The Housing Bubble and Financial Crisis Was Easy to See Coming

September 09, 2018

Ten years ago we saw the culmination of a period of ungodly economic mismanagement with the collapse of Lehman Brothers and a full-fledged financial crisis. The folks who led us into this disaster rushed to do triage and tend to the most important problem: saving the bankrupt banks.

They also had to cover their tracks. They insisted that the financial crisis was some sort of fluke event — a lot of bad things went wrong simultaneously — and who could have predicted or prevented that? They had a lot of assistance in this coverup because almost all the people who did and wrote about economics at the time also missed the housing bubble and the harm that its inevitable collapse would cause.

The coverup continues to the present, largely because the same people who messed up in the years leading up to the crash are still in positions of authority. They are still the ones writing and talking about economics in major news outlets. So we can expect a lot of “who could have known?” drivel in the weeks ahead.

CEPR will be putting out a paper soon showing once again how the bubble was easy to recognize as was the fact that its collapse would be a disaster. Today I will just share one chart that shows much of the story.

The bubble led to an unprecedented run-up in house prices (with no accompanying rise in real rents), which in turn led to residential construction hitting 6.5 percent of GDP, more than two full percentage points above the long-term average. (But hey, who could have noticed that?)

In addition, the bubble-driven increase in housing wealth led to an unprecedented consumption boom as people spent based on their housing wealth. (This is called the “housing wealth effect” which was very old news by the time I was in graduate school in the 1980s.) This consumption boom could be seen in the plunge in the savings rate which is reported monthly by the Commerce Department. That fell to a low of 2.2 percent in 2005. That compares to an average in the years before the stock wealth effect drove down the savings rate in the 1990s of more than 7.0 percent. It is currently also hovering near 7.0 percent. (FWIW, savings data are subject to large revisions. At the time, the savings rate in 2005 was reported as -0.4 percent [Table 10]).

The question everyone should ask the “who could have known?” crowd is how could you miss the unprecedented run-up in house prices. Even more importantly, how did you miss the extent to which it was driving the economy through the construction and consumption boom? And finally, what on earth did you think would replace more than 5.0 percentage points of GDP worth of lost demand ($1,000 billion in today’s economy) when this housing bubble burst?

Those are pretty simple questions, but you won’t see people asking them in major news outlets. They have too much stake in maintaining the myth that people managing the economy really know what they are doing and the crash and financial crisis were fluke events that could not be foreseen. It ain’t so.


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