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Still Getting the Housing Bubble Wrong

Tuesday, 21 August 2012 07:02

The collapse of the housing bubble led to the downturn. However that does not mean that housing is the road out, or at least not unless we expect to see another bubble. Ezra Klein presents this mistaken view in his column today.

The basic story is very simple. (Remember, the purpose of economics is to make simple things complicated so as to exclude most of the public from debates on the most important policy issues that affect their lives.) The economy in the bubble years was driven by the bubble. The huge run-up in house prices led to an extraordinary building boom. Residential construction, which is ordinarily 3-4 percent of GDP rose to more than 6 percent of GDP at the peak of the boom in 2005.

Bubble-inflated house prices created close to $8 trillion dollars of housing equity. The housing wealth effect implies that people would spend between 5 to 7 cents on the dollar of this additional wealth, creating between $400 billion and $560 billion in additional annual consumption. The property taxes on inflated house prices also helped support perhaps $80 billion or so in state and local government spending. For good measure there was a bubble in non-residential real estate that followed in the wake of the housing bubble, which created a boom in this sector as well.

When the bubble burst, there was nothing to replace the lost demand. Residential construction fell by more than 4 percentage points of GDP ($600 billion annually in today's economy). It fell below normal levels because the boom of the bubble years had led to record vacancy rates. Consumption plunged because the housing bubble equity disappeared. When the wealth was gone, the consumption that it generated also vanished. And, we saw cutbacks in government spending at the state and local level in response to the lost tax revenue.

All of this seems clear and simple. We lost $1.2 trillion to $1.4 trillion in annual private sector demand. Some of this has been replaced by the federal government's budget deficits, but not enough to fill the gap. So what would have various plans to rescue housing done?

Suppose we had instantly written off all underwater mortgages, would that have kept construction going? That's hard to see, since the enormous oversupply of homes would still be there.

Would that have sustained house prices? It's hard to see how or why, the problem is that the bubble had raised prices far above any level that could be justified by the fundamentals of the housing market. House prices today are pretty much in line with their long-term trend as we can see from the real Case-Shiller house prices index.

prices-building-costs-8-2012Source: Robert Shiller.

If house prices are basically right, why should we expect more consumption than we are now seeing. In fact, consumption remains unusually high, not low, relative to disposable income as shown below. (Adjusted disposable income has to do with the statistical discrepancy for those nerds out there.)


Source: Bureau of Economic Analysis, National Income and Product Accounts, Tables 2.1 and 1.7.5.

If consumption isn't low, then what is the story of how rescuing underwater homeowners would have saved the economy? There are some economists who argue that the consumption of underwater homeowners has a hugely disproportionate impact on the economy. That seems a bit hard to imagine.

Let's try some simple numbers. The total amount of underwater equity is estimated at around $700 billion. Suppose that we wiped that out tomorrow. If our underwater homeowners spent 15 percent of their equity each year, more than twice as large as the wealth effect more generally, this new equity would generate $105 billion a year in additional consumption, about 0.7 percent of GDP. That's helpful, but not close to enough to get us back to full employment.

Furthermore, this impact is probably not even realistic. Let imagine someone with a median home, worth roughly $180k. We'll give $60,000 a year in income, roughly 20 percent more than the overall median. (Homeowners have higher income on average.)

Let's assume that they are 25 percent underwater, which means that they have a mortgage of $225,000. We now wipe that out, in effect giving them $45,000 of additional equity. If they spend 15 percent of this equity, it would translate into $6,750 a year in additional consumption. Did this family earning $60,000 a year have $6,750 in annual savings that they now can divert to consumption since we set their mortgage above water? That seems unlikely. Perhaps they will borrow to support additional consumption, but how much and for how long? On average, people do have to save over their working lifetime if we expect them to have anything other than their Social Security in retirement. (Paying down a mortgage counts as savings.)

The story is even more dramatic if we give them a loan to value ratio of 150 percent. Then their mortgage is $270,000 and they are $90,000 underwater. If we write that one off and expect them to spend 15 percent of their new equity it comes to $13,500 a year. That doesn't seem very likely.

In short, the story of underwater homeowners holding up the recovery doesn't hold water. It is a tragedy for homeowners facing the loss of their homes and foreclosures can devastate communities, but it is not the story of the recession.

The simple story is that we need a new source of demand to fill the gap left by the collapse of the housing bubble. In the short term that can only be the government. In the longer term it will have to be trade, which means a reduction in the trade deficit. That means first and foremost getting the value of the dollar down, but macho politicians in Washington don't talk about a lower valued dollar. The folks on Wall Street don't like it.

