The Great Recession Didn't Have to Happen

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Dean Baker
AFL-CIO Online, January 25, 2010

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The country is suffering its worst downturn since the Depression of the 1930s. The U.S. unemployment rate is 10 percent and almost certain to get worse in the months ahead. More than 150,000 people are losing their home every month and nearly 20 million are now "underwater" in their mortgages—their houses are worth less than they owe on the loan. Millions of baby boomers have lost much of their life’s savings, and now most face retirement with little to support themselves other than their Social Security.

This is all bad news, but the really bad news is that it didn’t have to be this way. While many politicians try to describe this downturn as a natural disaster like a hurricane, it was the result of greed and incredible economic mismanagement. Wall Street greed has received considerable attention—but the failure of those in policy-making positions is still not fully appreciated.

In particular, the Federal Reserve Board completely failed to do its job. The basic issue was not hard. In fact, it was incredibly simple. For 100 years, from 1895 to 1995, house prices nationwide had just risen in step with the overall rate of inflation. Beginning in 1996, in step with the stock bubble, house prices began to outpace inflation. At their peak in 2006, house prices had risen by more than 70 percent after adjusting for inflation. This created more than $8 trillion in housing bubble wealth, $110,000 for every homeowner in the country.

There was no plausible explanation for this run-up in house prices other than a bubble. There was nothing on either the demand side nor on the supply side of the housing market to explain this huge jump in prices. On the demand side, incomes were not rising in this decade and population growth had slowed. On the supply side, the data showed that we were building houses at a near record pace.

Doubters also could examine the trend in rents. If house prices were being driven by supply or demand, then rents also should be outpacing inflation. They weren’t. Rents just kept even with the overall rate of inflation for most of this decade. Finally, vacancy rates were rising to record levels, another development inconsistent with house prices being driven by the fundamentals of supply and demand.

This evidence, all readily available to the Federal Reserve Board and anyone else who was interested, should have made it very clear that the run-up in house prices was a bubble. It also should have been evident that this bubble was driving the economy and that when it burst, as bubbles always do, that the economy would fall into a severe recession.

None of this is hindsight. Some of us were warning of the bubble as early as 2002. However, those in policy positions, like most of those in the economics profession, opted to ignore these warnings. They insisted that everything was just fine.

Of course they were wrong, as wrong as they could possibly be. Remarkably, the economists at the Fed and the others responsible for this disastrous policy are suffering no consequences. Unlike the school bus driver who drunkenly crashes his bus or the restaurant worker who leaves the stove on and burns down the restaurant, the economists who burn down the economy get to keep their jobs. In fact, Ben Bernanke, the chairman of the Federal Reserve Board who was at the center of economic policymaking since 2002, seems likely to be approved for a second term.

This shows how badly we need to change the course of politics in this country. It was bad enough that the Wall Street banksters were allowed to run wild for a decade and bring the economy to the brink of a Great Depression. However, it is truly amazing that the people who failed to rein them in get to keep their jobs. We have some real work ahead of us.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of False Profits: Recovering from 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.