The Guardian Unlimited, March 8, 2010
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The politicians and the media continue to refer to the economic downturn as being the result of a financial crisis. This is wrong. We have 15 million people out of work because the housing bubble that drove the economy since the last recession finally burst. The financial crisis may have been good entertainment for those who like to see huge banks collapse, but it was a sidebar. The real story was the rise and demise of the housing bubble.
Those who claim that the real problem was the financial system and its faulty regulation can be disproved with a single word: “Spain.” Spain is noteworthy because it now has an unemployment rate of more than 19 percent, the highest rate in any of the wealthy countries. Spain did not have a financial crisis. In fact, its well-regulated financial system is often held up as model for the United States.
Spain did have a horrific housing bubble. As a result, the share of construction in the economy rose from less than 8.0 percent of GDP at the end of the 90s to 12.3 percent in 2007. By comparison, it is typically less than 6.0 percent of GDP in non-bubble years in the United States. This rapid rate of construction led to enormous overbuilding, which meant that a collapse was inevitable with construction falling to far below normal levels.
The run-up in house prices also had the predictable effect on consumption. Because people believe that the run-up in house prices is based on fundamentals, homeowners assume that their newly created housing wealth is real and they spend accordingly. Spain’s saving rate fell from just under 6.0 percent in 2000 to 3.0 percent in 2007. When the housing wealth created by the bubble disappeared people naturally cut back their consumption.
This is Spain’s crisis. According to the IMF, housing starts in Spain fell by 80 percent from the peak of the boom. While total construction has not fallen as much (repairs and non-residential construction did not decline nearly as much), if construction in Spain fell by 50 percent, this would imply a loss in annual demand of more than 6 percent of GDP. That would translate into a drop in demand of more than $800 billion in the United States.
Similarly the loss of housing wealth reverses the housing wealth effect. If consumption fell enough to return the savings rate to its pre-bubble level, then this would imply a loss in annual consumption demand of more than 3 percentage points of disposable income. In the U.S. this would amount to more than $300 billion in lost annual consumption.
There is no easy mechanism to replace more than $1 trillion in lost demand. This is why Spain’s economy is in a severe slump right now. Note that just about all analysts agree, Spain’s financial system was well regulated and it had none of the loony loans and outright corruption that pervades Wall Street and the U.S. financial system. Yet, it is suffering from this economic downturn even more than the United States.
The moral of this story is that the problem is not first and foremost a financial crisis. It might be fun to watch the Wall Street and government boys sweat as they stay up late trying to keep the big banks from drowning in the cesspools they created. But this is all a sideshow. No one saved us from a “second Great Depression,” they just saved the jobs and wealth of the Wall Street crew.
The economy’s real problem is simply the loss of demand created by collapse of the bubble. Throwing even more money at the banks is a way to ensure that they don’t suffer from the consequence of their own greed and stupidity. It is not a way to restore the economy to health.
Restoring the economy to health is about finding a replacement for the demand lost as a result of the collapse of the bubble. In the short-term, this means increased government spending and tax cuts. Deficits put money in the economy, and using the old-fashioned view that people work for money, we can determine how much money we need to spend for the government to get the economy back towards full employment levels of output.
In the longer term, we need to move towards more balanced trade, with higher exports and fewer imports making up for the demand lost due to collapse of the housing bubble. This will require a lower-valued dollar – everything else in the trade picture is just for show.
We do need financial reform. We have an incredibly wasteful and reckless financial industry. But bad financial regulation by itself did not give us 10 percent unemployment, nor would good regulation have been sufficient to prevent it. Just ask the workers in Spain.