Bubble Boy Economist Ed Yardeni has a new fear: the real estate market.

(MONEY Magazine) – Bubble, bubble, toil and trouble." Okay, so I'm taking liberties with Shakespeare. But in the financial markets, as in Macbeth, talk of bubbles means that someone's up to no good.

Right now the talk is about a real estate bubble. Having just been burned badly in the stock market bubble of the 1990s, American investors are setting their sights on a new investment mania, residential real estate. Admittedly, buying a home is a time-honored tradition in this country. But just as the promise of ever-escalating stocks turned out to be too good to be true, the idea that you can't lose money on real estate may be setting us up for a fall.

Ed Yardeni, the chief investment strategist at Prudential Securities, believes that a bubble in housing is developing--a bubble that could do even more damage to the economy when it bursts than the collapse of the tech bubble has done over the past 2 1/2 years. Yardeni is well known for making bold predictions, his catastrophic forecasts for Y2K among them. Now, with all those year 2000 fears a distant memory, he thinks the next big problem on the economic horizon may occur where are hearts are.

Insana: Do you still think that a housing bubble is either occurring or likely to occur for the U.S. economy?

Yardeni: As you know, Ron, that's a rather controversial subject. I think most observers of the national housing market believe there is a bubble. The controversy is whether we're at the end of it and it's about to burst, or whether it's at an earlier stage. I think we're somewhere between the beginning and the middle of the housing bubble, so I certainly don't think it's about to burst. There are obviously some very solid fundamentals justifying higher prices, including both the aging of the baby boom and the entrance of baby boomers into the real estate market.

Insana: How long do you see this bubble continuing?

Yardeni: If, in fact, this continues, then we're talking about another 18 to 24 months of still higher home prices before we have to start to worry about a bursting bubble.

Insana: The people who argue with the notion that there is a bubble say that inventories of unsold homes haven't yet been built up, that there's no danger of overcapacity in the housing sector, the one sign that usually brings a bubble to a conclusion. What do you say to them?

Yardeni: I think that's a reasonable point. However, let's see what happens to home prices. Nationally they're up about 7% in the last 12 months, but there are a lot of metropolitan areas where home prices are up 20% to 25%--and most of that occurred in the last six months. So if we continue to see those kinds of appreciation rates in major metropolitan areas and start to see increases of more than 10% in the national average, I think you'll see people borrowing more against the gains, believing that you can't lose in real estate because home prices always go up. The main reason that there is the potential of a real estate bubble is because credit is amply and very cheaply available to purchase this asset. And notwithstanding Federal Reserve chairman Alan Greenspan's speech in Jackson Hole, Wyo. a few months back--that the Fed doesn't really have much to do with bubbles--the reality is that easy money is always a precondition for bubbles.

Insana: Alan Greenspan has argued that a national housing bubble is not only not likely but also nearly impossible. Why would you disagree with that statement?

Yardeni: That worries me because the Fed chairman was also blind to the Nasdaq bubble and argued that he wasn't going to bet against thousands of investors who believed that stocks were worth what they were paying back in '99 and early 2000. Greenspan is entitled to his opinion, and obviously he's got great credibility--I think overall he's done a fine job--but his track record on seeing bubbles and dealing with them isn't all that great. I would say in many ways he contributed to the stock market bubble in the late 1990s. It's unfortunate that he's chosen to even comment on the subject, because that suggests that, once again, he's not going to take any actions to avert a bubble, and he's not going to do anything to stop it.

The reality is the Fed needs housing to be strong, because right now that's the only sector that's responding to low interest rates.

Insana: What constitutes a bubble in housing compared with merely a bull market in housing?

Yardeni: Well, you know, it doesn't look like a bubble to the average individual buying a house, given that mortgage financing is at this time so cheap. But all the preconditions are there if home prices do continue to rise--partly based on good, solid fundamentals and partly on people's frustration with stocks and other financial assets, and their belief that you can't lose with real estate--and people increasingly borrow that equity as they refinance their mortgages. As they leverage up their real estate holdings, they become more vulnerable to having to sell that house if they can't make the mortgage payments, either because they lose their job or because interest rates rise down the road, as hard as that is to imagine right now. A bubble is always easy to define after the fact. It's an enormous run-up in prices that seems totally justified by the fundamentals--and then suddenly something happens to make people realize that the prices are too high.

