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Investigating the Collapse: Looking for the Killer We Already Know

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Dean Baker
Truthout, June 1, 2009

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Congress may establish a commission to investigate the causes of the economic crisis. This may be a useful exercise in publicly shaming those who are responsible for an enormous amount of unnecessary suffering. That would be a good thing.

These people should be held accountable. Those in the financial sector who broke the law should go to jail, or at the least, lose their ill-gotten fortunes. The public officials whose incompetence and/or corruption allowed for this disaster should lose their jobs and never again be given a position of public trust.

These could be positive outcomes from an investigative commission. However, such a commission could have a negative role. It could be part of an ongoing effort to rewrite history and cover up for those who were responsible for this disaster.

The basic point is straightforward. This crisis was simple and easy to see for any competent economist. We had an $8 trillion housing bubble. This bubble was driving the economy ever since the recession in 2001.

The bubble led to an enormous boom in construction, as builders made enormous profits selling new homes at bubble-inflated prices. It also led to a huge surge in consumption as homeowners spent a large portion of their bubble generated housing equity.

Bubbles inevitably burst. (That’s why they are called “bubbles.”) When this bubble burst, it was inevitable that housing construction would collapse and consumption would plummet throwing the economy into a steep recession. There were no ands, ifs, or buts in this story. It was an absolute certainty and totally predictable. The only question was the exact timing.

How could economists recognize the housing bubble? This also was very simple. We have data covering more than 100 years showing that from 1890 to 1995 nationwide house prices just tracked the overall rate of inflation. Suddenly in the mid-90s, coinciding with the stock bubble, house prices began to substantially outpace the rate of inflation. By their peak in 2006 nationwide house prices had outpaced inflation by more than 70 percent.

There was nothing on either the demand or supply side that could explain this huge run-up in house prices. Incomes had grown well in the late 90s, but were actually stagnant in the current decade. Population growth and new household formation had slowed markedly from the pace decades earlier when the baby boomers were forming their own households for the first time.

On the supply side, we were building homes at a near record rate. Obviously, there were no serious supply constraints.

Finally, as a check we could examine rents, since any major change in fundamentals should have a substantial impact on both the rental and ownership side of the market. Rents slightly outpaced inflation in the late 90s and just tracked inflation in this decade.

All of this should have led any serious economist to be yelling at the top of their lungs about the dangers of a housing bubble. Yet, almost none did. This was inexcusable; people should lose their jobs for this failure.

What about the bad loans, the over-leverage, and the unregulated derivatives? Yes, these all fed the bubble, and allowed it to grow much larger than otherwise would have been possible. These evils were also the basis for the enormous paychecks for people like Robert Rubin, Henry Paulson, and Angelo Mozilo and the rest.

The political influence of the Wall Street crew was undoubtedly a major factor in the failure to clamp down on the bubble. In other words, it was not just that the economists were incredibly incompetent, although many were. It is also that many were quite willing to look away from a looming disaster that was further enriching the rich and powerful. Welcome to modern economics.

But it is important to keep the bubble front and center and the finance secondary for two reasons. First, the bubble is the story. If we somehow had an $8 trillion housing bubble, with no bad loans, over-leveraged banks or bad derivatives, we would still be pretty much in the same place we are today: a collapsed housing sector, plunging consumption and a severe recession with mass unemployment and record foreclosure rates.

The second reason for keeping finance secondary is that, unlike the bubble, the specifics of finance are complicated. Most people cannot follow the details of collaterized debt obligations or credit default swaps. Focusing on this aspect of the crisis will lead the public to believe that the collapse really was hard to see coming and that people therefore cannot be held accountable. In short, shifting the focus to finance is a victory for the “who could have known?” gang.

So, it would be great if Congress outs the boys and girls at the Fed, the Treasury, the SEC and the other regulatory institutions who allowed this bubble to grow on their watch as well as the Wall Streeters who profited off the nation’s pain. But if this is an effort to cover-up responsibility, then let’s just save the money and wait until we get honest representatives in Congress to establish such a commission.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.