Dean Baker
TPMCafé, April 11, 2009

See article on original website

There is no doubt that the economy would be better off if most of our banks were not insolvent, but only those who are really bad at arithmetic would think that repairing the banking system will restore prosperity. The economy would still be faced with a massive shortfall in demand with the unemployment rate soaring into the double digits.

The basic problem is that the economists who missed the housing bubble (EMHB) somehow still don't understand how the bubble drove growth earlier in this decade. There were two main channels:

Residential construction expanded from its average of 4 percent of GDP to more than 6 percent of GDP at its peak in 2005; and

Consumption boomed based on ephemeral housing bubble wealth, as the adjusted saving rate turned negative over the years from 2004 to 2008, compared to a post World War II average of 8 percent.

The collapse of the bubble has derailed these engines of growth. Housing construction is now less than 3 percent of GDP and the adjusted saving rate is approaching its post-war average. This is why the economy is slumping and the unemployment rate is soaring. There is no sector that can readily fill a gap in demand in the neighborhood of 8-9 percentage points of GDP.

The zombie banks don't help matters since their near death condition makes them less willing to lend money to businesses who might be able to get a loan from solvent institutions, but even if the banks were fully solvent, little about this basic picture would change.

Households are not spending more because many have just seen most of their wealth disappear with the collapse of the housing bubble and the plunge in the stock market. The rise in the savings rate is exactly what standard consumption models predict; we don't need any stories about zombie banks to explain the drop in consumption.

Similarly, the plunge in housing construction is the result of massive overbuilding. It will take years for population growth to absorb the inventories of unsold homes. Fixing the banks won't absorb excess housing supply.

There is a similar story in non-residential construction. There was a bubble in this sector that developed as the housing boom began to subside. As a result, there is now enormous excess capacity in hotels, as well as office and retail space.

If consumption and construction are not likely to be affected much by the health of the banks, this leaves investment in equipment and software as a potential source of growth. But even here the impact of the financial crisis may be exaggerated.

While some businesses are undoubtedly having difficulty expanding due to lack of access to credit, this is not the case across the board. There are plenty of large healthy companies, like Microsoft, IBM, and Verizon that can currently borrow at very low interest rates. Investment by these firms is not being restrained by the state of the banking system.

It is also important to note that many small businesses can't get loans right now simply because we are in a severe downturn. This makes all businesses much more risky bets now than in normal times.

However, there are undoubtedly businesses that would be able to get loans if the banks were healthy, but who can't raise capital now because of the financial crisis. But how much difference can this make? Here's where the knowledge of arithmetic would be so helpful to economists.

Let's assume that cleaning up the financial system would increase investment and software by 20 percent. This would be a huge increase, given that many firms would be little affected, either because they already have ample access to capital or because they are complete basket cases.

Investment in equipment and software accounts for less than 7 percent of GDP. This means that a hypothetical bank clean-up would increase GDP by less than 1.4 percent. In other words, it will fill approximately one-sixth of the shortfall created by the collapse of the housing bubble.

If the EMHB knew the limited effect that a potential bank clean up could have on the economy perhaps they would not spend so much time thinking of ways to funnel taxpayer dollars to banks. Of course if the EMHB had a better grasp of arithmetic then they wouldn't have missed the housing bubble in the first place and we wouldn't be in this mess today.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.