Professor Shiller is one the great students of irrational exuberance, (an excellent book worth reading) he has also been very bearish on the housing boom taking place throughout the world.

In this letter, I noticed something interesting that we mustn’t forget, and that is the fundamental long term shift in attitude towards housing. The housing correction will come, it may even be similar to the Japanese crash of the late 80’s and 90’s but over time things will more than recover. See the parts I have highlighted.

Take a look ……..

What Are Homebuyers Thinking?

Many places around the world have been in a housing boom since the late 1990’s. As I argued last year, in the second edition of my book Irrational Exuberance , the boom is rooted in speculative investment by ordinary homebuyers, fueled substantially by the worldwide perception that capitalism has triumphed, and that all people must look out for themselves by acquiring property. Convinced that private ownership has become essential to smart living, buyers bid up home prices.

Moreover, the fear that one must get in on the boom before it is too late often drives people to bid up home prices faster now. This certainly seems to be the market psychology in China and India, where rapidly rising incomes and newly successful people are widely expected to put pressure on markets for land, real estate, and construction materials. Real estate booms have been going on in these countries’ major cities for years. In China, despite some signs of weakness – the Shanghai market is down, for example – price growth is still robust in much of the country.

But the boom generated by such beliefs cannot go on forever, because prices can’t go up forever, and there are already signs of a hard landing. In the United States, newspapers and magazines are trumpeting reports in the last few months that the decade-long boom in home prices may be at an end, and that the bubble may be bursting. The psychology has suddenly changed, creating widespread fear of sharp drops in US home prices.

The new futures market for single-family homes at the Chicago Mercantile Exchange (which I helped establish last May with our firm MacroMarkets LLC) is predicting that by next August prices will fall between 6% and 8% in all ten US cities traded.

If home prices crash in the US, the bastion of capitalism, could it destroy confidence and end the boom in other countries? If so, could a worldwide recession follow?

This scenario is a distinct possibility, although there are reasons to be skeptical. Most importantly, the ultimate sources of the housing boom – the beliefs about capitalism and future economic growth – seem solidly entrenched.

The downward price trend in the US market, for example, does not seem to reflect underlying changes in long-run economic confidence. The survey that Karl Case and I conducted in May and June of this year, under the auspices of the Yale School of Management, shows sharp declines in short-term expectations for home prices in the US, but relatively little change in long-term expectations. Most people still believe that housing is a great long-term investment.

Maybe real estate prices are unlikely to fall to pre-boom levels because the fundamental change in perceptions concerning capitalism’s triumph will be longstanding. Changes in people’s fundamental ways of thinking are not easily reversed. Nor, therefore, is their interest in housing as a major speculative investment asset likely to change.

The transformation in investors’ beliefs is striking. Before the real estate boom of the late 1970’s, hardly anyone was worried about rising home prices. A search of old newspapers finds surprisingly few articles about the outlook for home prices. Those that did appear generally seem to be based on the assumption that minor fluctuations in construction costs, not massive market swings, drove the modest home price movements that they noted.

Indeed, hardly anything interesting about home prices was ever reported at all, aside from an occasional comment in an article about something else. For example, an article in The Times of London in 1970 argued that rising home prices reflected the switch to a new British Standard Time (imposed as a three-year experiment in 1968 to facilitate commerce with Western Europe by putting Britain in the same time zone). The article claimed that the change raised costs by forcing British construction workers to perform more of their jobs in relative darkness. Speculative investment behavior was hardly an issue in those rare instances in which home prices were discussed.

To understand the nature of the subsequent shift, consider that it is hard to find anyone today who worries that automobile prices will soar because rising demand in China and India for steel and other materials will push automobile prices out of reach in the future. Though a small group of collectors invests speculatively in antique or specialty cars, the idea of speculating in automobiles just is not in the public consciousness. That is how it was with housing until the late 1970’s.

Now that we think differently about real estate, we will never be the same again. But, of course, housing prices can only rise so fast. High and rapidly rising home prices tend to stimulate new housing supply, which in turn tends to undermine prices. Over a period of years, as people see how much new supply there is, they may begin to revise their view that homes are such a terrific investment, causing a gradual, but eventually significant, drop in home prices.

Indeed, while changes in fundamental perceptions may not occur easily or fast, they should never be ruled out. Urban land prices in major Japanese cities have steadily dropped over much of the period since 1991, as the enormous faith in the miraculous powers of Japanese capitalism gradually faded.

The same kind of erosion in home prices could occur in many cities around the world. All that is required is that growth in housing supply eventually outstrips investors’ faith in capitalism to sustain faster growth in demand.