One of the most amazing things about the human mind is that it is incapable of remembering pain.
Of course, we retain the memory of having been in pain. But the actual pain itself is forever wiped from our memory once it is gone. Just think how terrible it would be if every time we thought about some past pain, we experienced it as vividly as we did when it first occurred? It would be the most awful of curses.
While this mental self-defense mechanism saves us from insanity, however, it also leads to complacency. After the pain is gone, we tend to forget that it ever happened. By contrast, pleasure can be relived deeply over and over again - memories of past loves almost never leave us, for example. Thus, euphoria has a more long-lasting impact than equally intense suffering. This is a key reason why humans make some of the same mistakes over and over again. They remember what is good and forget what is bad.
This is the fundamental mechanism that gives rise to economic bubbles - unsustainable increases in asset prices that are frequently driven by nothing real at all. In the 1600s, the Dutch created a huge bubble in the buying and selling of tulips, which eventually collapsed. Bubbles are akin to fads and fashions that can change as abruptly as the weather. But for a time, they can lead to enormous profits for those lucky enough to get in at the beginning and smart enough to get out before the inevitable crash.
One consequence of bubbles is that they give rise to con artists and charlatans, who take advantage of both the gullible and the sophisticated. The former may not realize they are being conned, while the latter delude themselves that they can con someone else and still come out ahead. This is sometimes called the "bigger fool" theory, where someone knowingly buys an overpriced asset because he believes there is a bigger fool out there who will be willing to pay even more for it.
The great economist Walter Bagehot identified this phenomenon more than 100 years ago. "The good times ... of high price almost always engender much fraud," he wrote in 1873. "All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, when most people think they are making it, there is a happy opportunity for ingenious mendacity."
Readers of this column know that I am convinced that the housing market is in a bubble that will probably end sooner rather than later. Of course, there is much disagreement about this among economists, but almost all of those saying that the housing market is healthy are the same people who told us that the stock market was not in a bubble back in 1999. Then, they were convinced that economic fundamentals justified sky-high prices for stocks. Today, they are saying that economic fundamentals justify sky-high housing prices.
However, it is simply implausible to believe that housing starts can continue to grow far faster than the number of households, that prices can continue to rise far faster than incomes, or that interest rates will stay at historically low levels. Eventually, things will return to trend. Just as price-earnings ratios far higher than we ever saw in the past were a sign that the stock market was overvalued in 1999, so, too, we know that interest rates today are too low and necessarily will rise. When the P-E ratio fell, so did stock prices. And when interest rates rise, housing prices will fall.
I hope the optimists are right. I don't want my house to fall in value any more than anyone else does. But the optimists have no credibility as far as I am concerned. I lost too much money when the stock market collapsed to give them another chance. As they say, fool me once, shame on you - fool me twice, shame on me. So I will hope for the best, but prepare for the worst.
Homeowners who plan to stay put and have fixed-rate mortgages probably have nothing to fear. But they should be wary of tapping equity that may not be there in a year or two. The people who need to be most careful are new homebuyers and investors who have overextended themselves to buy houses more expensive than they can really afford, using interest-only or negative amortization loans. If prices fall even a little, such people will find themselves with negative equity, which could lead to widespread defaults, with ominous implications for the financial system as a whole.
In my opinion, prudence should be the order of the day for anyone planning to buy a house, refinance or take out a home-equity loan.
