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.

Like What You’ve Read? Support CounterPunch
Weekend Edition
September 4-6, 2015
Vijay Prashad
Regime Change Refugees: On the Shores of Europe
Lawrence Ware
No Refuge: the Specter of White Supremacy Still Haunts Black America
Paul Street
Bi-Polar Disorder: Obama’s Bait-and-Switch Environmental Politics
Kali Akuno
Until We Win: Black Labor and Liberation in the Disposable Era
Arun Gupta
Field Notes to Life During the Apocalypse
Steve Hendricks
Come Again? Second Thoughts on My Ashley Madison Affair
Paul Craig Roberts
Whither the Economy?
Ron Jacobs
Bernie Sanders’ Vision: As Myopic as Every Other Candidate or Not?
Rob Urie
Capitalism and Crisis
Jeffrey St. Clair
Arkansas Bloodsuckers: the Clintons, Prisoners and the Blood Trade
Richard W. Behan
Republican Fail, Advantage Sanders: the Indefensible Budget for Defense
Ted Rall
Call It By Its Name: Censorship
Susan Babbitt
“Swarms” Entering the UK? What We Can Still Learn About the Migrant Crisis From Che Guevara
Andrew Levine
Compassionate Conservatism: a Reconsideration and an Appreciation
John Wight
Adrift Without Sanctuary: a Sick and Twisted Morality
Binoy Kampmark
Sieges in an Age of Austerity: Monitoring Julian Assange
Colin Todhunter
Europe’s Refugee Crisis and the Depraved Morality of David Cameron
JP Sottile
Chinese Military Parade Freak-Out
Kathleen Wallace
The Child Has a Name, They All Do
David Rosen
Why So Few Riots?
Norm Kent
The Rent Boy Raid: Homeland Security Should Monitor Our Borders Not Our Bedrooms
Michael Welton
Canada’s Arrogant Autocrat: the Rogue Politics of Stephen Harper
Ramzy Baroud
Palestine’s Crisis of Leadership: Did Abbas Destroy Palestinian Democracy?
Jim Connolly
Sniping at the Sandernistas: Left Perfectionism in the Belly of the Beast
Pepe Escobar
Say Hello to China’s New Toys
Sylvia C. Frain
Tiny Guam, Huge US Marine Base Expansions
Pete Dolack
Turning National Parks into Corporate Profit Centers
Ann Garrison
Africa’s Problem From Hell: Samantha Power
Dan Glazebrook
British Home Secretary Theresa May: Savior or Slaughterer of Black People?
Christopher Brauchli
Poor, Poor, Pitiful Citigroup
Norman Pollack
Paradigm of a Fascist Mindset: Nicholas Burns on Iran
Barry Lando
Standing at the Bar of History: Could the i-Phone Really Have Prevented the Holocaust?
Linn Washington Jr.
Critics of BlackLivesMatter# Practice Defiant Denial
Roger Annis
Canada’s Web of Lies Over Syrian Refugee Crisis
Chris Zinda
Constitutional Crisis in the Heart of Dixie
Rannie Amiri
Everything Stinks: Beirut Protests and Garbage Politics
Graham Peebles
Criminalizing Refugees
Missy Comley Beattie
In Order To Breathe
James McEnteer
Blast From the Past in Buenos Aires
Patrick Higgins
A Response to the “Cruise Missile Left”
Tom H. Hastings
Too Broke to Pay Attention
Edward Leer
Love, Betrayal, and Donuts
Louis Proyect
Migrating Through Hell: Quemada-Diez’s “La Jaula de Oro”
Charles R. Larson
Class and Colonialism in British Cairo
David Yearsley
Michael Sarin: Drumming Like Summer Fireworks Over a Choppy Lake