Comments (16)Add Comment
written by foosion, August 21, 2012 8:30
If there never was a housing bubble, would unemployment be lower than it is today?
Director of Finance
written by Shawn, August 21, 2012 8:51
If you write off the underwater part of their mortgage, that brings their equity to zero (before it was a negative). Taking away negative equity is not the same as giving them new equity. Now their payments might go down, giving them more disposable income which would be a better argument. How much of that new disposable income might they spend and how much would just go to servicing other debts or get saved.
written by David Lovinger, August 21, 2012 8:55
Verry sensible. But it seems that isince housing was a bubble, and therefore produced an unsustainable growth rate, we need something to replace some percentage of that as an economic engine. Is there any reasonable (and quantitative) way to estimate that?
"house prices are basically right" - Really?
written by Paul, August 21, 2012 9:22
According to Shiller's chart, housing prices are at the same level they were back in the late 1970's. In what sense is that the "right" price for housing as compared to say gasoline which was $1/gallon back then.

Consumption is nowhere near its historic trend line either and now appears to be stalling:


Unless consumption, especially of housing, is massively increased, full employment will never occur. Keynes was right:

"If it is impracticable materially to increase investment, obviously there is no means of securing a higher level of employment except by increasing consumption. . . . I should support at the same time all sorts of policies for increasing the propensity to consume. For it is unlikely that full employment can be maintained, whatever we may do about investment, with the existing propensity to consume."
The General Theory of Employment, Interest, and Money, p.325.

written by AlanInAZ, August 21, 2012 10:00
Perhaps Dean could be more specific in the future as to how we get the dollar down. Interest rates are already very low and the world seems to want dollars for "safety".
Efficiency standards?
written by Rich, August 21, 2012 10:28
I'm curious if anyone believes that a massive investment in home and business efficiency could help fill the bubble's gap. The govt could mandate a minimum level of energy star rating on all housing sales and offer loan guarantees to meet these requirements. These loans could be subsidized and a portion of them could be paid back with a monthly cost no more than the amount of monthly savings from reduced energy consumption.

These loans could be extended to current home owners and could also allow owners to finance even higher efficiency standards all the way to Net Zero homes if they choose.

This would put a lot of home construction workers back to work. It doesn't cost the home owners anything because their monthly costs would be offset by lower energy bills. It lowers the price of energy for everyone since it reduces energy demand. It helps restore some of the home equity since energy efficient homes are more valuable. It boosts renewable energy development as more homes try to achieve Net Zero rating. And it would cost the tax payers very little since loans are being paid back.

I find it hard to see a negative but I'm just not sure how the numbers work out.
written by skeptonomist, August 21, 2012 1:56
Dean is certain that the housing bubble produced a huge excess of houses, but other economists are not (e.g. DeLong). The "Quantity Index" that Dean showed a couple of days ago is evidently a very derivative measure and is certainly nothing like the raw data on housing starts:


In terms of actual housing starts the 2006 peak was nothing special, and the increment over 2000 was actually rather small.
There was certainly a partly speculative bubble in house prices, which was facilitated by the lack of regulation of finance, but this does not prove that excess houses were produced (has the current high price of gold resulted in an excess of gold?).

What is certain is that foreclosures and other mortgage problems are preventing the housing market from clearing and reaching a "natural" price level. This should have been cleared up a long time ago, and would have been if the authorities had put as much effort into it as in bailing out the banks.
Are you including the Federal reserve
written by Floccina, August 21, 2012 2:05
In the short term that can only be the government.

Are you including the Federal reserve in the Government.
Housing Starts Averaged 30 Percent Higher in 2002-2006 than in 1994-96
written by Dean, August 21, 2012 8:17
I'm not sure what DeLong thinks he is talking about, the data is pretty clear, there was a building boom in that period. Btw, the start numbers don't count dilapidated homes that were renovated or commercial properties converted to residential uses.


these are real house prices. Is there a passage in Keynes where he says that consumption will rise as much as we would like it to in order to bring about full employment?

getting the dollar down would require work, but assuming that we have people capable of tying their shoes in Washington, it could be done.
Trade is also short term
written by Alex Hamilton, August 21, 2012 8:31
Another fantastic column! This really clarifies a lot...

One quibble: the trade deficit is also a short term issue; I imagine you'd agree, bringing down the dollar should happen ASAP (as well as shifting taxation from payroll/incomes to imports)

When can the US just declare that it's a developing country (aren't all countries always developing in some sense?) to get around WTO nonsense?
"Getting the Dollar Down"
written by Paul, August 21, 2012 9:46
Any country that deliberately pursues a policy of devaluing its currency relative to others is in direct violation of G20 rules as a currency manipulator. While it may be possible to indirectly reduce the value of the dollar, obviously we would invite retaliation by other countries which would seek to maintain the value of the dollar and have the means to do so as China and Japan have clearly demonstrated. The EU, Russia and others could easily join together to thwart a devaluation of the dollar and it is hard to believe that they wouldn't do exactly that to preserve their market positions.

