Beating up on Brad DeLong
from 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.
See article on original website
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of False Profits: Recovering from the Bubble Economy. He also has a blog, “Beat the Press,” where he discusses the media’s coverage of economic issues.
Mr. Baker knows way more about economics that I do; but his observation that Mr. De Long is “mainstream” and as good as you can get there mostly flummoxes me – or does it prove the narrowness of “mainstream”, as people here regularly try to teach? I stumbled into this from DeLong:
http://delong.typepad.com/sdj/2010/11/why-are-the-technocrats-of-the-center-missing-in-action.html
from an exchange here:http://www.interfluidity.com/v2/998.html
When you look at DeLong’s proposals to balance the budget (setting aside entirely the arguments from the MMT people at UMKC and Levy that no such thing should be done in the foreseeable future), cutting defense is noticeably not there – unless it’s smuggled in with Pay-Go. Is that just real politic? Or a genuine mainstream belief? I don’t know….
What I do know is that the parameters in respectable media are simply whacked. Megan McCardle is a woman so full of it her plumbing backs up – and then she complains about it in print. (I do not exaggerate, I wish I’d saved the url.) She writes about recent events in Ireland and Spain:
http://www.theatlantic.com/business/archive/2010/11/are-we-entering-another-phase-of-financial-crisis/67080/
Her reference point economists are Cowan and Kling….
My point is not to sully this blog with lower rent voices squawking in – but rather, since Mr. Baker also beats on the press for being less than what it can and should be, I wanted to share what I see in what’s considered reasonable discourse.
I also was bemused that both Krugmann and DeLong are taking a drubbing here, as the Steve Waldman blog (Interfluidity referenced above) was recently focused on them – Waldman’s some kind of libertarian econ, near as I can tell, but he was arguing that things WOULD be better if more of what Krugmann and DeLong would do got done….
The true value of landed property is the capitalised rental value. Any deviation from this norm indicates a bubble. Lenders should be constrained by regulation to recognise this fact. They will not do it voluntarily because they are after the rent for themselves.
As I see it, money for homes got real cheap via ‘financially innovative new loan products’ and just plain cheating on mortgage applications on the consumer/origination side. This made it possible for everyone to qualify for a loan, so everyone wanted a home. Ergo, higher demand for a limited supply = prices go up + new construction kicks into high gear = bubble.
… from that point on I agree with Mr. Baker. However, our economy doesn’t exist in it’s own bubble – and that’s where ‘financial innovation’ via the securitization trend came into play, and greatly magnified our problem into one of socialized risk and privatized gain, globally.
The result was a huge sucking sound reflecting money being sucked out of the real economy and into the coffers of banks at a consumer, institutional, federal, and global level via bank bailouts which are now sucking the same wind out of national budgets. Add the knock-on austerity measures as icing on the cake and you see that, while the US housing bubble was at the center of the problem, the problem is rightly characterized as a global financial markets’ crisis.
So, the economic problem at hand is far greater than the sum of the US housing bubble’s $1.2T in lost private demand.
It’s a functional equation of deregulation incentivizing ‘financial innovation’ which both 1) provided the oxygen to inflate the housing bubble, and 2) helped blow that bubble big enough to encompass the globe.
In other words, I think they’re not mutually exclusive, and should not be segmented as if they are.