February 07, 2011
Boston Review, February 7, 2011
Most economists and financial experts would give the banking system in Spain high marks. It is well regulated and well capitalized. In September of 2008, when the financial world was melting down following the collapse of Lehman Brothers, Spain was relatively unaffected. Yet the unemployment rate in Spain today is more than 20 percent.
Clearly there is more to the story of the current worldwide economic slump than the flame out of Bear Stearns, Lehman, and AIG. But the Financial Crisis Inquiry Commission (FCIC), tasked by Congress with determining the causes of that slump, isn’t giving us the more complete picture.
The problems with the FCIC’s report, released at the end of January, stem from the Commission’s very inception: it was focused on the wrong topic. The FCIC investigated risky investments, lax regulation, excessive leverage. And it downplayed the more mundane, but vastly more important, collapse of the housing bubble.
The FCIC was set up to investigate a sidebar rather than the real story. Given the definition of its mission, the Commission did a reasonably good job. However, its 662-page report is a distraction from the real reasons why 25 million Americans are unemployed, underemployed, or have given up looking for work altogether. The real story doesn’t require 662 pages; it can easily be summed up in a few paragraphs.
We knew the bubble was coming . . .
The story of the downturn is the story of the $8 trillion housing bubble and its collapse. This bubble was driving the economy in the last decade in the same way that the stock bubble drove the economy in the late ’90s. Just as the collapse of the stock bubble led to a recession in 2001, the collapse of the housing bubble led to a recession in 2007. Both collapses and the resulting economic fallout were predictable. They also could have easily been avoided if those in charge of economic policy (e.g., Fed Chairmen Alan Greenspan and Ben Bernanke) had been doing their jobs.
Housing prices rose dramatically starting in the mid-’90s, around the same time the stock bubble began to inflate. At their peak, nationwide housing prices were more than 70 percent higher than the long-term trend in prices suggested they ought to be. This surge in prices drove the economy both directly, by fueling a massive construction boom, and indirectly, by spurring consumption.
Residential construction accounted for 3–4 percent of GDP in the early and mid-90s. It topped out at more than 6 percent of GDP in 2005. This construction boom led to enormous overbuilding and historically high vacancy rates. When the bubble burst, it was inevitable that construction would plunge to levels well below normal until the excess housing could be absorbed by the economy. This meant a falloff of close to $600 billion in annual demand.
There was also a bubble in non-residential real estate. This non-residential bubble lagged a bit, but followed the same predictable pattern as the residential bubble: a building boom produced enormous overcapacity and a dive in construction after the bust. Non-residential construction is down by more than one-third as a share of GDP since its peak, leading to the loss of another $100 billion in annual demand.
The collapse of the housing bubble also reduced consumption through what is known as the “housing wealth effect.” The housing wealth effect is estimated at five to seven cents on the dollar, meaning that homeowners will on average increase their annual consumption by between five and seven cents for every additional dollar of housing they own. This means that the $8 trillion of housing-bubble wealth implied an increase in annual consumption of between $400 and $560 billion. Now that most of the bubble wealth is lost, so is this consumption.
The total reduction in annual demand as a result of the collapse of the bubbles in residential and non-residential real estate is close to $1.2 trillion, or 8 percent of GDP. There is nothing in the economist’s bag of tricks that easily replaces such a large loss in demand. This is why anyone who noticed the housing bubble should have recognized that catastrophe loomed.
And the bubble was hard to miss. For a hundred years, U.S. housing prices tracked the overall rate of inflation. This is a long trend, especially in the largest market in the world. Economists don’t expect to see a break from such a trend without fundamental shifts in the market.
No such shifts occurred. There was nothing on the demand side that could plausibly explain the sudden rise in house prices. Income growth was good in the late ’90s, but in keeping with growth during post–World War II boom, three decades that saw no increase in real house prices. And incomes stopped rising in the oughts, in any case. The population grew during this period, but the rate of household formation was much slower than in the ’70s and ’80s, when the baby boomers were having children and buying their first homes.
If demand wasn’t surging, perhaps there were new supply constraints? Not likely, given near-record levels of construction and record-setting vacancy rates, which were visible as early as 2002.
Finally, that there was no notable increase in rents during this period shows conclusively that house prices were not being driven by the fundamentals of the housing market: if there were fundamental economic factors driving up home prices, then rent prices would have increased apace. In short, there was no excuse for anyone in a policy-making position to miss the housing bubble.
. . . And we could have done something about it
There were many people well position to rein in the bubble. The first and simplest course of action for the Federal Reserve, the Treasury, and other actors in government would have been to warn of the bubble by documenting its existence and detailing the damage that the economy and individual investors would suffer from its collapse.
