Home > Uncategorized > The housing bubble and financial crisis was easy to see coming

The housing bubble and financial crisis was easy to see coming

from Dean Baker

Ten years ago we saw the culmination of a period of ungodly economic mismanagement with the collapse of Lehman Brothers and a full-fledged financial crisis. The folks who led us into this disaster rushed to do triage and tend to the most important problem: saving the bankrupt banks.

They also had to cover their tracks. They insisted that the financial crisis was some sort of fluke event — a lot of bad things went wrong simultaneously — and who could have predicted or prevented that? They had a lot of assistance in this coverup because almost all the people who did and wrote about economics at the time also missed the housing bubble and the harm that its inevitable collapse would cause.

The coverup continues to the present, largely because the same people who messed up in the years leading up to the crash are still in positions of authority. They are still the ones writing and talking about economics in major news outlets. So we can expect a lot of “who could have known?” drivel in the weeks ahead.

CEPR will be putting out a paper soon showing once again how the bubble was easy to recognize as was the fact that its collapse would be a disaster. Today I will just share one chart that shows much of the story.

The bubble led to an unprecedented run-up in house prices (with no accompanying rise in real rents), which in turn led to residential construction hitting 6.5 percent of GDP, more than two full percentage points above the long-term average. (But hey, who could have noticed that?) 

In addition, the bubble-driven increase in housing wealth led to an unprecedented consumption boom as people spent based on their housing wealth. (This is called the “housing wealth effect” which was very old news by the time I was in graduate school in the 1980s.) This consumption boom could be seen in the plunge in the savings rate which is reported monthly by the Commerce Department. That fell to a low of 2.2 percent in 2005. That compares to an average in the years before the stock wealth effect drove down the savings rate in the 1990s of more than 7.0 percent. It is currently also hovering near 7.0 percent. (FWIW, savings data are subject to large revisions. At the time, the savings rate in 2005 was reported as -0.4 percent [Table 10]).

The question everyone should ask the “who could have known?” crowd is how could you miss the unprecedented run-up in house prices. Even more importantly, how did you miss the extent to which it was driving the economy through the construction and consumption boom? And finally, what on earth did you think would replace more than 5.0 percentage points of GDP worth of lost demand ($1,000 billion in today’s economy) when this housing bubble burst?

Those are pretty simple questions, but you won’t see people asking them in major news outlets. They have too much stake in maintaining the myth that people managing the economy really know what they are doing and the crash and financial crisis were fluke events that could not be foreseen. It ain’t so.

  1. Robert Locke
    September 10, 2018 at 12:57 pm

    Of course the crisis was predictable, I like many intelligent people watching increasing private debt in the form of credit card and prime morrgages in the 1980s, realized that a crisis was in the making.

  2. patrick newman
    September 10, 2018 at 3:44 pm

    People can sustain unsustainable borrowing if interest rates are kept low and there is a regular income even when it is below inflation – but not forever. So you need to look at what may disturb the house of economic cards resting on shifting sands – trade war?

  3. September 10, 2018 at 8:57 pm

    With appreciation to Dean Baker, I think mainstream observers were slightly less stupid. Everyone could see that housing was valued higher than the historic norm, and people spent on credit more than usual. So everyone could see there was a degree of, let’s say optimism, in the economy: People were counting on value that wasn’t created yet.

    The key question for a modern economy, which I don’t think is as simple as callineabecause to count on wealth or income only when it’s in the bank is austerity economics. Some degree of irrational optimism, that if we borrow and build and market things the money will come, is required for our economies to function. But how much?

    It’s not a trivial question. We can put some limits around it. At one end you have the “no bubble” limit: The economy can only run so fast that in the long run investments on;t lose value. But that’s a very restrictive limit, beholden to profit. It may be no better than cyclic austerity. At the other end you have the real supply limit: how much can a war or bubble economy produce? Quite a lot it seems. If we don’t use money to keep score, why isn’t that high level of production the norm? Somewhere in the middle is a philosophical “how much is enough” demand limit that we need to find.

    So with a bow to Dean and his insights, I don’t think that “are we in a bubble or not” is the key question. It’s in how much of a bubble we should be in, or how much our economy should be bounded by optimism and politically arranged sharing rather than on accounting and profit calculations.

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