Home > The Economy > The story of the housing crash recession that politicians don’t want to tell

The story of the housing crash recession that politicians don’t want to tell

from Dean Baker

The economy is certain to occupy center stage in the presidential race this fall. Unfortunately neither Governor Romney nor President Obama is likely to give us an accurate account of the economic problems we are now facing.

Romney’s efforts seem intended to convince the public that President Obama has turned the country into the Soviet Union, with government bureaucrats shoving aside business leaders to take the commanding role in the economy. He will have lots of money to make this case, which he will need since it is so far from reality.

Corporate profits are at their highest share as a percentage of the economy in almost 50 years. The share of profits being paid in taxes is near its post-World War II low. The government’s share of the economy has actually shrunk in the Obama years, as has government employment. Perhaps Romney can convince the public that the private sector is being crushed by burdensome regulation and taxes, but that has nothing to do with reality.

Unfortunately, President Obama’s economic advisors have not been much more straightforward with the American people, never offering a clear explanation of why the economy has taken so long to recover. They have pointed out that economies often take long to recover from the effects of a financial crisis like the one we experienced in the fall of 2008, but that is not an explanation for why we have not recovered.

The basic story is actually quite simple. The housing bubble had been driving the economy prior to the recession. It created demand through several channels. A near-record pace of housing construction added about 2 percentage points of GDP to annual demand, or more than $300 billion in the current economy.

The $8 trillion in ephemeral housing wealth created by the bubble led to a huge surge in consumption. Tens of millions of people borrowed against bubble-generated equity or decided that they didn’t need to save for retirement. When house prices were going up 15-20 percent a year, the house was doing the saving. The result was a huge consumption boom on the order of 4 percent of GDP or $600 billion a year.

In addition, there was a bubble in non-residential real estate that followed in the wake of the housing bubble. This raised non-residential construction above its normal levels by close to 1 percent of GDP or $150 billion a year.

Adding these sources of demand together, the bubble generated well over $1 trillion in annual demand at its peak in 2005-2007. When the bubble burst, this $1 trillion in annual demand vanished as well. That is the central story of the downturn.

To recover we must find some way to replace this demand; however, that is not easy. People will not go back to their old consumption patterns because they know they need to save more. Tens of millions of people have much less wealth than they expected at this point in their lives after they saw the equity in their homes largely vanish. Tens of millions of baby boomers are approaching retirement with almost nothing but their Social Security to support them.

Given the huge loss of wealth from the collapse of the housing bubble, it is not reasonable to expect consumption to rise to fill the demand gap. It doesn’t make much more sense to expect investment to do the job. Historically, investment in equipment and software has been close to 8 percent of GDP. It is pretty much back to that level today. To fill the demand gap created by the collapse of the housing bubble, the investment share of GDP would have to nearly double to 14 percent.

This would be almost impossible to imagine at any time, but it is especially far-fetched at a time when much of the economy is operating far below its capacity. Businesses are unlikely to spend a lot of money expanding their facilities when the existing capacity is sitting idle regardless of how nice we are to job creators.

Over a longer term we can expect that net exports will fill the demand gap. If we bring our huge trade deficit close to balance by selling more abroad and importing less, it will provide a substantial boost to demand. However, this will require that the dollar fall in value relative to the currencies of our trading partners, making U.S. products more competitive. That is a process that will take time. With many of our trading partners also in severe slumps, we cannot expect any major improvement in our trade balance in the immediate future.

This leaves government as the only remaining source of demand. This is not a question of whether we prefer the government or the private sector. We need the government sector to fill the gap in demand because the private sector will not do it. And that will be true no matter how much we love the private sector and its job creators.

Until we get our trade deficit closer to balance we will need large government deficits to fill the gap in demand created by the housing bubble. That is the simple reality that neither party seems anxious to tell the people.

See article on original website

  1. July 1, 2012 at 10:15 pm

    You are 100% correct.
    All “the king’s men know that before we can put everything back together again, we must resolve the housing and construction sector ,period !
    Even though you can’t do a thing about it, if you wish just for the sake of knowing, here is a solution you chould work on:

    Excerpt ….”Do for the housing sector what you did for the auto sector”
    And do it in such a way that the new personal income tax rate would be zero.
    (google) “Great News !! Zero Income Taxes Solves….”

  2. July 2, 2012 at 6:11 am

    A house price bubble is a land price bubble and there is no wealth created. It is just a heap of paper. It was only ever a Ponzi scheme. It really would help just to call things by their proper names.

  3. July 2, 2012 at 8:14 am

    Actually, this would be the perfect time – when the housing market has cratered – to impose a Land Value Tax. This is a tax on just the Land (in classical economics, defined as ALL nature’s resources), not on improvements (like buildings). We would get more improvements (untaxed) and less hording and speculating (taxed). We would get a good, consistent source of revenues to government. We would create millions of new jobs as Land opportunities opened up and infrastructure industries rushed to fill the gap.
    The other thing we should do is to have government stop borrowing and simply issue money, debt-free, as the constitution, Art. 1, Sec. 8, clause 5, allows it to do, and as Lincoln did in 1862, and as was continued through 1974 (U.S. Notes), and as we do every year with (debt-free) coins. This would produce hundreds of billions in immediate savings through seigniorage, and be an immediate credit to the government’s account at the Fed. More importantly, it is money that could be used for public works jobs, like in FDR’s time, but without the debt.

