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Masters of Illusion

Two Fed economists propose a controversial solution to a long-term puzzle: Why do home prices soar in both high and low inflation eras?

December 1, 2007


Douglas Clement Editor, The Region

In the early 2000s (you may recall) the housing market was hot. And in prescient reports on world property values, the Economist magazine warned of a housing price bubble—in the United States and elsewhere—fueled, in part, by “money illusion.”

Lured by low interest rates and convinced that they were getting a historic deal, people were taking out mortgages, snapping up homes and sending prices rapidly upward. But these borrowers were making a common error—they were forgetting about inflation. The low nominal interest rates of the early 2000s were accompanied by low inflation rates—indeed, the Fed was worried about deflation—so the inflation-adjusted rate of interest was not necessarily a great bargain. “Home-buyers who think that low interest rates make buying a house cheaper are suffering money illusion,” observed the Economist.

Economists Martin Schneider and Monika Piazzesi
Minneapolis Fed Senior Economists
Martin Schneider and Monika Piazzesi

Though the term was coined by John Maynard Keynes, “money illusion” was treated most fully by Irving Fisher in his 1928 book by that name. Fisher defined it as “failure to perceive that the dollar, or any other unit of money, expands or shrinks in value.” In other words, it’s thinking about money in nominal terms rather than purchasing power. A person who falls prey to money illusion won’t grasp that inflation wears away the real value of money as relentlessly as rust corrodes iron.

Still, many economists believe that “money illusion” is a myth. People are, for the most part, rational beings and make lucid if imperfect financial decisions. After reviewing the concept and debate over its relevance in the Palgrave dictionary of economics, Brown University economist Peter Howitt notes, “In short, the attitude of economists to the assumption of money illusion can best be described as equivocal.”

Illusion or not, the disease appeared to be pandemic in the early 2000s, and the Economist was reasonable to highlight it as a possible source of the extraordinary boom in housing prices.

But there’s just one problem with this picture: Housing price booms also occurred in the 1970s, when nominal interest rates were extremely high. If low nominal interest rates lure buyers into housing markets, wouldn’t high nominal rates repel them, sending home prices down? If money illusion is a fact of economic life, how can we account for booms when nominal interest rates—and inflation rates—are both high and low?

In a recent paper, two Minneapolis Fed staff economists provide an intriguing answer, and their theory hinges on the idea that not all investors are alike: Some succumb to money illusion; others are immune. As a result, investors disagree about the real interest rate and perceive different rates of return to various assets, including homes. Their interaction in credit markets fuels housing price booms in both high and low inflation environments. Indeed, the economists’ work suggests that as credit markets proliferate, the potential for price booms increases.

“Disagreement about real interest rates between … investors stimulates borrowing and lending and drives up the price of collateral,” write Monika Piazzesi and Martin Schneider in “Inflation Illusion, Credit, and Asset Pricing,” a National Bureau of Economic Research working paper. “The resulting housing boom is stronger if credit markets are more developed.”

An international pattern

Piazzesi and Schneider, senior economists at the Minneapolis Fed, begin their paper with a presentation of evidence. For 12 industrialized nations,1 they present data on stock and house values, inflation rates and real interest rates from 1970 to 2004.2

The patterns revealed are remarkable. In each country, to greater and lesser extents, housing values rose and stock values declined during the high inflation era of the late 1970s and the low inflation period of the early 2000s. “During the inflation episode of the late 1970s and the early 1980s,” they write, “the price-dividend ratio of housing was relatively high, while the price-dividend ratio of stocks was relatively low. During the disinflation episode of the 2000s, the same situation emerges. Moreover, ex post real rates [of interest] were low, or even negative, during both episodes.”

“So it’s a common pattern,” notes Piazzesi, “and these international facts convinced us that it’s not just an [anomaly] in the United States that you can observe high house prices in both high and low inflation environments.”

Two types of investors

To explain this persistent phenomenon, Piazzesi and Schneider assume the existence of two kinds of investors: those who ignore inflation and those who account for it. Their paper uses shorthand to refer to them, respectively, as “illusion investors” and “smart investors.”

