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:
July 26, 2016
Andrew Levine
Pillory Hillary Now
Kshama Sawant
A Call to Action: Walk Out from the Democratic National Convention!
Russell Mokhiber
The Rabble Rise Together Against Bernie, Barney, Elizabeth and Hillary
Jeffrey St. Clair
Don’t Cry For Me, DNC: Notes From the Democratic Convention
Angie Beeman
Why Doesn’t Middle America Trust Hillary? She Thinks She’s Better Than Us and We Know It
Paul Street
An Update on the Hate…
Fran Shor
Beyond Trump vs Clinton
Ellen Brown
Japan’s “Helicopter Money” Play: Road to Hyperinflation or Cure for Debt Deflation?
Richard W. Behan
The Banana Republic of America: Democracy Be Damned
Binoy Kampmark
Undermining Bernie Sanders: the DNC Campaign, WikiLeaks and Russia
Arun Gupta
Trickledown Revenge: the Racial Politics of Donald Trump
Sen. Bernard Sanders
What This Election is About: Speech to DNC Convention
David Swanson
DNC Now Less Popular Than Atheism
Linn Washington Jr.
‘Clintonville’ Reflects True Horror of Poverty in US
Deepak Tripathi
Britain in the Doldrums After the Brexit Vote
Louisa Willcox
Grizzly Threats: Arbitrary Lines on Political Maps
Robert J. Gould
Proactive Philanthropy: Don’t Wait, Reach Out!
Victor Grossman
Horror and Sorrow in Germany
Nyla Ali Khan
Regionalism, Ethnicity, and Trifurcation: All in the Name of National Integration
Andrew Feinberg
The Good TPP
400 US Academics
Letter to US Government Officials Concerning Recent Events in Turkey
July 25, 2016
Sharmini Peries - Michael Hudson
As the Election Turns: Trump the Anti-Neocon, Hillary the New Darling of the Neocons
Ted Rall
Hillary’s Strategy: Snub Liberal Democrats, Move Right to Nab Anti-Trump Republicans
William K. Black
Doubling Down on Wall Street: Hillary and Tim Kaine
Russell Mokhiber
Bernie Delegates Take on Bernie Sanders
Quincy Saul
Resurgent Mexico
Andy Thayer
Letter to a Bernie Activist
Patrick Cockburn
Erdogan is Strengthened by the Failed Coup, But Turkey is the Loser
Robert Fisk
The Hypocrisies of Terror Talk
Lee Hall
Purloined Platitudes and Bipartisan Bunk: An Adjunct’s View
Binoy Kampmark
The Futility of Collective Punishment: Russia, Doping and WADA
Nozomi Hayase
Cryptography as Democratic Weapon Against Demagoguery
Cesar Chelala
The Real Donald Trump
Julian Vigo
The UK’s Propaganda Machinery and State Surveillance of Muslim Children
Denis Conroy
Australia: Election Time Blues for Clones
Marjorie Cohn
Killing With Robots Increases Militarization of Police
David Swanson
RNC War Party, DNC War Makers
Eugene Schulman
The US Role in the Israeli-Palestine Conflict
Nauman Sadiq
Imran Khan’s Faustian Bargain
Peter Breschard
Kaine the Weepy Executioner
Weekend Edition
July 22, 2016
Friday - Sunday
Jeffrey St. Clair
Good as Goldman: Hillary and Wall Street
Joseph E. Lowndes
From Silent Majority to White-Hot Rage: Observations from Cleveland
Paul Street
Political Correctness: Handle with Care
Richard Moser
Actions Express Priorities: 40 Years of Failed Lesser Evil Voting
Eric Draitser
Hillary and Tim Kaine: a Match Made on Wall Street
FacebookTwitterGoogle+RedditEmail