Ben Bernanke responded to Paul Krugman's post last week, which agreed with my argument that the main cause of the Great Recession was the collapse of the housing bubble rather than the financial crisis. Essentially, Bernanke repeats his argument in the earlier paper that the collapse of Lehman and the resulting financial crisis led to a sharp downturn in non-residential investment, residential investment, and consumption. I'll let Krugman speak for himself, but I see this as not really answering the key questions.

I certainly would not dispute that the financial crisis hastened the decline in house prices, which was already well underway by September of 2008. It also hastened the end of the housing bubble-led consumption boom, which again was in the process of ending already as the housing wealth that drove it was disappearing.

I'll come back to these points in a moment, but I want to focus on an issue that Bernanke highlights, the drop in non-residential investment following the collapse of Lehman. What Bernanke seemed to have both missed at the time, and continues to miss now, is that there was a bubble in non-residential construction. This bubble essentially grew in the wake of the collapsing housing bubble.

Prices of non-residential structures increased by roughly 50 percent between 2004 and 2008 (see Figure 5 here). This run-up in prices was associated with an increase in investment in non-residential structures from 2.5 percent of GDP in 2004 to 4.0 percent of GDP in 2008 (see Figure 4).

This bubble burst following the collapse of Lehman, with prices falling back to their pre-bubble level. Investment in non-residential structures fell back to 2.5 percent in GDP. This drop explains the overwhelming majority of the fall in non-residential investment in 2009. There was only a modest decline in the other categories of non-residential investment.


Again, the collapse of Lehman hastened this decline, but the end of this bubble was inevitable. In this respect, it is worth noting investment in non-residential structures is pretty much the same share of GDP today as it was at the trough of the Great Recession, supporting the view that the issue was levels were extraordinarily high before the downturn, rather than being extraordinarily low in the downturn itself.

This brings us back to residential investment and consumption. As Figure 1 shows, residential investment even now is just 4.0 percent of GDP. That is much closer to the 2.5 percent of GDP in the trough than the 6.8 percent of GDP at the peak of the bubble. It is worth noting that it should not have been surprising that residential investment would fall below trend following the bubble, given the enormous overbuilding that lead to record vacancy rates even before the crash. Again, the drop is almost entirely explained by the collapse of the bubble, even if the timing was determined in part by the financial crisis.

The same story applies to the end of the consumption boom. The housing wealth created by the bubble-led savings rates to fall to a record low of just over 2.0 percent in 2005 (Figure 2). Savings rose to more than 7.0 percent of disposable income in 2009, following the collapse of Lehman. (Savings is defined as disposable income minus consumption.)

While the crisis surely hastened the decline in consumption and the implied rise in saving rate, the saving rate ten years later is still roughly 7.0 percent, the same level it was at in the Great Recession. It is very hard to see how consumption was excessively depressed by the financial crisis, as opposed to simply returning to normal levels following the collapse of the bubble. 

The basic story is that demand plummeted first and foremost because of the collapse of the housing bubble, along with the collapse of the bubble in non-residential construction that arose as the housing bubble began to deflate. The financial crisis undoubtedly hastened these collapses, but a steep drop in demand was made inevitable by these unsustainable bubbles that had been driving the recovery from the 2001 recession.