In conversation at the Minneapolis Fed, the economists explain that the distinction isn’t a question of intelligence, but of financial knowledge and experience. “Many people have a very good estimate of what inflation is going to be,” says Piazzesi. “But they have a hard time distinguishing between real and nominal rates of return.” In other words, intelligent people may well hold illusions when it comes to financial calculation and asset allocation.

“Smart” investors, on the other hand, understand the “Fisher equation,” which states that the real rate of interest equals the nominal rate minus expected inflation. Suppose a bank offers a certificate of deposit at 5 percent a year when expected inflation is 3 percent. An illusion investor will ignore inflation and simply expect a 5 percent return, but a smart investor will realize that the CD’s real return is just 2 percent. This higher level of financial sophistication gives smart investors an edge in calculating relative returns to different assets.

“It seems natural to assume that not everybody is equally financially sophisticated,” says Piazzesi. “To allow people to deal with inflation differently was a very natural way of thinking about the market.”

“Especially the housing market,” adds Schneider, “where you have lots of households who don’t make many other major financial decisions like buying stocks.”

“Right,” Piazzesi continues. “Many people don’t need to process all that information because they’re not faced with big investment decisions. And then there are others who are very sophisticated. They know exactly how returns work and what the real and nominal returns are.”

The model

What happens in a market with both types of investors? To explore the effects of investor interaction, the economists build a mathematical model in which households choose between consuming their resources immediately and saving them for later. If they save, their next decision is whether to invest their savings in bonds or housing. This asset allocation decision is based on current prices of bonds and homes, and expected payoffs to each, which depend on interest rates and inflation.

The economists place a few other constraints on their model. A crucial one: Households can’t borrow against future income; they can borrow only by issuing debt that uses their homes as collateral.

They then compute an equilibrium for a benchmark version of the model in which all households (both illusion and smart) agree on expected bond payoffs—in essence, a period when expected inflation and the nominal interest rate are at their long-run averages. At this benchmark, they find, “the house price is independent of expected inflation.” Home values, in other words, are determined by real fundamentals, such as the present value of future housing services.

But if households disagree? Here there are two possibilities, but both have the same effect on housing prices.

Soaring markets

Suppose expected inflation is below its historical average. Smart investors will take this into account when making their asset allocation decisions, but illusion investors will ignore it. Smart investors will subtract low expected inflation from the nominal return from bonds and understand that real bond returns are attractively high: They'll lend money. Illusion investors, ignoring the impact of inflation, will simply see low nominal rates of interest and a prime time to borrow, investing the funds in housing. Borrowers who perceive low real interest rates are willing to pay more for houses, so prices will climb: A housing boom results.

What about the opposite scenario: expected inflation above the historical average? Illusion investors will invest in bonds because they see them offering high nominal interest rates. Smart investors will subtract high inflation from nominal rates of interest on bonds and realize that real rates of interest are historically low. They’ll borrow from illusion investors, using homes as collateral. Again, as borrowers perceive low real interest rates, housing prices will soar.

The first scenario of disagreement on bond payoffs describes the housing market of the 2000s: low inflation, low interest rates and a housing price boom. The second scenario is the 1970s: high inflation, high interest rates and, again, a housing price boom. But the role of smart and illusion investors is reversed. In the 1970s, smart investors borrowed money from illusion investors. In the 2000s, smart households were the lenders.

“So, our model says that the boom of the 2000s was one where the
illusion people were the big borrowers,” explains Schneider. “Of course, in any period, young people tend to borrow more than the old, and there are other predictable patterns. But aside from that, in the 2000s it was the illusion investors who were borrowing a lot, the financially-not-as-sophisticated people.”

“And this was different than the ’70s when the borrowers were the smart guys, according to our model,” continues Piazzesi. “They understood exactly what was going on with inflation. They thought, ‘Okay, we’re paying a high nominal rate for our mortgage, but that’s not bad because we’re going to get a great deal later [because of inflation.]’ The unsophisticated people saw the high nominal interest rate and thought, ‘Oh, great, I’m going to lend to these people.’ It seemed like a great deal to them.”

