January 17, 2017
Max Ehrenfreund features a rather silly debate among economists about explanations for the housing bubble (wrongly described as the “financial” crisis) in a Wonkblog piece. The debate is over whether subprime mortgages were central to the bubble. Of course, subprime played an important role, but the focus of the piece is on new research showing that most of the bad debt was on prime mortgages taken out by people with good credit records.
I sort of thought everyone knew this, but whatever. The more important point is that economists continue to treat the housing bubble as something that snuck up on us in the dark and only someone with an incredibly keen sense of the housing market would have seen it. (I focus on the bubble and not the financial crisis, because the latter was very much secondary and really a distraction. By 2011, our financial system had been pretty much fully mended, yet the weak economy persisted. This was due to the fact that we had no source of demand in the economy to replace the demand generated by the housing bubble.)
Anyhow, there was nothing mysterious about the housing bubble. We had an unprecedented run-up in real house prices with no remotely plausible explanation in the fundamentals of the housing market. This could be clearly seen by the fact that rents were just following in step with the overall rate of inflation, as they have generally for as long as we have data. (This is nationwide, rents have outpaced inflation in many local markets, as have house prices.) The bubble should also have been apparent as we had record vacancy rates as early as 2002. The vacancy rate eventually rose much higher by the peak of the market in 2006.
It should also have been clear that the collapse of the bubble would be bad news for the economy. Residential construction reached a peak of 6.5 percent of GDP, about 2.5 percentage points more than normal. (When the bubble burst it fell to less than 2.0 percent of GDP due to massive overbuilding.) Also, the housing wealth effect led to an enormous consumption boom as people spent based on $8 trillion in ephemeral housing wealth.
In short, there was really no excuse for economists missing the bubble or not recognizing the fact that its collapse would lead to a severe recession. The signs were very visible to any competent observer.
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