I have yet to see the Big Short, but folks I know who have seen it say it's a great movie. But apart from its dramatic qualities, we have to once again raise the question of whether the story of the downturn is really a story of a financial crisis or a burst housing bubble.

I see that the generally astute Neil Irwin weighs in on the side of the financial crisis in his review of the movie.

"A lot of people thought a decade ago that there might be a housing bubble. Few of them understood the connections between housing prices and poor lending practices, and the connection from poor lending practices to complex, highly rated securities, the connection between those securities to the balance sheets of major banks, and the peril to the economy if just a few of them faltered.

"At each link in that chain, there were people aware that something was wrong, but lacked the ability to put those pieces together and connect bad lending in Florida suburbs with the existential risk being taken by companies like Bear Stearns and Lehman Brothers.

"The impossible job for the regulators (and journalists, and credit rating agencies) of the future is to better understand how the pieces within the infinitely complex economy and financial system connect with one another.

"'The Big Short' is a powerful reminder of how hard that will be."

I have been around the block on this one many times, most recently with Brad DeLong back in April (see also here and here). The basic point is that the demand created by the housing bubble was driving the economy prior to the crash. This demand was felt through two channels. First, record high house prices pushed residential construction to record levels of GDP. Second, at its peak the bubble had created $8 trillion (@ 60 percent of GDP) of ephemeral housing equity.This led to an enormous consumption boom as people were spending based on this bubble generated equity.


When the bubble burst housing construction fell back not just to its normal levels, but to its lowest share of GDP on record. The reason is that the construction from the bubble led to enormous overbuilding, which meant record high vacancy rates. The loss of $8 trillion in housing wealth led to an end of the bubble driven consumption boom. Taken together, the falloff in residential construction and the drop in consumption implied a loss in annual demand of more than 6 percentage points of GDP (@ $1.1 trillion in today's economy).

There was no easy way to replace this loss in demand. Investment was not about to jump by 50 percent. Net exports could and did increase, but this is a slow process. In short, when the bubble burst we were destined to have a serious recession with or without the financial crisis.

My simple way of framing this issue is by posing the question of when the financial system had largely recovered (2011 or 2012) what component of demand would have been larger if we had not had the financial crisis? I have never heard anyone give an answer to that one that passes the laugh test.

There are three reasons why it is important to get the story on the housing bubble and the financial crisis straight.

1) We have to understand the nature of the risk asset bubbles pose. When a bubble moves the economy, like the stock bubble in the 1990s and the housing bubble in the last decade, its collapse poses a risk to the economy. There can be bubbles in many sectors whose collapse may be bad news to people banking on its further growth, but these bubbles will not be a threat to the economy unless they actually had been responsible for large amounts of demand. 

This is the reason for my lack of concern about the possibility of bubbles in a limited number of real estate markets and narrow sectors of the stock market. I am somewhat concerned about a bubble in commercial real estate. (See all those "for lease" signs around downtown DC?). But the impact is just not that large. A collapse will mean slower growth, not a recession.

2) We should recognize that policy makers at the White House, the Fed, and the leading lights of the economic profession were virtually all out to lunch in not recognizing that the collapse of the bubble would mean a serious recession. The story was simple, yet they somehow missed it. I'm all for giving people a second chance and everything, but the country has the right to expect a bit more from highly paid people in positions of responsibility. If a dishwasher or custodian messed up their job as badly as these folks, they would be out of a job. Somehow we apply lower standards to Fed chairs.

3) The focus on the financial crisis creates a phony story of being rescued from disaster. The banks had put themselves into bankruptcy by virtue of their greed and incompetence. If the market had been allowed to work its magic, Goldman Sachs, Citigroup, and most of the other behemoths would be out of business. We would have been able to eliminate this horrible albatross on the economy with one blow. 

Instead Geithner, Bernanke, Paulson and the rest ran to the banks' rescue. We are supposed to feel good about this because it saved us from a Second Great Depression. But there was nothing about the collapse of these banks which would have condemned us to a decade of double-digit unemployment. We know how to spend money. That is how you avoid a depression. As then Fed chair Ben Bernanke once said, we have a printing press, so we can finance as much spending as we want in a recession.  

In short, the bailouts were not about saving the country from a Second Great Depression, they were about saving Wall Street banks from the market. Not much to feel good about there.

So, watch the movie and enjoy the show. It should be at least as much fun as the financial crisis. But remember, the real story was the housing bubble.