THE X FACTOR: Yale University economics professor Robert Shiller says understanding how ‘animal spirits' work in the markets will bring more clarity to decisionmakers on the role of economic policy and government regulation. Photo: Chris Volpe After three long years of cliff-diving, an agonizing long tail of uncertainty has gotten very, very old for home builders. Their capital-intensive business models are exhausted even if their need for a plan—just a solid plan to get through the next 12 months—is not. After all, how many home builders will be around to witness the beginnings of recovery if their business plans and pro formas are populated with “maybes,” “it depends,” and “I don't knows”?

Economists seem better suited to handle doubt and unknowns when it comes to what's next and why. Yale economics professor Robert Shiller has become a household name in real estate and well beyond it, thanks in large part to a measurement tool he and colleague Karl Case developed to capture insight into repeated sales home prices, known as the S&P/Case-Shiller Home Price Indices.

Still, much as the S&P/Case-Shiller index—and its stunning vertical drop in the past 18 months—has become a flash point of the housing and economic crisis, and a critical knowledge point for anybody in any business that's trying to unravel the financial damage these crises have inflicted, Dr. Shiller himself thinks an “x factor” weighs as importantly to understanding the future as any data point.

So what is a guy who's relatively unfazed by dramatic unknowns and inexplicable economic gyrations going to tell a group of executives who are obsessed down to the very last half-percentage point about where house sale prices might settle? Shiller spoke with such executives at the Builder 100 Conference in Chicago in May. As much as these leaders wanted to hear when and at what level the Case-Shiller index will stabilize, his response, more often than not, was, “It depends.”

Depends on what?

That “x factor.” That x factor, deriving from a term first used in modern economics by John Maynard Keynes in the 1930s, is “animal spirits.” Simplistically, animal spirits are forces of collective human psyche that account for economic ups and downs that supply and demand of goods and labor resources do not and cannot explain.

“A striking fact about the big [financial, credit, employment, housing] mess we're in is that no one knows what to do,” Shiller confessed to some of home building's leaders. “It's all done on gut feeling.”

And just as Keynes revolutionized economics with the 1936 publication of The General Theory of Employment, Interest and Money, Shiller has set about raising an argument against today's conventionally held economics theory and practice, which has led to wide-scale deregulation of finance and other industries. With greater understanding of how animal spirits—moods, contagions of excitement or panic, irrational behavior, etc.—work in the markets, Shiller believes that decisionmakers will get more clarity about the role economic policy and government regulation can and should play in the economy and business.

To help explain the housing run-up, Shiller points to the relationship between residential investment—which counts dollars spent on all construction and improvements to for-sale and for-rent housing—and the nation's Gross Domestic Product (GDP). In fact, by 2006, residential investment as a percentage of GDP was higher than it had been in more than half a century.

“The essence of the housing bubble is contagion,” Shiller said. “In the social contagion of excitement, we're seeing an excess of animal spirits.” Prior to 2006, the last record for residential investment as a percentage of GDP was in the late 1940s, early 1950s. “As the threat of military conflict with Korea grew clear, people rushed to build, because they'd seen how the government shut down construction during World War II, and they wanted to get the work done before a new war broke out,” he said. In other words, fear of not getting to build drove the spending craze.

For a silver lining these days, Shiller is studying the University of Michigan index of consumer sentiment, which takes people's pulses on whether they're afraid we're heading into an economic depression or not. After slipping into scary territory at the start of 2009, April's numbers showed a dramatic recovery.

In trying to decipher the animal spirits at work in the sentiment snap-back, Shiller notes that people in general—the ones who know less about the deep, disturbing details of financial dislocation—feel more confident about the future than professionals who are more financially knowledgeable and closer to the problems. Animal spirits may be at work, he suggested, and they may just offset the fact of further technical dislocation in the financial markets.

“People are saying, ‘we've gotten over the scare,'” Shiller said. “It's got me wondering whether this point could be the real turning point in the economy.”

Still, Shiller is an economist, not a home builder. He follows that fillip of encouragement with his oft-used refrain. “I just don't know.”