A NYT article on the seemingly healthy state of the world economy carries the headline, "The economy is humming. Banks are cheering. What can go wrong?" The piece is written as though we need to fear the possibility that another financial crisis is just around the corner. We don't.
It's become popular in the economics profession to highlight the financial crisis as the culprit behind the Great Recession, as opposed to the collapse of the $8 trillion housing bubble. This is very self-serving for economics profession because finance can be complicated. After all, not many people are experts on collaterized debt obligations and all the various risks that can be created if they and other complex derivatives lose value.
By contrast, the housing bubble was a pretty simple story. We had an unprecedented run-up in nationwide house prices that could not plausibly be explained by the fundamentals in the housing market. Rents were following their historic pattern, pretty much rising in step with the overall rate of inflation. And, we already had a record vacancy rate even before the bubble burst. That doesn't fit a story with house prices being driven by the fundamentals of supply and demand in the housing market.
And the bubble was clearly driving the economy. Residential construction hit a record share of GDP in 2005, at almost 6.5 percent. (Normal is around 3.5–4.0 percent.) The $8 trillion in bubble generated housing wealth also led to a consumption boom, with consumption hitting a record high as a share of GDP.
It should have been obvious both that there was a bubble and that there would be no easy way to replace the demand generated by the bubble after it burst. The fact that virtually the entire economics profession failed to recognize the situation is an enormous embarrassment. Therefore, we get the complicated financial crisis story as a cover-up.
The financial crisis story also has the added dividend of justifying the Wall Street bailout. After all, the alternative was a Second Great Depression. No one really has a coherent story as to why we would have been condemned to a Second Great Depression if we let the market work its magic on Goldman Sachs, Citigroup, and the rest, but if we're already in the magical mystery world of financial crisis land, then sure, maybe the curse from letting the big banks go under will condemn us to a decade of double digit unemployment.
Anyhow, returning to the present, do we have reason to fear the collapse of bubbles again sinking the economy? Well, the stock market is high and could easily plunge by 10–15 percent (not a prediction, just a possibility). Similarly, house prices are getting high again, although this time largely in step with rents, indicating that it is mostly the fundamentals of the market. We could see some reversal here also, but that would mostly be in limited markets. That's bad news for the homeowners in those markets, especially moderate income homeowners who are seeing the biggest run-up in prices, but it won't sink the economy.
Overall, neither the stock market or housing market are driving the economy in a big way. Investment is not especially high, unlike the stock bubble years and construction is moving along at a very moderate pace. Consumption is getting kind of high, undoubtedly in response to the wealth created by the stock and housing market, but even if it fell back to more normal levels it probably would not cause a recession and certainly not anything like the 2007–2009 recession.
So we don't have to worry about too much going wrong just now, even though it's a safe bet that the finance crew will get themselves in trouble (and that we will bail them out when they do). The story is not as good elsewhere. House prices look pretty bubbly in Canada, Australia, the United Kingdom and a few other places. When these prices come back down to earth it may not be a pretty story, and the cry "who could have known?" will be heard throughout the land.