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The Big Short, the Housing Bubble and the Financial Crisis

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.

Dean Baker / December 22, 2015