    • July 2, 2012 at 8:19 am

      Good to see someone has the right idea. Pity it always has to be left to a commentator to mention this. Why?

    • July 2, 2012 at 3:53 pm

      I agree Scott, but I object to the following statement no matter who says it.

      “The other thing we should do is to have government stop borrowing and simply issue money, DEBT-FREE (emphasis mine) “.

      If governments issued money to pay their expenses and never taxed it back wouldn’t the money eventually become worthless? Governments issue money redeemable for the payment of TAXES. It is the removal of money by taxation that makes the money worth something.

      Money that is spent and has to be paid back is a full circle, just like a loan.

      It is NOT DEBT-FREE. It is, however, INTEREST-FREE. And it does not depend upon, nor provide guaranteed profit to, private investors, for the use of what should be a public utility.

      • July 2, 2012 at 4:52 pm

        I deliberately left off the issue of taxing it back to demonstrate that these are not necessarily connected. That is, you could, in theory, pr perhaps to stimulate the economy, issue new debt-free money without taxing it back.
        But yes, if we are worried about inflation, and if we want to be fair (2 different things), we should implement the only fair tax: the Land Value Tax.
        One other point; no public entity has ever put out as much money as the private Central Bank (yes it is, check the phone book, the Supreme Court, and the Fed’s own statements), and yet they are also the ones who get to claim there is no inflation too. Well, anyone who has bought food or gas, paid tuition or a hospital bill, knows that is not true. There are many causes for inflation but a Land Value Tax on commodities (part of the Land, under classical economics), would depress prices, making at least that part of inflation – which only benefits elite speculators – go away.

      • July 2, 2012 at 5:14 pm

        Scott – Explain to me how the LVT simply wouldn’t be rolled into commodity prices to cover these costs, thus raising prices? The speculator still gets his cut, and passes at least some of the cost of the LVT to the consumer. Food commodity demand is inelastic, and speculator activity during this downturn has driven food prices upwards, but consumers keep buying food. The higher food prices have only depleted sales in other consumer markets.

      • July 2, 2012 at 5:29 pm

        This is a common objection to LVT. The short answer is that as taxes on commodities go up, the price must come down, because the market won’t pay more for the commodity. Let’s say the price of a barrel of oil is $100, and the true cost, averaging it out for simplicity here, of pumping it out is $80 (in reality, it is probably much less). If the tax takes that $80, the speculator can’t suddenly add $80 (or $60) to the remaining $20, since the market simply won’t pay $180 total for a barrel of oil. Now you can see why the 1% fights the LVT!

        But, remember, nature, not Man, provide the oil in the ground. Yes, it costs money to drag it up, refine it, transport it and sell it – and producers should get to keep 100% of that. But the rest is from nature and rightfully belongs to all of us, equally. Also, pollution should be taxed, as it fouls our common air, land (small ‘l’ for actual land) and water.

      • Peter Bowman
        July 2, 2012 at 7:55 pm

        Surely the way forwards is to combine government issued money and a land value tax. If the government-issued money was well-directed and for example used to improve infrastructure that will increase land values around where the investments have taken place. Traditionally these benefits accrue to the land owners even though they have done nothing to earn them. However, if there was a land value tax in place there would be a mechanism to return the increase in value back to the government and prevent the currency being devalued. There is the possibility of the effects of sound investment generating a virtuous circle by providing increased public revenue allowing for further investment.

  4. July 2, 2012 at 2:41 pm

    I maintain a parallel view, but with a different way forward that entails the middle class pursuing independent proprietorships to bootstrap themselves out of this mire.

  5. July 2, 2012 at 8:16 pm

    Why not an easy simple solution:
    (Excerpts from “justaluckyfool”)
    A Monetary Sovereignty can “print” unlimited amounts of its currency. It must however guard against inflation and moral hazard.
    What if this Monetary Sovereign nation were to issue its currency by way of interest bearing loans, this interest would replace taxation. (Any other tax, be it personal or otherwise is not fair. no matter how you want to slice it-it would not be fair.
    If the US were to make $500 trillion available at 2% for 36 years ($5 trillion for purchase of all residential mortgages and $5 trillion for construction industry loans) these loans would end the housing crisis and the construction sector crisis instantly, WITH NO INCREASE IN THE DEBT. A loan is an asset that would double in value,which contains a means for recovery that is so strong it will not only inhibit inflation but also would end personal income taxes. He who has the power of compound interest has the most powerful force in the universe.
    We must take away this power from the private banks. The Federal Reserve has to power to force them to 100% reserve banking. If they wish to keep their derivitives ($327 trillion) make them borrow it (make the bubble solid by liquidity).
    Please challenge this idea, just imagine We The People having an income of $1 quadrillion
    over the next 36 years ($500 trillion @2% for 36 years) part of which we would have to redistribute if for no other reason than “to form a more perfect government”, than that the loans could be paid back. It is mathematically impossible to pay back $1 quadrillion if only $500 trillion were “printed.


    Improve it, use it as your own,for the betterment of mankind.

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