January 27, 2014
The story of the housing bubble and the impact of its bursting is pretty damn simple. If we go back to the bubble years, 2002-2007, the housing market was driving the economy. It was doing this both directly as construction spending peaked at close to 6.5 percent of GDP, two percentage points above its average over the prior two decades. It also drove consumption as people spent based on the equity in their home created by the bubble. The savings rate fell to almost zero based on this housing wealth effect.
When the bubble burst, we had nothing to replace the lost demand. Housing construction fell to well below normal levels in response to the huge overbuilding of the bubble years. At the trough construction was down by more than 4.0 percentage points of GDP or $660 billion a year in today’s economy. Consumption also fell as the home equity that was driving it disappeared. If we assume a housing wealth effect of 5-7 percent (i.e. a dollar of housing wealth increases annual consumption by 5-7 cents) then the loss of $8 trillion in housing wealth would correspond to a reduction in annual consumption of between $400 billion and $560 billion. Taken together, the loss of construction and consumption spending imply a loss in annual demand of more than $1 trillion.
That’s the basic story, unfortunately it is far too simple for most analysts to understand. Hence we have Robert Samuelson bemoaning the fact that the Fed wasn’t able to instill the confidence to get businesses to invest and consumers to spend. The problem with the Samuelson story is that its basic facts are wrong.
Non-residential investment is almost back to its pre-recession share of GDP. Given the weak demand in the economy, this is very impressive. It certainly doesn’t give any evidence of a lack of confidence. And consumers are spending. The savings rate is now below 5.0 percent of GDP. This compares to a pre-stock and housing bubble average of more than 10.0 percent of GDP. The only time that the saving rate has been lower has been at the peaks of the stock and housing bubbles. In short, Samuelson is looking for an explanation for weaknesses in spending that do not exist.
The need for additional demand stems primarily from the trade deficit. This creates a gap in demand of roughly 3.0 percent of GDP, which would be closer to 4.0 percent of GDP if we were at full employment. For some reason, Samuelson doesn’t discuss this issue, perhaps because he doesn’t have access to the data.
(Reports are that Ezra Klein left the Post because it’s so hard to get government data there.)
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