FacebookTwitterGoogle+RedditEmail

When the Bubble Burst

by DEAN BAKER

For a mainstream economist Brad DeLong is about as good as you get. He is widely read in a number of areas including even (heaven forbid) economic history. He also is extraordinarily open-minded, recognizing that neo-classical economics may not hold all truths past, present, and future. This leaves me perplexed as to how he could be so off the mark in his understanding of the current crisis.

He sees the core problem as a loss of $500 billion in housing wealth from excessive exuberance in a few markets pushing house prices too high. Due to poor regulation, this triggered the financial earthquakes of September 2008, putting us where we are today.

My arithmetic is a bit different. I see the collapse of an $8 trillion housing bubble that was driving the economy. The collapse of this bubble cost us more than $1.2 trillion in annual private sector demand (@ 9 percent of GDP). The financial crisis was good entertainment, but secondary. There is nothing in our economist’s bag of tricks that gives us an easy mechanism for replacing 9 percent of GDP quickly, which leaves me wondering what the reality grasping Mr. DeLong been smoking?

The story of the bubble is painful, yet simple. Beginning in the mid-90s nationwide house prices diverged from a 100-year long trend. By the peak of the bubble in 2006, house prices were more than 70 percent above their trend level. This created more than $8 trillion in housing bubble wealth.

This wealth drove the economy in two ways. It had a direct effect in propelling construction, which peaked at 6.2 percent of GDP, about 2.5 percentage points above its post-war average. The bubble wealth also lead to a huge surge in consumption — through the long-known housing wealth effect. With a wealth effect of 5-7 cents on the dollar, the bubble would have been expected to lead to $400 billion to $560 billion in excess consumption demand.

When the bubble burst, consumption predictably plummeted. Throw in another $6 trillion in lost stock wealth and we get a decline of $600 billion to $800 billion in consumption. (The stock wealth effect is estimated at 3-4 cents on the dollar.)

The end of the bubble driven construction boom did not just cause residential construction to revert to its normal level. The huge overbuilding of the bubble years meant that there was an enormous oversupply of housing. Residential construction has fallen back by more than 3.0 percentage points of GDP or close to $500 billion a year. There was a follow-on bubble in non-residential construction which has also burst. Add in the loss of another $100-$200 billion in annual demand from non-residential construction.

This gets a total loss in annual demand of more than $1.2 trillion. Note that the financial crisis appears nowhere in this story. Exactly what mechanism do we have in the private economy for replacing $1.2 trillion in private demand in a short period of time?

Do we have some story whereby consumers who have just lost much or all of their life savings will keep spending as though nothing has happened? Do businesses suddenly go out and invest like crazy (they would have to more than double the share of equipment and software spending in GDP to fill the gap) at a time when demand has fallen through the floor? Do exports suddenly surge even when the dollar rises and other countries are experiencing similar downturns?

Brad, like most of his kind, didn’t see the bubble on the way up. But surely he should be able to recognize the bubble and its consequences now.

Frankly, I am at loss to understand the fixation on financial markets as an explanation for the crisis. Large firms are sitting on more than $2 trillion in cash. Furthermore, they can borrow much more at historically low interest rates. If there are good investment opportunities out there, we should expect these highly liquid large firms to be running wild taking advantage of them while their smaller competitors are crippled by a lack of access to credit.

We don’t see this. In fact, Wal-Mart, Starbucks and the rest of scaled back their expansion plans in recognition of the weak economy. Let’s get this discussion back to reality. The problem was and is the housing bubble, let’s not muddle the picture.

DEAN BAKER is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy and False Profits: Recoverying From the Bubble Economy.

This column was originally published by TPM Café.

 

 

Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.

More articles by:
Weekend Edition
May 27, 2016
Friday - Sunday
John Pilger
Silencing America as It Prepares for War
Rob Urie
By the Numbers: Hillary Clinton and Donald Trump are Fringe Candidates
Paul Street
Feel the Hate
Daniel Raventós - Julie Wark
Basic Income Gathers Steam Across Europe
Andrew Levine
Hillary’s Gun Gambit
Jeffrey St. Clair
Hand Jobs: Heidegger, Hitler and Trump
S. Brian Willson
Remembering All the Deaths From All of Our Wars
Dave Lindorff
With Clinton’s Nixonian Email Scandal Deepening, Sanders Must Demand Answers
Pete Dolack
Millions for the Boss, Cuts for You!
Gunnar Westberg
Close Calls: We Were Much Closer to Nuclear Annihilation Than We Ever Knew
Peter Lee
To Hell and Back: Hiroshima and Nagasaki
Karl Grossman
Long Island as a Nuclear Park
Binoy Kampmark
Sweden’s Assange Problem: The District Court Ruling
Robert Fisk
Why the US Dropped Its Demand That Assad Must Go
Martha Rosenberg – Ronnie Cummins
Bayer and Monsanto: a Marriage Made in Hell
Brian Cloughley
Pivoting to War
Stavros Mavroudeas
Blatant Hypocrisy: the Latest Late-Night Bailout of Greece
Arun Gupta
A War of All Against All
Dan Kovalik
NPR, Yemen & the Downplaying of U.S. War Crimes
Randy Blazak
Thugs, Bullies, and Donald J. Trump: The Perils of Wounded Masculinity
Murray Dobbin
Are We Witnessing the Beginning of the End of Globalization?
Daniel Falcone
Urban Injustice: How Ghettos Happen, an Interview with David Hilfiker
Gloria Jimenez
In Honduras, USAID Was in Bed with Berta Cáceres’ Accused Killers
Kent Paterson
The Old Braceros Fight On
Lawrence Reichard
The Seemingly Endless Indignities of Air Travel: Report from the Losing Side of Class Warfare
Peter Berllios
Bernie and Utopia
Stan Cox – Paul Cox
Indonesia’s Unnatural Mud Disaster Turns Ten
Linda Pentz Gunter
Obama in Hiroshima: Time to Say “Sorry” and “Ban the Bomb”
George Souvlis
How the West Came to Rule: an Interview with Alexander Anievas
Julian Vigo
The Government and Your i-Phone: the Latest Threat to Privacy
Stratos Ramoglou
Why the Greek Economic Crisis Won’t be Ending Anytime Soon
David Price
The 2016 Tour of California: Notes on a Big Pharma Bike Race
Dmitry Mickiewicz
Barbarous Deforestation in Western Ukraine
Rev. William Alberts
The United Methodist Church Up to Its Old Trick: Kicking the Can of Real Inclusion Down the Road
Patrick Bond
Imperialism’s Junior Partners
Mark Hand
The Trouble with Fracking Fiction
Priti Gulati Cox
Broken Green: Two Years of Modi
Marc Levy
Sitrep: Hometown Unwelcomes Vietnam Vets
Lorenzo Raymond
Why Nonviolent Civil Resistance Doesn’t Work (Unless You Have Lots of Bombs)
Ed Kemmick
New Book Full of Amazing Montana Women
Michael Dickinson
Bye Bye Legal High in Backwards Britain
Missy Comley Beattie
Wanted: Daddy or Mommy in Chief
Ed Meek
The Republic of Fear
Charles R. Larson
Russian Women, Then and Now
David Yearsley
Elgar’s Hegemony: the Pomp of Empire
FacebookTwitterGoogle+RedditEmail