The Guardian Unlimited, August 18, 2008
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Next week, central bankers meet in Wyoming – but holding economic elites to account is not on the agenda.
The central bankers of the world will be gathering next week for their annual meeting at Jackson Hole, Wyoming. They use this opportunity to talk about the major issues confronting the world economy, as well as an opportunity to spend some time in a very beautiful holiday spot.
When they met in Jackson Hole in 2005, the meetings were devoted to an Alan Greenspan retrospective, honouring his 18-year tenure as Federal Reserve Board chairman, which was due to end the following January. A number of papers were presented analysing his record at the Fed, including one that raised the question of whether Greenspan was the greatest central banker of all time.
I suspect that the elite Jackson Hole crew will not be debating whether Greenspan was the greatest central banker of all time this year. The world is now facing the most serious financial crisis since the Great Depression. That's not my assessment; those were the words of Alan Greenspan.
And, how did we get here? Well, the centrepiece in this story is that the United States allowed an $8tn housing bubble to grow unchecked. Between 1996 and 2006, house prices rose by more than 70%, after adjusting for inflation. In the previous century, from 1896 to 1996, house prices had just kept even with the overall rate of inflation.
When you suddenly see a sharp divergence from a long-term trend like this, it is reasonable to look for an explanation. Was there some fundamental factor on either the supply or demand side that was suddenly causing house prices to skyrocket?
A quick investigation revealed no obvious suspects. On the supply side, there were no major new constraints that were impeding construction. In fact, housing starts were at near-record levels over the years 2002-2006, so there was no reason to believe that any developments on the supply side could explain skyrocketing house prices.
The demand side didn't feature any obvious culprits either. The rate of population growth and household formation had slowed sharply. If demographics could explain a sharp rise in house prices then we should have seen the surge in the 70s and 80s. That was when the huge baby boom cohort was first forming their own households. In the current decade the baby boomers are preparing for retirement.
Neither was there any plausible income story. Income grew at a healthy but not extraordinary rate in the years from 1996 to 2000, but income growth has been very weak throughout the current decade.
Finally, if the run-up in house prices could be explained by the fundamentals of the housing market, then we should expect to see a comparable increase in rents. But, there was no unusual run-up in rents. They did slightly outpace inflation in the late 90s, but they actually were falling behind inflation by the early years of this decade.
If the run-up in house prices could not be explained by the fundamentals, then it was a bubble, which would burst. This was easy to see for anyone who cared to look, but Greenspan and his sycophants could not be bothered. Greenspan insisted that everything was fine – there was no housing bubble – and virtually the whole economics profession acted as enablers touting Greenspan's wisdom.
While the exact timing and path of the housing market's collapse and the resulting turmoil in financial markets could not be predicted, the basic course of this tsunami was entirely foreseeable. The collapse of the bubble will destroy in the neighborhood of $8tn of housing wealth. Most of these losses will be absorbed by homeowners ($8tn comes to $110,000 per homeowner), but if just 10% of the loss ends up on bank financial sheets, the losses will be $800bn.
That is enough to put many banks under. Losses of this magnitude were virtually certain to sink Fannie Mae and Freddie Mac, institutions who hold almost nothing except mortgages and mortgage-backed securities. The current financial crisis was therefore an inevitable follow-on to the collapse of the housing bubble and will almost certainly amplify its negative impact on the economy.
This all seemed painfully obvious from even a quick look at the housing data back in 2005 when the central bankers were honouring Alan Greenspan. In fact, it should have been obvious at least three years sooner.
But the economic elites were convinced that everything was just fine. Their new mantra is "who could have known?" (Actually, that is an old mantra. They said the same thing after the stock bubble collapsed.) The really tragic part of this story is that there are no consequences.
The same group of economists that led the economy into this catastrophe still has its hands on the wheel. Holding them accountable for their disastrous performance is simply not on the agenda.
So, let's all hope that the Jackson Hole crew has a good time at their summer retreat. We've paid a big price for it.
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.