The Housing Bubble and the Lesser Depression: Either the Very Sharp Dean Baker or I Am Hopelessly Confused

And, of course, I think that it is him…

Dean maintains and has long maintained that the financial crisis was froth that had little impact on the overall economy:

Dean Baker: The Simple Reason for the Long Downturn: Housing Bubble Burst: “Many economists and business writers view the duration and severity of the downturn as…

…[having] something to do with the financial crisis… looming as a dark cloud hanging over the head of an otherwise healthy economy. Fortunately, for arithmetic fans the story was never very difficult. In the last business cycle the economy was being driven in large part by a housing bubble. The unprecedented run-up in nationwide house prices lead to booms in both residential construction and consumption…. In the 1980s and 1990s… residential construction accounted for an average of less than 4.4 percent of GDP. At the peak… in 2005, construction rose to more than 6.5 percent of GDP…. The $8 trillion in equity created by the housing bubble made homeowners feel wealthier…. When the bubble burst, homeowners cut back their consumption since this wealth no longer existed…. A long and severe downturn that was entirely predictable. There is no mystery about the downturn or the potential routes to recovery. The only problem is that the people in control of economic policy have no interest in taking the steps necessary to bring the economy back to full employment…

I agree that the vanishing of $8 trillion of housing equity pushed private consumption down by an annual amount of $400 billion after the bubble burst. And I agree that the boom in construction pushed private investment spending up by an annual amount $300 billion before the bubble burst. And I agree that with a simple multiplier of 2 those two shocks to autonomous spending can account for the downturn.


There are other things going on as well.

The first $250 billion of the fall in construction spending had no net effect on the level of economic activity. Why not? Because the financial flows that had and would have funded construction were redirected to fund increased exports and increased business investment:

FRED Graph FRED St Louis Fed

There is every reason to think that, in the absence of the financial crisis, the Federal Reserve’s lowering interest rates as consumption spending fell in response to the decline in home equity would have pushed down the value of the dollar and made further hikes in business investment a profitable proposition and so directed the additional household savings thus generated into even stronger booms in exports and business investment: in the absence of the financial crisis, what was in store for the U.S. was not a long, deep depression but, rather, a shallow recession plus a pronounced sectoral rotation.

Graph S P Case Shiller 20 City Composite Home Price Index© FRED St Louis Fed

But the financial crisis doubled the size of the housing bubble collapse. After all, housing values are now halfway back from their 2009 trough to their 2006 peak.

And it was the financial crisis–not the collapse of the housing bubble–that led to the final tranche of the decline in construction, and to the catastrophic collapses in business investment and exports in 2008:

FRED Graph FRED St Louis Fed

And slow recovery since has been the product of three factors since:

  1. The inability given low inflation of the Federal Reserve to push interest rates low enough to attain the financial crisis-depressed Wicksellian natural rate of interest.

  2. The extraordinary fiscal austerity since the start of 2010.

  3. The failure to reorganize the broken housing finance channel and thus restore residential construction to some semblance of normality.

FRED Graph FRED St Louis Fed

Indeed, even with the zero lower bound on interest rates constraining monetary policy, we would probably have had a satisfactory recovery were it not for fiscal austerity and the failure to clear the clogged housing-finance channel. The business-investment and exports recoveries have been impressive:

FRED Graph FRED St Louis Fed

None of the catastrophe we have suffered and continue to suffer was baked in the cake by the housing bubble.

April 2, 2015

Connect with us!

Explore the Equitable Growth network of experts around the country and get answers to today's most pressing questions!

Get in Touch