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Shiller Says Today’s Housing Mirrors Ponzi Scheme

Yale economist Robert Shiller has a second edition of his bestseller, Irrational Exuberance, now in print. It includes a new chapter making the case that we are in a housing bubble. But there’s still that pesky question of when it all will end. He says real estate in the U.S. has enough upward momentum to keep going for a while, but it’s inevitable that prices will drop.

The author contends that an asset derives its true value from the income that it will throw off in the future. (With a stock that means, strictly speaking, the dividends it pays.) With an owner-occupied house, it’s what economists call “imputed rent”...what you would have to pay to rent an equivalent house.

In many U.S. markets today, the monthly cost of buying a house is significantly higher than the monthly rent on an equivalent house. So by the “imputed rent” test, it makes no sense to buy.

Shiller says people buy anyway because they assume that house prices will keep rising, meaning they can sell out later for a profit. That of course requires that another buyer will come along who also assumes that prices will keep rising, which will require yet another such optimistic buyer down the road...and so on, and so on.

This happens to be the definition of a Ponzi scheme, Shiller says. He maintains this real estate market craziness cannot continue. But to make a bet about when it’s going to end—now that would be really crazy.

Editor’s Note: The World Wealth Report, produced by Capgemini and Merrill Lynch, shows that Americans with $1 million or more in liquid assets cut back real estate holdings to 13% of their portfolios in 2004. Their drop in real estate holdings is a contrast to everyday consumers who continue to buy up homes and drive up prices. Market experts say the wealthy are often at the forefront of investing and financial trends, and this shift could be a leading indicator of a market peak.