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. Yok
    September 13, 2018 at 5:22 pm

    Just saw hunkering Hank at Yale calling it just that – ” a totally unpredictable one off event.”

  2. Risk Analyst
    September 13, 2018 at 8:00 pm

    So, why did they miss it? There is a long list of reasons. One is the idea Shiller brought up in his Narrative Economics paper is that not only in politics but also in economics people search for stories to explain their world, and once a narrative is chosen it can become self-reinforcing and itself impact the situation (Soros calls this reflexivity). By middle cycle, people had heard years of reasons why the housing prices were justified such as new permanently lower interest rates based on the great moderation, limited land supply against ever increasing population, inflows of foreign investment and so on and given the high rate of home ownership and increases in home equity, these same people had an emotional self interest in believing this narrative. You could reference also the academic idea of bounded rationality, which is the non-confrontational way of saying people are not necessarily very smart.

    I took that same set of negative savings numbers you cite and concluded from that and from revised probability from the average length of time between recessions that we were due. When I went to the head of the trading floor, I was dismissed with a statement about how economists are of little value. He just did not want to deal with contrary information. At the time he literally kept his eye on the door because the next group was waiting to present him with another hot deal. The narrative had taken on a life of its own and people just did not want to hear information conflicting with how they understood the world (behavioral economics would call this confirmation bias). Perversely, I had literally cut my probability of recession forecast in half in the email I sent to set up the meeting just because of this fear, but he could not even deal with that lowered percentage probability. And on a personal note, I do not consider myself one of those who foresaw the GFC because I was just looking for a plain-vanilla slow down and recession for a couple of quarters.

    As I said there is a long list, and I will provide one more point. It is the horrible state of economics in education, with no diversity and lazy dogmatic instruction. Take Geithner as an example. His graduate degree was in some kind of international economics if I recall correctly, and I tried to back track to what the actual textbooks were that he used. I guess (I would like to ask him) that he used the first edition of Sargent’s Macroeconomics book as his main source of macro knowledge. That will not prepare anyone for being the role of risk manager at the NY Fed. He even says in his autobiography that he did not discover such ideas as Minsky until after the GFC began, and by then it was far too late. Linking RATEX into the above narrative economics, there is also a reinforcing idea that RATEX and neoclassical provided the reassurance that things are stable or stabilizing. That is not what you want in a risk manager.

  3. Helen Sakho
    September 13, 2018 at 11:41 pm

    It all depends on the risk manager in question! If you look up the background to Mrs. May, and her father and her husband (sometimes trusted adviser, sometimes husband, always managing perfectly to up his shares in the arms industry) you will always end up with the right analysis. Globally of course.

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