Dear Friends —
Robert J. Shiller is not your typical economist. For one thing, he doesn’t throw out a lot of numbers and statistics. The reason you want to pay close attention to Shiller, a professor at Yale University, is that he is remarkably prescient: his book "Irrational Exuberance," which predicted the bursting of the technology stock bubble, came out in early 2000. A month later the market started its painful three-year decline.

The sequel to this book, "Irrational Exuberance, Second Edition," was published this spring. In addition to updating the work he did on the stock market, Dr. Shiller added a new chapter — on the bubble in real estate.

Ask an economist to define a "bubble" and you expect a mathematical answer including such terms, perhaps, as "intrinsic value," annual rates of return, and various ratios. Shiller admits he doesn’t have a short, simple definition and then goes on to say that defining a bubble "is similar to the way psychiatrists define a mental illness, that is, it involves a list of symptoms."

Indeed, to hear Shiller describe a financial bubble it sounds like a disease. "It’s a social contagion," he says, "An epidemic whose mode of transmission is word of mouth. It’s emotional. People keep hearing about price increases. There’s a tinge of envy about other people who have done well, which brings more and more people into the market. This, in turn, pushes prices up." In other words, it's a self-fulfilling prophecy.

For a while.

"It’s naturally self-limiting," says Shiller. "Prices can’t continue to go up forever."

So, does the good doctor (no pun intended) think we are experiencing a bubble in the housing market?

"Not everywhere. It’s a matter of degree," according to Shiller. "It tends to occur where land is scarce or where it’s difficult to build." Which explains why much of the ridiculous price increases we’ve been seeing have been concentrated on the East and West Coasts. After all, there’s only so much beachfront property.

But what about the housing boom in places like Las Vegas? Turns out, what looks like an endless stretch of wide open desert is actually in relatively short supply, thanks to restrictions imposed by the Bureau of Land Management which controls much of the area.

In many landlocked urban areas, according to Shiller, zoning laws are making it life difficult for developers. For instance, there may be limits on high-rise apartments. The solution is as much political as economic: "As pressures mount," he says, "zoning laws will be relaxed."

Surprisingly, while others are quick to point to historically low mortgage rates as the key ingredient sparking the unprecedented rise in residential real estate in recent years, Shiller dismisses this as "minor." Instead, he says the driving factor is "a change in the way we relate to society. I think we are living in a capitalist world right now."

He defines this is one where "you have to live off what you make, where everyone owns things, deals in markets, people are incentivized by the profit motive. I’m a fan of it as long as we have social insurance to protect people against the vagaries of capitalism. The more people think like business people, the more advanced our economy becomes."

He believes President Bush’s "ownership society" is another name for this type of system. "A capitalist economy does perform very well but it creates anxieties."

Consider that just a few generations back Americans weren’t worried about their investments — most didn’t have any! Our grandparents felt they’d be OK if they were decent citizens, and worked hard, says Shiller. In addition, "the government reassured us with slogans like 'A chicken in every pot.' People believed we'd take care of each other. The idea that home prices would get out of reach was not on their minds."

In fact, it wasn’t until after World War Two that average Americans saw home ownership within their grasp thanks to government-subsidized mortgages for veterans.

Now, says Shiller owning a home "has become a self-respect issue. You have to own your house now. It’s humiliating not to own a home. It’s a frightening thought." So as prices skyrocket, desperate buyers will agree to interest-only mortgages just to grab a piece of the American Dream.

Which could turn out to be a nightmare.

Or, at best, a mirage.

When he started researching the housing market Shiller says he was dumbfounded that no one had ever looked at the trend in U.S. residential real estate prices over any extended period of time. So he meticulously constructed his own.

Which led him to a rather startling conclusion: residential real estate has not been the wonderful investment most people believe it to be.

In fact, except for two periods — the early 1940s and the late 1990s — when adjusted for inflation, home prices in this country "have been mostly flat or declining."

This trend holds true even in what Shiller calls the "glamour cities" such as Los Angeles — where you hear of recent double-digit price increases. That's because while these areas get a lot of publicity when real estate prices skyrocket, they also tend to experience periods of significant price declines (which get less media coverage). As a result, the average inflation-adjusted price increase in Los Angeles real estate since 1980 isn’t much higher than that seen in Milwaukee.

Huh?! How can this be possible? We all know people — our parents or grandparents, perhaps — who bought their house for $30,000 and sold it for, say, more than $80,000 thirty years later.

Do the math. This works out to an annual return of about 3.5 percent — the average rate of inflation for the 20th century. Sure gramps got more for it than he paid, but all he earned was the inflation rate. When you factor that out, what he got back was his initial investment.

And a place for his family to live, which is the main reason you should be buying a home, according to Shiller. Speculating on real estate, hoping to get out at the right time so you can make a killing can get you into trouble. Because, just like the tech stock phenomenon, the real estate bubble is going to end and it could be ugly.

Just as he doesn’t give low interest rates credit for sparking the housing frenzy, Shiller doesn’t think higher rates will end it, at least not directly. In his opinion, talk starts financial bubbles and talk — the negative kind — ends them. "People change their minds. It’s like the stock market boom. There was lots of talk about the Internet bubble. That led to a decline in Internet stocks and started a contagion."

The tremendous volume of talk about the real estate bubble suggests to Shiller that "we could be coming to an end." In fact, prices are showing signs of cooling in some formerly hot markets such as Boston and San Diego as homes take longer to sell.

When asked if people should be buying residential real estate right now Shiller cautiously replies, "Not if you don’t need a place to live." He points out there are advantages to owning a home, provided, he adds, you don’t "overreach and can afford what you buy. Owning your home means you don’t have to worry about the rent going up if you’ve got a fixed-rate mortgage," he says.

The point is if you’re counting on real estate to be your ticket to a rich retirement, Shiller’s research suggests you shouldn’t bet on it. He expects that "home prices are going to be pretty stable over the next 100 years." They’ll increase at a rate similar to or just slightly above inflation. He predicts, "A hundred years from now in San Diego you’ll see glamorous high rises with ocean views [and they’ll be cheap]" in terms of what a dollar will buy at that point.

"The returns on real estate over the long term will not be like the stock market," says Shiller. "People don’t understand this." While he fully endorses owning some real estate as part of a diversified portfolio, he calls buying a second home a "risky investment" right now.

Whether you live in one of the "hot" housing boom areas or not, the most important issue is not whether or when the bubble will burst, but what the "end" will it look like. Shiller confesses he has no idea. He says a lot depends on the other factors or "symptoms" in the mix.

In the extreme scenario, buyers start to default on adjustable-rate mortgages and trigger a financial crisis in the banking sector. Real estate prices nosedive as properties are abandoned. If this is compounded by significantly higher oil prices, "it could change the psychology," says Shiller. "Consumer confidence plummets and people pull back on spending." This causes a downward economic spiral and leads to recession.

In the "soft landing" version, real estate prices simply remain flat for years, much as they did after the boom in the 1970s, until they’re back in line with inflation. "This is what people are counting on happening," says Shiller. He considers this outcome unlikely "because the signs of a bubble are stronger."

Though he admits there are so many variables it’s impossible to forecast it precisely, Shiller says he senses that the housing bubble is "more likely to turn out badly."

Later this week: Another economist, UCLA’s Dr. Edward Leamer, provides a way to measure the real estate bubble in your area and explains why all Americans should be worried, no matter where we live.

Hope this helps,

Gail

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