Tuesday, September 6, 2005

One of the most amazing things about the human mind is its inability to remember pain. Of course, we retain the memory of being 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 when it first occurred. It would be the most awful of curses.

However, while this mental self-defense mechanism saves us from insanity, it also leads to complacency. After the pain is gone, we tend to forget it ever happened.

By contrast, pleasure can be relived deeply over and over. Memories of past loves almost never leave us. Thus euphoria has a longer-lasting effect than equally intense suffering. This is a key reason humans make some mistakes repeatedly; they remember what is good and forget what is bad.

This fundamentally produces economic bubbles — unsustainable increases in asset prices often 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 like 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.

Bubbles 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; the latter delude themselves 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 a bigger fool somewhere will 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 I am convinced the housing market is in a bubble that will probably end sooner rather than later. Of course, there is much disagreement among economists. But almost all those saying the housing market is healthy told us the stock market was not in a bubble in 1999. Then they were convinced economic fundamentals justified sky-high stock prices. Now, they say economic fundamentals justify sky-high housing prices.

However, it is simply implausible to believe housing starts can continue growing far faster than the number of households, that prices can continue rising far faster than incomes or that interest rates will stay historically low.

Eventually, things will return to trend. Just as price-earnings ratios far higher than in the past were a sign the stock market was overvalued in 1999, we know interest rates today are too low and necessarily will rise. When the P/E ratio fell, so did stock prices. 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 with me. I lost too much money when the stock market collapsed to give them another chance. 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 exist 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 whole financial system.

In my opinion, prudence is in order for anyone planning to buy a house, refinance or take out a home equity loan.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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