The Bubble and the Great Recession: The Need for Denial

September 21, 2018

(This post originally appeared on my Patreon page.)

The tenth anniversary of the collapse of Lehman brought a flood of news stories on the financial crisis. The housing bubble, whose collapse precipitated the crisis, was only mentioned in the background if at all.

In keeping with the general tenor of the commentary, Brookings brought in former Fed chair Ben Bernanke to present a paper saying the story of the Great Recession really was the financial crisis. To my knowledge, they did not have anyone making the case for the bubble.

I won’t go through the whole story here since I just did a paper on the topic. (I’m happy to say Paul Krugman largely agrees with me.) Rather I will say why I think there is such an aversion to acknowledging the importance of the housing bubble to the Great Recession.

The first reason to discount the bubble is that acknowledging its importance in the Great Recession highlights the immense failure of public policy that led to this disaster. The point is that the bubbles, and especially bubbles that drive the economy, are easy to see.

After largely tracking the overall rate of inflation for 100 years, house prices began to hugely outstrip inflation in 1996. This run-up in house prices should have been hard to miss. It was reported in government data that were published quarterly. The fact that there was no corresponding increase in rents and that vacancy rates were rising through the bubble years should have been a serious warning that something wasn’t right in the housing market. The deterioration of mortgage quality in the later years of the bubble was a widespread joke among people in the real estate business.

It should also have been easy to see that the bubble was driving the economy. Residential investment went from an average of less than 4.5 percent of GDP in the prior two decades to a peak of 6.8 percent of GDP in 2005. This is the GDP data that are published quarterly. How does an economist not notice this?

The run-up in house prices was also causing a consumption boom. The saving rate (the percentage of income not consumed) fell to 2.0 percent at the peak of the bubble. This compares to a pre-stock bubble average of more than 7.0 percent. How could an economist miss this one? (The savings data has been revised substantially upward in recent years. It was reported as being negative at the time.)

In short, the housing bubble and its effects should have been easy to see. By contrast, the financial crisis was complicated. We had new and exotic instruments like collateralized debt obligations and credit default swaps (CDS). These were little understood and poorly regulated. No one knew that AIG had issued $600 billion in CDS on mortgage-backed securities.

If we can blame the Great Recession on the financial crisis, then economists are in large part off the hook. Sure, deregulation of finance may have gone too far, but it is not as though we had the warning sign of a huge housing bubble flashing “danger, danger, danger.”

As a sidebar, it should not have been surprising that a collapse of the housing bubble would send a tidal wave through the financial sector. Housing is always a heavily leveraged asset and it became much more so during the bubble years. It should have been obvious that mortgages issued with zero down, on homes losing 30–50 percent of their value, were likely to default in large numbers. The only question is who was stuck holding the tab.

For my part, I always downplayed the financial aspect when writing about the bubble from 2002–2008. This was both because I felt it was less important and also because I wanted people to take my argument seriously. Yelling about a looming financial crisis is a good way to get people to dismiss your argument. (I did suggest that Fannie Mae and Freddie Mac were likely to be seriously stressed by the collapse of the bubble, if not actually go bankrupt. I recall being at a conference where I got several staffers of these companies very angry with this suggestion.)   

The second reason why many want to blame the financial crisis is that it can justify the bailout of the banks. If the financial crisis was responsible for the Great Recession, think of how much worse it would have been if not just Lehman, but also Citigroup, Goldman, and the other big banks went under. There is little doubt that the initial downturn would have been worse if the chain of bankruptcies was allowed to run its course, but this is not a second Great Depression story.

Keep in mind, unlike in the Great Depression, we now have Federal Deposit Insurance. This means that people don’t have to worry about banks not being able to hand them the money in their accounts. And some common sense moves that were done along with the bailout, like guaranteeing all non-interest bearing accounts of any size, would have helped to maintain stability in a financial system where banks were going bankrupt.

Also, the Fed had the power to single-handedly support the commercial paper market, as we discovered the weekend after Congress approved the TARP when Bernanke announced a special commercial paper lending facility. This meant that it was complete nonsense that healthy companies like Boeing or Verizon, that depend on selling commercial paper to pay their bills, would be unable to meet their payrolls.

And of course, nothing would prevent Congress from having a massive stimulus the day after the tsunami of financial collapse. People often make the assertion that Congress would have done nothing, allowing a severe recession to linger indefinitely. That seems implausible given the record of even Republican congresses. (The first stimulus took place with George W. Bush in the White House, when the unemployment rate was 4.7 percent.)

More importantly, that is a political assessment, not an economic judgment. There was no economic reason that a massive stimulus could not have been put in place in 2009 (or 2010 or 2011) preventing us from experiencing anything like a second Great Depression.

While it would have been best to do a bailout that imposed harsh terms on the banks (e.g. concrete plans for downsizing and serious caps on executive compensation), we would have still been better off with a chain of bankruptcies than what we got. The chain of bankruptcies would have been a form of instant financial reform, downsizing the bloated sector. We would have been left with a much smaller financial industry in which seven-figure paychecks were largely history.

Just to remind everyone, a smaller financial sector is a more efficient financial sector. Finance is an intermediary good. It is not like education or housing, which directly provide services to people. We only value finance because it allocates capital, like allowing business and homebuyers to borrow.

In this sense, we should think of it as being like trucking. Both finance and trucking are essential for the economy, but the fewer people employed in the sector, the better. We only want more people in finance if it allows it to somehow do its job better of allocating capital. Just as we would only want more people employed in trucking if it meant we were getting our goods more quickly or had less spoilage on perishable items.

In the last four decades, the narrow financial sector (securities and commodities trading and investment banking) has more than quadrupled as a share of the economy. It would be difficult to argue that out savings are more secure and that capital is being better allocated than was the case four decades ago. In this sense, we can think of our bloated financial sector as being comparable to a trucking sector that employed four times as many people, but was no better at delivering the goods.

The crisis in 2008 gave us a chance for a short order downsizing of the financial sector. The bailout ensured that the bloat would continue.

In this respect, it is interesting to compare the reaction of economists to the crisis facing the financial sector to their reaction to the loss of 3 million manufacturing jobs between 2000 and 2007 due to the exploding trade deficit. While the vast majority of economists seem to have supported the effort to save the Wall Street banks, they almost all turned their heads on the manufacturing workers and their communities, which were devastated by the trade deficit.

In fact, many economists have even played games with the data to try to insist that it didn’t happen. Manufacturing employment has been falling as a share of total employment since the end of the 1960s, but strikingly, the levels of employment changed little between 1970 and 2000, apart from cyclical fluctuations.

The loss of more than 3 million manufacturing jobs between 2000 and 2007 (pre-crash) was completely out of line with what we had seen in prior decades. It can easily be explained by the trade deficit. If we import another 4 percent of GDP worth of manufactured goods ($800 billion a year in today’s economy), it means we need fewer manufacturing workers here.

That seems pretty straightforward, but many economists have focused on the declining manufacturing share of total employment to deny anything unusual happened to manufacturing employment in the last decade due to the trade deficit. It’s not very honest, but that is the nature of the economics profession today.


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