FacebookTwitterGoogle+RedditEmail

When the Bubble Burst

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.

 

 

More articles by:

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.

Weekend Edition
June 22, 2018
Friday - Sunday
Karl Grossman
Star Wars Redux: Trump’s Space Force
Andrew Levine
Strange Bedfellows
Jeffrey St. Clair
Intolerable Opinions in an Intolerant Time
Paul Street
None of Us are Free, One of Us is Chained
Edward Curtin
Slow Suicide and the Abandonment of the World
Celina Stien-della Croce
The ‘Soft Coup’ and the Attack on the Brazilian People 
James Bovard
Pro-War Media Deserve Slamming, Not Sainthood
Louisa Willcox
My Friend Margot Kidder: Sharing a Love of Dogs, the Wild, and Speaking Truth to Power
David Rosen
Trump’s War on Sex
Mir Alikhan
Trump, North Korea, and the Death of IR Theory
Christopher Jones
Neoliberalism, Pipelines, and Canadian Political Economy
Barbara Nimri Aziz
Why is Tariq Ramadan Imprisoned?
Robert Fantina
MAGA, Trump Style
Linn Washington Jr.
Justice System Abuses Mothers with No Apologies
Martha Rosenberg
Questions About a Popular Antibiotic Class
Ida Audeh
A Watershed Moment in Palestinian History: Interview with Jamal Juma’
Edward Hunt
The Afghan War is Killing More People Than Ever
Geoff Dutton
Electrocuting Oral Tradition
Don Fitz
When Cuban Polyclinics Were Born
Ramzy Baroud
End the Wars to Halt the Refugee Crisis
Ralph Nader
The Unsurpassed Power trip by an Insuperable Control Freak
Lara Merling
The Pain of Puerto Ricans is a Profit Source for Creditors
James Jordan
Struggle and Defiance at Colombia’s Feast of Pestilence
Tamara Pearson
Indifference to a Hellish World
Kathy Kelly
Hungering for Nuclear Disarmament
Jessicah Pierre
Celebrating the End of Slavery, With One Big Asterisk
Rohullah Naderi
The Ever-Shrinking Space for Hazara Ethnic Group
Binoy Kampmark
Leaving the UN Human Rights Council
Nomi Prins 
How Trump’s Trade Wars Could Lead to a Great Depression
Robert Fisk
Can Former Lebanese MP Mustafa Alloush Turn Even the Coldest of Middle Eastern Sceptics into an Optimist?
Franklin Lamb
Could “Tough Love” Salvage Lebanon?
George Ochenski
Why Wild Horse Island is Still Wild
Ann Garrison
Nikki Haley: Damn the UNHRC and the Rest of You Too
Jonah Raskin
What’s Hippie Food? A Culinary Quest for the Real Deal
Raouf Halaby
Give It Up, Ya Mahmoud
Brian Wakamo
We Subsidize the Wrong Kind of Agriculture
Patrick Higgins
Children in Cages Create Glimmers of the Moral Reserve
Patrick Bobilin
What Does Optimism Look Like Now?
Don Qaswa
A Reduction of Economic Warfare and Bombing Might Help 
Robin Carver
Why We Still Need Pride Parades
Jill Richardson
Immigrant Kids are Suffering From Trauma That Will Last for Years
Thomas Mountain
USA’s “Soft” Coup in Ethiopia?
Jim Hightower
Big Oil’s Man in Foreign Policy
Louis Proyect
Civilization and Its Absence
David Yearsley
Midsummer Music Even the Nazis Couldn’t Stamp Out
FacebookTwitterGoogle+RedditEmail