing markets? How uncertain were the fundamentals around housing in the United States during the Great Convulsion? And does it make sense to say that one domain is more uncertain than another? Can uncertainty be put on a continuum? I think that there's a great deal.

You can make a case for radical uncertainty in China's housing markets 10 years ago. You can make a case that there's both upside and downside uncertainty that's sort of mind-boggling in terms of the political uncertainty because the government is, as a legal fact, owns all the land. Because China's growth rates are spectacular, because there are enormous differences across space in the productivity and the wealth of China. China is a place with radical uncertainty. There was very little going on in America's housing markets 20 years ago that was somehow or other an era of radical uncertainty. Maybe a little lack of clarity about which place was going to become, you know, more restrictive about new building. But by and large, the fundamentals were relatively static.

It's hard to point to anything except for interest rates that would give you any big change in housing prices during that time period. And even interest rates, as I've tried to suggest, didn't move enough that you think that it was radical. So I think that I agree with you. I think there are times in American history, there are times in global history, certainly, where you really are facing radical uncertainty. But I refuse to cede the point that in 2003, in the US, we were looking at some world in which nothing was predictable. It really seemed to me like a pretty static world. GDP was pretty flat. Unemployment was pretty flat. Not a lot that seemed so huge. If anything, you have more of a chance for arguing radical uncertainty now than you do then. Is that sort of like a version of the curate's egg, though?

You know, it's only a little bit uncertain. Well, you know, if that's your model, it seems to me like you can argue that that little bound of uncertainty is pretty much true in every asset market ever. So there's some, I mean, it's... Fair enough. So, Ed, one of the things I i do or i did up until the pandemic struck was attend property investor seminars in australia not to invest myself necessarily but more from an anthropological lens and one of the interesting narratives which continually

popped up at many of these seminars was that the median Sydney house price in 25 years time would be 6.349 million dollars and that that figure recurred so I was interested in in digging and finding out where it came from and it came from an Aussie homelands report but basically what was happening was that people were extrapolating house price growth over the previous 25 years in australia forward to the next 25 years so the price i should clarify would be 6.349 million dollars in 25 years time and that was just a simple extrapolation but assuming three percent wages growth which is pretty pretty generous for aust generous for Australia given the experience of recent decades, a price of $6.349 million would imply who lead these seminars are examples of what you would call entrepreneurs of error or what Cass Sunstein and Tamor Karan might call availability entrepreneurs. guess, myopically rational. I don't think we could call it wholly irrational, but it's rational in the sense that they are just taking a very limited window and extrapolating recent

price growth forward. I haven't ended that with a question mark, but I'll just throw that open to you if you have any comments. So I think the extrapolative buyer is, I think, one of the best models that's out there for sort of understanding the semi-rationality that goes into buying. So together with Charlie Nathanson, we published an article in the Journal of Financial Economics that sort of shows what happens when people do exactly what you just suggested, which is they speculate out. And the answer is you get very big bubbles. And the logic is typically flawed because the price rise today already embeds expectations about future growth. So if you see prices grow between last year and this year, one of the prime reasons why they might go up a lot is that people have updated expectations about future growth. So it's already backpedaled into the price.

Now, if you then take that growth and say, oh, now, look, my growth thing was wrong. I've got to update that even further. Then you can get unbelievable swings in prices that come out of that model. And yet those are very standard ways in which high prices are justified, often by, as you suggest, by entrepreneurs who, let's say, have an interest in predicting these high booms. So I'm not going to make a prediction about Sydney's prices in 25 years. I really don't know. And indeed, Sydney is a highly restricted area.

As we well know, it's not going to be particularly easy to build. But I do know that there certainly have been millions of investors over in light of rationality? Well, I think the answer is that you get easy credit, and it's often pretty easy to justify prices that are far off with only small errors. So this sort of extrapolation error is not a huge error. It's not believing that you can turn base metal into gold. It's not, you know, it's not, it's not, it's a thing which is sort of mathematically reasonable. There are states of the world which is even mathematically right. So when a small error can translate into a big change in price, and when there's a banker who will lend on that, then it's hard to imagine how you won't get

bubbles. And that's, in fact, what I think we're looking at is, you know, small errors can translate into big changes in price. And it's a commodity, it's an object on which it's easy to use it as collateral. And I think that's the basic lesson here is that we should continue to expect to have them. Public policy needs to plan to make the system robust to them rather than, you know, we can try and educate ourselves in ways that limit our own tendency to make foolish mistakes about our own real estate purchases. But it's just too tempting a thing for someone who's just got a little bit of extra optimism, a little bit of extra willingness to extrapolate, to find themselves significantly overpaying for housing. Ed Glazer, thank you so much for joining me. Thank you so much. What a fun thing.

Thank you so much for listening. I hope you enjoyed that conversation as much as I did. For show notes, including links to everything we discussed, you will find those on my modestly titled website, josephnoelwalker.com. That's my full name, J-O-S-E-P-H-N-O-E-L-W-A-L-K-E-R.com. Please do subscribe to or follow the podcast, depending on which which app you use to ensure that you never miss updates. When we release new episodes, the audio engineer for the jolly swagman podcast is Lawrence Moorfield. Our very thirsty video editor is Alf Eddie. I'm Joe Walker until next time.

Thank you for listening. Ciao.