“So in the ’70s, it was smart investors driving up house prices, and more recently, the relatively unsophisticated people,” says Schneider.

Credit markets and subprime mortgages

According to the economists’ model, structural development in financial markets can also contribute to housing price booms. As Schneider explains, “For disagreement about real interest rates to spill over into housing prices, there needs to be a connection between the two markets. In our model, the connection is that you can only borrow if you have a house for risk collateral.”

With collateral in the model, there is a clear relationship between leverage—loan-to-value ratios—and home prices. Also, according to the paper, “with more opportunities for leverage, it takes fewer inflation illusion agents to generate enough disagreement for a house price boom.” Taken together, these characteristics of the model “suggest that financial development may explain why the house price booms of the 2000s were typically stronger than those of the 1970s.”

In separate work with Matthias Doepke at the University of California, Los Angeles, Schneider has shown that recent development of financial markets has increased the fraction of households who participate in mortgage markets, especially among lower income groups. An increase in mortgage market participation rates, according to the Piazzesi/Schneider model, should lead to housing price booms. Also, an inflow of households with less financial experience may well generate more disagreement about real rates of interest—the source of housing price jumps, according to the model.

Today’s housing market

What does the model tell us about the current period, when housing prices have moderated and the subprime mortgage market has imploded? The Piazzesi/Schneider model predicts a housing price boom only if nominal interest rates (driven mainly by inflation expectations) are either very high or very low. “Over the last two years, or year and a half, nominal rates have gone back to more typical values, closer to historical averages,” observes Schneider. “So inflation illusion should be less important because people perceive the cost of borrowing to be higher. They do less of it, and there’s less demand for collateral. There is less disagreement [about rates of return].” And more moderate pricing.

The model also suggests that the fraction of the population that drove up house prices in the early 2000s were those who suffered from inflation illusion—by definition the financially unsophisticated and by implication those with less experience in credit markets.

“It’s the financially unsophisticated households, at least according to our model, who were driving the [recent] housing price boom,” notes Piazzesi. “To the extent that these people were getting their hands on mortgages they could not afford because they were not informed well enough about how the mortgage was structured, I think you could argue that by analogy these people may have bought mortgage products they should not have bought.”

“We haven’t looked at the data on this,” adds Schneider, “but it seems at least from the anecdotal evidence that a lot of the borrowers, especially borrowers who took on a lot of mortgage debt and therefore are now in trouble, those households were not very sophisticated financially.”

The broader agenda

Asked about motivation for this paper, Schneider points out that macroeconomists have devoted a great deal of attention to bond and equity markets but, by comparison, have largely neglected houses, the primary financial asset of most U.S. households.

“Housing as an asset, and the behavior of its price, is somehow not at the forefront of research in finance and macro,” he notes. “Over the last year we’ve thought a lot about the fact that housing is a very important asset for U.S. households, but most asset pricing models do not include housing pricing. That is something that we’ve long been wondering about.”

Important in its own right, understanding the behavior of the housing market is also crucial because of its interrelationship with the stock and bond markets; this link will guide future efforts. “Our general research agenda is to understand movements in house prices, stock prices and interest rates, so the three big markets: bonds, stocks and housing,” says Piazzesi. “This was a setup that builds understanding of the interaction of housing markets and bond markets. What’s not yet apparent is whether inflation illusion is something that could also explain low stock prices in the ’70s.”

Compared to housing markets, equity markets have far more financially sophisticated participants, so inflation illusion should have had less impact on stock prices. “It would be very interesting to quantify the impact [inflation illusion has] on markets other than housing and bonds,” says Piazzesi. “Inflation illusion helps [us] understand housing and bond markets but not necessarily others. So we’re thinking about different ways of integrating this story in larger setups where people trade equity.”


