CEPR - Center for Economic and Policy Research


En Español

Em Português

Other Languages

Home Publications Blogs Beat the Press The Problem is a Collapsed Housing Bubble, Not a Financial Crisis #4306

The Problem is a Collapsed Housing Bubble, Not a Financial Crisis #4306

Saturday, 29 September 2012 17:00

It is remarkable how people keep insisting, in spite of all the evidence to the contrary, that the problem of the downturn is a financial crisis rather than simply a collapsed housing bubble. The latter story is simple. Housing construction was driven by bubble-inflated prices. When prices plunged, construction collapsed. Not only did we no longer have inflated prices to drive construction, we also had an enormous oversupply as a result of 5 years of near record rates of construction. From 2006 to 2009 construction fell by more than 4 percentage points of GDP, leading to a loss of more than $600 billion in annual demand.

In addition, the loss of $8 trillion in housing wealth lead to sharp falloff in consumption. While the housing wealth effect is a long-established and widely accepted economic phenomenon, most discussions of the financial crisis act as though this effect does not exist. The wealth created by the run-up in house prices led to a consumption boom as the saving rate fell to near zero. With the collapse of the bubble, consumption fell back as the wealth that has been driving it disappeared.


Source: Bureau of Economic Analysis.

However, contrary to what is widely asserted, for example by David Leonhardt in his column today, consumption remains high, not low. The saving rate averaged more than 8.0 percent of disposable income in the years prior to the rise of the stock bubble in the 90s. Currently, it is between 4 and 5 percent of disposable income. If anything, we should be asking why consumption is so high, not why it is low.

It would be too absurd to expect bubble levels of consumption in the absence of the bubble. However this is what proponents of the financial crisis theory seem to be arguing. In short, the collapse of the bubble led to a gap of more than $1 trillion in lost demand due to the plunge in construction and the falloff in consumption. What if any part of this requires a story about the financial crisis?

Comments (13)Add Comment
written by bobs, September 30, 2012 4:16
This housing bubble was itself a financial crisis (since banks issue mortgages) so the term 'financial crisis' is technically correct in this context. It also puts the blame on banks, where it belongs, and not on the mythical "greedy homebuyer."
Cart before the horse
written by EMIchael, September 30, 2012 8:35
Without the fraudulent actions of the investment banks artificially increasing the amount of AAA MBSs, the housing bubble does not happen.
written by Peter K., September 30, 2012 9:18
What if, as Leonhardt suggested, the Obama adminstration pushed harder on the Fed and on housing? Aren't there still a lot of people "underwater" who would be borrowing and spending if they weren't. This fact doesn't appear to square with the high levels of non-savings/consumption.

It would have been nice if Leonhardt had mentioned worksharing. The Times has before.
Collapsed Housing Bubble
written by Bob, September 30, 2012 9:52
Certainly agree about the significance of the housing bubble. However, like others, I fail to see the resistance to also recognizing the significance of what was going on with financial institutions: the irresponsible financing allowed to create the bubble; the extraordinary leveraging permitted by the regulators; the lack of transparency of financial institution balance sheets which resulted in unwillingness for normal lending relationships to continue; the irresponsible growth of the credit default market; and others. All of these seem to me to be either contributing factors to the creation of the bubble or contributing factors to why the damage was as substantial as it was. Do you mean to ignore these and similar factors? The bubble resulted in a substantial loss of wealth but so did the problems of the financial system which it seems to me are somewhat separate.
written by skeptonomist, September 30, 2012 10:29
There is no current financial crisis, but the effects of the housing bubble linger. Actually the undeniable financial collapse affected much more than housing itself; there was a decline in private investment larger than any since the Depression, and not nearly all of this was housing.

The question is, what should be done to prevent collapses in the future. In this post and some others Dean seems to be saying that all we have to worry about is asset bubbles, and if the Maestro does his job and blows the whistle we will be OK. This has never worked before; there is no evidence that the Fed can safely deflate an asset bubble even if they detect and acknowledge it. What needs to be done above all is to reform and regulate banking and finance so that dangerous asset bubbles are less likely to develop and will be less dangerous. A lot of people have lost sight of this need, and insisting that housing is the only problem doesn't help.
written by Locus, September 30, 2012 10:49
First, Baker should be criticizing Paul Krugman who has been the loudest advocate of using the "output gap" metric, complaining that there is no reason why the US shouldn't be consuming at the same rate as it did during the height of the housing bubble.

Second, this post seems at odds with this conversation between Baker and Lauren Lyster.