Raising Consumption to Achieve Full Employment

Dean, here is the Keynes' passage you are looking for and it contradicts your position on saving:

"The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished.

It is of this fallacy that it is most difficult to disabuse men’s minds. It comes from believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield. Now, prospective yield wholly depends on the expectation of future effective demand in relation to future conditions of supply. If, therefore, an act of saving does nothing to improve prospective yield, it does nothing to stimulate investment." The General Theory, pp.211-12

In other words, saving money now is the fundamental problem of our economy that must be overcome to achieve full employment. Saving must be discouraged by low interest rates and high inflation along with tax incentives to consume. This could be done and Krugman, et al., has been encouraging higher inflation. If he and others would get on board with incentives to consume, instead of obsessing about a presumed "balance sheet" recession, we could get to full employment. Everything must be done to discourage savings now.
Question about lower mortgage payment
written by Shri, August 21, 2012 10:30

I understand the point about equity consumption, but isn't there also increased consumption due to lower mortgage payments - similar to lower interest rates due to refinancing? Or Am I missing something?

Keynes did not say that people will consume because we want them to
written by Dean, August 22, 2012 4:07

you're going to have to look deeper in Keynes. I'm talking about behavior, not policy. Consumption is high relative to disposable income, not low. That is the reality. Would it be good for the economy today if it were higher, sure, but that doesn't mean that consumption will rise just because we want it to. You would need additional policies (as you suggest), to get consumption higher.
As far as the U.S. being a pathetic powerless country, tell that to Iraq. The U.S. bullies countries all the time about things of far more consequence than currency values. How about we get the dollar down by 30 percent against the yuan and a number of developing country currencies and in exchange let them tell Pfizer, Merck and Microsoft to get lost on their intellectual property claims. That sounds like a great win-win. I suppose if the u.S. weren't such a small powerless country we might be able to pull something like this off.
One Dollar in the Hands of a Consumer
written by Ron Alley, August 22, 2012 7:25
One dollar in the hands of a consumer can have only one destination. Each consumer chooses where that dollar will be directed. The housing bubble, and its persistence, are not isolated economic events. Both are aspects of an ongoing financial asset bubble. Government actions to date have not addressed the financial asset bubble.

If a consumer is paying more in mortgage payments, both in interest and principal reduction payments, than new buyer would pay (assuming a fair market price and a fair market interest rate) then the consumer is directing the excess payment dollars to rentiers -- the financial industry.

Currently a consumer who is underwater on her home loan has no recourse other than taking an up-front loss on a sale or refinancing. The most effective action that government can take is to give such consumers recourse.
written by Eric377, August 22, 2012 7:31
While this is a better look at the situation than most articles, it still doesn't get at the other half of the equation - the price paid to write down debt and the effect that has on consumption. There seems to be two general ideas out there: first is that the US Treasury heavily compensate creditors to provide this boon to selected debtors. I suppose we could pay for it by cutting SNAP payments or really getting serious about leaning on students debtors, or defering a bit of bridge and road maintenance for another decade, because this Congress sure isn't going to pay for it any other way. Second, some kind of magical process gets even creditors holding performing loans to call up their debtors and tell them to forget then next $40,000.
Devaluing the Dollar to Gain International Trade Advantage
written by Paul, August 22, 2012 8:41
Deliberately driving down the value of the dollar versus other currencies not only violates G20 rules and is politically impossible, it is also anti-Keynesian:

" But if nations can learn to provide themselves with full employment by their domestic policy . . . there would no longer be a pressing motive why one country need force its wares on another or repulse the offerings of its neighbour, not because this was necessary to enable it to pay for what it wished to purchase, but with the express object of upsetting the equilibrium of payments so as to develop a balance of trade in its own favour. International trade would cease to be what it is, namely, a desperate expedient to maintain employment at home by forcing sales on foreign markets and restricting purchases, which, if successful, will merely shift the problem of unemployment to the neighbour which is worsted in the struggle . . . ." The General Theory, pp.382-383.

Getting Consumers to Spend Their Money

Is not that hard to do because every retailer in America does it everyday: provide cash incentives (tax credits), advertise and promote. During WWII the government raised massive amounts of cash selling war bonds and it could do the reverse now. But many economists and politicians are against encouraging consumers to buy because in their Puritan thinking, consumption is immoral. Virtue is saving. American consumers will spend money if the deals are good.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.