Piazzesi and Schneider have collaborated often, preparing half a dozen research papers together on asset pricing and the macroeconomy. A shared background helps to explain the relationship. The two attended the same undergraduate institution in Germany, the University of Bonn, and the same graduate school, Stanford University. From 2000 to 2003, they were both assistant professors at UCLA.

But the following year, Schneider took a position at New York University, where he received tenure this year. And Piazzesi went to the University of Chicago’s Graduate School of Business, where she too was granted tenure. (Piazzesi received the 2005 Bernácer Prize as Europe’s best financial or macroeconomist under the age of 40 and the 2006 Elaine Bennett Prize, given by the American Economic Association every two years in recognition of outstanding research by a woman at the beginning of her career.)

Working together at the Minneapolis Fed has given Piazzesi and Schneider more time to collaborate, and productivity has thrived through face-to-face exchange of ideas, drafts and proofs. Piazzesi often spent time here even before becoming a senior economist in August; Schneider has been on staff since 2005. “But, of course, it’s easier if I can just walk down the hall and show him the new estimation,” observes Piazzesi. “It’s easy to get very intense when you’re geographically close together.” In the fall of 2008, the two economists will leave the Fed and their current academic affiliations to join the economics faculty at Princeton University. (Both economists later decided to accept professorship offers from Stanford University, and moved there in the fall of 2008.)

The Summers critique

In 1981, a young economist at Harvard examined the evidence for and against money illusion and observed that in nearly a century’s worth of data, nominal interest rates didn’t adjust systematically to inflation expectations, as theory predicts they will. The evidence “suggests that Fisher was correct in pointing to money illusion as the cause of the imperfect adjustment,” he wrote. “It appears to be difficult to reconcile the data with standard economic models of fully informed and rational agents.”

Lawrence Summers, later secretary of the Treasury and Harvard University’s president, thus joined the longstanding debate over the existence of money illusion. The rational expectations revolution that swept through macroeconomics in the 1970s and ’80s argued that economic actors were rational—they couldn’t be fooled, whether by policy surprises or money illusions. The very concept of “money illusion” was dismissed as an illusion. In his 1971 presidential address to the American Economic Association, economist James Tobin noted—ironically—“An economic theorist can, of course, commit no greater crime than to assume money illusion.”

And, indeed, while Summers’ review generally seemed to support the notion of money illusion, he also furnished a strong counterargument: the 1970s housing market. “If home buyers displayed substantial inflation illusion,” he wrote, “high nominal interest rates should have choked off housing demand, and led to a decline in real prices.”


“It’s true,” acknowledges Piazzesi, “that in the ’70s all long-term asset prices should have been down together. Stock prices should have been down, as they were, and house prices should have also been down. And they weren’t. That tension discouraged a lot of people from thinking about inflation illusion.”

The Summers critique does not apply to the Piazzesi/Schneider model because there are heterogeneous economic actors—some who suffer the illusion and others who don’t. As a result, the coexistence of money illusion and a soaring housing market makes sense in eras of both high and low inflation.

Still, by suggesting that money illusion affects housing markets and bond markets, and by proposing that economic actors may differ from one another, Piazzesi and Schneider are clearly treading on thin ice within their profession. When a visitor notes that taking that stance is controversial, especially for an economist from the University of Chicago, where rational economic agents are stock in trade, Piazzesi laughs. “Oh, yes,” she admits. “My colleagues give me a great deal of grief about it.”

But her colleagues also know she and Schneider may be right.


1 The 12 countries are Australia, Canada, France, Germany, Ireland, Italy, Japan, Netherlands, Spain, Sweden, the United Kingdom and the United States.

2 The stock and house values are, technically, price-dividend ratios. For stocks, relevant data were readily available using Morgan-Stanley Country Indices. For houses, the financial equivalent of a dividend is rent, but obtaining accurate, internationally comparable price and rent data for houses was more problematic than for stocks. Piazzesi and Schneider prefer national accounts data, but they were available only for the United Kingdom and the United States. For the other countries, the economists relied on price indexes constructed by national central banks and rent data available from Thomson Datastream, a financial database.