June 30, 2014
The basic story of the Great Recession is about as simple as they come. The economy was being driven by a housing bubble and the bubble burst. The combination of the loss of housing construction, due to the enormous overbuilding of the bubble years, and the loss of the consumption that had been driven by bubble generated housing wealth, created a gap in annual demand of more than $1 trillion. That’s all simple and easy.
And what did economists think would fill that gap in demand, manna from heaven? Did they expect another building boom even when vacancy rates were at record highs? Better go study the basics of supply and demand. Did they expect investment to soar at a time of massive excess capacity? That one would not be supported by any studies of the determinants of investment I have seen. Would consumers just ignore the $8 trillion in housing wealth they saw vanish and spend just as though nothing had changed?
None of these sound remotely plausible, so what did economists think would fill a trillion dollar gap in annual spending? Of course the government could do it with more spending and/or tax cuts, but since we have a religious cult in Washington that says it is better to keep millions out of work than to run deficits, this was a political impossibility. (Of course we could have a lower valued dollar to reduce the trade deficit, but economists try to ignore the $500 billion trade deficit. That’s another part of the cult.)
Anyhow, we have a simple story as to why we are facing a severe downturn. And of course it was simple to see the bubble. House prices had risen by more than 70 percent in real terms, breaking with a century long trend in which they had just kept pace with inflation. There clearly was nothing in the fundamentals to justify this sudden price surge. Income growth was weak as was population growth. And, there was no shortage of housing as indicated by both record vacancy rates and the fact that there was no increase in real rents.
In short, this is about as easy and simple as it gets and nearly every economist in the country completely blew it. For this the economics profession has enormous grounds for embarrassment. It’s sort of like the fire department that rushes to the burning school building and watches in horror as it goes up in flames because they had forgotten to turn on the fire hydrant. No one would want to own up to that mistake. Nor are economists anxious to own up to the horrible economic disaster that happened because they were utterly clueless about basic economics.
So, instead we get the “it’s all so complicated story.” Robert Samuelson gives us the latest in the “it’s all so complicated story,” a piece from the Bank of International Settlements [BIS] (amazingly placed outside of the economics mainstream by Samuelson), which tells us the real problem was that central banks sought to counteract business cycles. See, when we got economic downturns (generally brought on by central banks raising interest rates), central banks like the Fed thought it was a good idea to lower interest rates, boosting growth and putting people back to work.
The BIS tells us that this was all wrong. As a result of this countercyclical policy we saw big debt bubbles grow, which eventually crashed and wrecked the economy. We would have been much better off if we just let all those people sit unemployed.
The BIS is of course right about the dangers of bubbles, but was there really no way to have growth without bubbles? Couldn’t we, for example, have a lower valued dollar thereby increasing net exports and in that way boost the economy? If not, maybe they could give us a hint why not. Or maybe we could run larger budget deficits, unless the BIS requires its economists to be members of the anti-deficit cult.
And we could take steps to stem bubbles before they grow so dangerous. If there had been intelligent life at the Fed there might have been concern about the NINJA (no asset, no income, no job) loans that were driving the housing market. The National Association of Realtors report that nearly half of first-time homebuyers in 2005 put down zero or less might have also sparked concern. The Fed could have tried to use its regulatory powers to rein in these bad loans. It could have also offered clear warnings (sort of like forward guidance) that house prices would fall. I can’t speak for other potential homebuyers, but it would influence my decision on buying a house if I heard the Fed chair say that house prices are over-valued and that it is prepared to take steps to bring them down.
Anyhow, all of this is old hat to BTP readers, but it is important to understand the economics of the economics profession. Economists have enormous incentive to say it’s all very complicated and who could have known. It protects their jobs and self-esteem and could even mean increased funding flows so that we know enough to prevent something like this again.
The same incentives apply to economic reporters and columnists. After all, for their sources they relied almost exclusively on the people who completely missed it. They have no incentive to say that they had been too clueless to figure things out for themselves or at least find an economist who had a clue.
So, almost everyone you hear talking about the Great Recession has a huge incentive to say that it’s all so complicated. It isn’t, they aren’t telling the truth.
Typos corrected, thanks to several readers who called them to my attention.
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