Baker argued that the government needs to step in and deficit spend to counteract the fall off in private sector demand but today he tells us that "It would be to absurd to expect bubble levels of consumption in the absence of the bubble" and "If anything, we should be asking why consumption is so high, not why it is low." If Baker believes consumption is too high then why does he support massive trillion dollar deficits in an attempt to sustain the unsustainable?
@Locus and Leonhardt: A Locus with No Focus
written by Last Mover, September 30, 2012 12:01
1) Demand from the bubble did not exceed full employment demand in the aggregate. It was engineered by Greenspan et al to displace reduced demand from lost wages in order to achieve full employment demand.

2) When bubble demand collapsed, aggregate demand fell accordingly because there was no demand to replace it, thus the output gap.

3) Baker refers to consumption relative to disposable income that is high now despite the deep recession. If high absolute levels of consumption during the bubble prevailed now as expected by those claiming it is too low now, there would be no output gap and there would be full employmentregardless of whether there was a financial crisis.

For those who fail to grasp such complicated explanations there's plenty of openings in MSM to write on this topic and get it exactly backwards.
written by MacCruiskeen, September 30, 2012 2:08
"the loss of $8 trillion in housing wealth"

I would argue that there was not this much housing wealth loss. The "wealth" was an illusion created by fraud. If you buy a house based on a certain appraised value, and borrow against it, but the appraiser pulled the number out of his derriere because the mortgage broker needed him to "hit" it so that he could rig the underwriting system, does that "wealth" magically get created? Is this wealth like Pinocchio, it will become real if we wish enough? Yes, people borrowed against this "wealth" and that borrowing drove a lot of consumption, and now that the illusion has failed, and only the debt remains, we slowly go back to living within our means, or closer to it.
There is still a financial crisis
written by mattcarmody, September 30, 2012 2:59
As long as there is no root and branch reform of the financial sector we are always going to be at the mercy of a financial meltdown.

Minsky hit the nail on the head: When too big to fail institutions are continuously bailed out by the USG, the concept of moral hazard rises to a whole new level.

The next meltdown will require a much larger bailout, a bailout that will truly bankrupt the nation and impoverish all but the top tier. Maybe that's what it'll take to finally bring the system of finance capital to an end at the hands of outraged Americans.

I won't hold my breath.
written by Calgacus, September 30, 2012 5:19
MacCruiskeen: read Last Mover's explanation above your comment.

However fraudulently financed, the houses built in a bubble are real wealth. The money created by the banks & supported by the mortgage on the house is real and employs real people, employs the people they spend their money on, etc. No matter how much one wishes, this reality doesn't go away.

We cannot "live beyond our means"; the concept makes no sense. We cannot import from the future, or whatever wacky idea is embedded in the mainstream way of "thinking".

Sure, the debt remains. Thing is to resolve it like FDR did, close the most fraudulent and insolvent banks, keep the ones that are basically sound but might be suffering because of a bad economy open. Give debt relief to ordinary people, apply the law against foreclosing on them. And above all, decide to have full employment. Real full employment would resolve all the financial problems quick enough, all on its own.

The USA & even more, Europe, has been living (far) below its means for 40 years. Forcing people to not work is always & everywhere insane. Unemployment is always & everywhere a government decision.
written by MacCruiskeen, October 01, 2012 8:59
Calgacus--yes, the money created by the banks to finance the mortgages are real, but that doesn't account for all the fraudulent housing wealth, which is the housing wealth for all homeowners, whether they got a mortgage in the bubble or not. If fraud drives up the house sale prices in a neighborhood, it affects the valuations of everyone in the neighborhood. This is clearly what Dean's $8 trillion refers to.
written by Locus, October 01, 2012 9:44
Last Mover,

The absolute level of real personal consumption expenditures is higher than during the bubble years.


You got it "exactly backwards".
written by liberal, October 02, 2012 9:57
Calgacus wrote,
However fraudulently financed, the houses built in a bubble are real wealth.

That misses the point.

The houses are real wealth, yes. But the bubble wasn't a "house" bubble. It was a "residential land" bubble. Houses depreciate, whereas land appreciates, pretty much in tune with GDP, which is why it's vulnerable to bubbles.

Land values is capitalized land rent (net of taxes). If future income streams from land rent are overestimated due to bubble behaviors and actions, then yes, in that sense the wealth is "fraudulent."

Write comment

(Only one link allowed per comment)

This content has been locked. You can no longer post any comments.


Support this blog, donate
Combined Federal Campaign #79613

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.