Insana: How would a burst real estate bubble affect the economy?

Yardeni: We would probably lose the only sector that is clearly responding very positively to lower interest rates. And then the Fed would just completely lose its power to revive the economy, and we would have to start worrying about a deflationary scenario a la Japan for the past 10 years.

Insana: Now, Ed, you're hardly a stranger to provocative or even hyperbolic forecasts--Y2K, for instance....

Yardeni: Guilty as charged, Ron.

Insana: What led you last year to start thinking about the prospects for a housing bubble when most people thought the stock market would drag real estate down almost immediately?

Yardeni: I watch savings deposits data every week and, again, with all due respect to the Federal Reserve chairman, just about every economic historian who has studied the history of bubbles has concluded that easy money is a precondition for bubbles. The Fed has been forced to lower interest rates dramatically to offset the deflationary, recessionary consequences of the bursting of the Nasdaq bubble. And there's clearly only one sector that's benefiting from the Fed's easy money, and that's housing. It's being financed by individuals who are pouring money into savings accounts instead of buying stocks. In the past 52 weeks, half a trillion dollars has poured into savings deposits. It's not a liquidity trap, because the banks are lending that money out to the mortgage market. In the year that ended in the second quarter, we had $600 billion in additional mortgage lending.

Insana: In other words, the individual investor is now recycling his savings into the mortgage market rather than the stock market?

Yardeni: Exactly. For over a year now, the Fed has been trying to avert a very severe recession, and so far it has succeeded. But by keeping interest rates extremely low at a time when people want to be very liquid, it is creating a huge pool of very cheap money that's going straight into the real estate market. It's keeping existing home sales at near-record highs. Greenspan has really been an unusual Fed chairman in the sense that he wants us to prosper all the time; when we get into trouble, he tries to bail us out.

Insana: So he is trading one bubble for another?

Yardeni: In some ways he's the bubblemeister--though he's certainly not the only contributor to these bubbles.

Insana: Alan Greenspan does not believe that monetary policy inflates or deflates asset bubbles. You obviously don't agree.

Yardeni: I think he's wrong. He's trying to rewrite history, because the reality is that he gave so many speeches in which he basically acted as a cheerleader for the bubble. Greenspan is the one who had the credibility and promoted the idea of a New Economy more than anybody on Wall Street did. At the same time that he's trying to rewrite history, he's also trying to distance himself from any responsibility.

Insana: While we wait to find out who is correct here, Yardeni or Greenspan, can you offer any practical advice to individuals who might want to participate in the real estate market but not get popped by another asset bubble?

Yardeni: Despite my misgivings, real estate right now is one of the best tax deals on the planet. If you're a married couple and you own your home for two years, you get to keep all of the capital gains up to $500,000 tax-free forever. There's no better deal anywhere in the tax code. Then you can do it again. And you don't even have to wait five years anymore. You just have to live in the next house for two years. That could be another major contributor to a housing bubble: If more and more people become aware of the extraordinary tax advantage of capital gains and real estate, that could feed into my scenario.

Insana: But the trick, as in the stock market, is not to get overleveraged.

Yardeni: Absolutely. Let's forget about getting rich quick--getting rich slow is not a bad way to go. And, you know, I'm not rooting for this to turn into a bubble. I just think all the preconditions for that are there. Real estate is much more widely owned than stocks, and so it could have a much more damaging impact if we ratchet prices up too fast relative to the fundamentals and then are forced to take them down when the bubble bursts.

Most individuals should stay home and enjoy it, fix it up. If they want to invest in real estate in the stock market, the home-builder stocks are really cheap. They've been very volatile lately; it's been a wild ride. There's still a lot of skepticism about the long-term growth prospects of home builders. But if you want to own stocks with price/earnings ratios under 10, the home builders are the place to be.

Insana: We can worry about the bubble, then, another time. Thanks, Ed.

Ron Insana is co-anchor of CNBC's Business Center. His new book, TrendWatching, will be published in November by HarperBusiness.