The second route that the Fed and other regulators could have pursued was to crack down on the bad lending behavior that fueled the bubble. The slipshod practices and outright fraud that were the basis of many loans were not secrets.
Remarkably, Greenspan gave these shenanigans his stamp of approval and praised the inventiveness of the financial industry. Just when the market was really going crazy in 2004, the Securities and Exchange Commission (SEC) responded by easing the leverage restrictions on investment banks. If the SEC had gone the other way and tightened restrictions, it could have saved the country a great deal of pain.
Finally, the Fed could have burst the bubble at any point by raising interest rates. High interest rates are the enemy of bubbles everywhere, and the Fed, under Greenspan and Bernanke, could have ensured the quick impact of raising rates by tying them to the extent of the bubble. In this scheme the initial rate hike could be accompanied by a Fed announcement that the rate hikes would continue until housing prices fell to their pre-bubble levels. This would have caught the attention of mortgage issuers and investment bankers and the suckers buying their junk.
Much of this story is in the FCIC report but only as background. The foreground is the collapse of Lehman and AIG and the near meltdown of the financial system in the fall of 2008. The scenes of Bernanke and then-Treasury Secretary Henry Paulson warning of the end of the world if Congress didn’t immediately pass the Troubled Assets Relief Program (TARP) occupy center stage.
But the end-of-the-world scenario invented by the Paulson-Bernanke team was a charade designed to save the Wall Street banks. Had their scenario come to pass, the financial system might have shut down temporarily—most likely for no more than a few days—which would have been followed by the Fed restarting the system with a flood of liquidity. This is more or less what happened in Iceland, where GDP is now growing again at a healthy pace.
To be clear, a shutdown of the financial system would be a terrifying event, best to avoid. But the idea that this would have led to a second Great Depression—a decade of double-digit unemployment—is complete nonsense. We know how to reflate the economy.
The suggestion that the prolonged downturn is explained in any important way by the financial crisis is absurd. Consumers may be pessimistic about the state of the economy, but the reason they are not spending is that they lost trillions of dollars of housing wealth. The saving rate is still under 6 percent. This is up from near zero at the peak of the housing bubble, but it is still down from its postwar average of close to 8 percent. Instead of asking why consumers aren’t spending, we should be asking why they aren’t saving more.
All this talk of saving the financial system, and the FCIC’s inordinate concern for its role in our current economic woes, give undue credence to another narrative that’s great for banks, but harmful to the rest of us. Faced with the fact that banks aren’t lending much, some influential voices, such as Bernanke and National Economic Council Director Gene Sperling, have taken to decrying a supposed “credit crunch.” But financial institutions are not nearly as constrained as people think. Larger firms are well capitalized; they aren’t lending to small businesses because what looked like a good bet during days of 4.5 percent unemployment is a lot less attractive now, when unemployment is twice as high.
The large firms that dominate the economy are sitting on trillions of dollars in cash and can borrow as much as they like directly on credit markets at extraordinarily low interest rates. If there really were great investment opportunities that small businesses couldn’t pursue due to their lack of access to credit, we would expect to see the Wal-Marts and Starbucks of the world expanding like crazy to take advantage of their competitors’ temporary weakness. However, this is not happening, therefore access to credit clearly is not the issue.
The real story is the lack of demand outlined earlier. The solution is simple: the government should spend lots of money. Simple, that is, except for the political obstacles. That is why the FCIC report is a distraction, one more item contributing to the myth that the country is suffering primarily from a financial crisis.
The national obsession with finance goes beyond the specific events of the crisis. Americans have this misplaced notion that a giant, largely unregulated finance industry is good for us, and we too-readily assume that the success of finance is the success of the nation. That’s why the industry routinely threatens to go overseas in response to increased regulation or taxation—and gets what it wants. But apart from the fact that this is a bluff in most cases, why should we care if the titans of finance packed up and left?
The United States has seen its textile industry go overseas, along with much of its steelmaking, auto manufacturing, and even software programming. Why should we be any more concerned about buying our financial services from a foreign bank or insurer than we are about buying our clothes from a foreign manufacturer? There certainly is no economic theory that says this would be a problem.
Even the treatment of the stock market as a measure of economic well-being results from a peculiar obsession with finance. In principle the stock market is supposed to measure the value of future corporate profits. Expected future profits may rise because people are more optimistic about the overall state of the economy. In this sense rising stock prices could be viewed as positive for everyone, but only if associated with the belief that the bigger pie gets distributed widely.
However, investors may expect higher profits because they anticipate a redistribution of income from wages or taxpayers to corporate profits. In this case, there would be no reason for the vast majority of the public, who own little or no stock, to be celebrating an increase in the stock market. Growth of that sort would imply lower, not higher, living standards for them.
Remarkably, many people who consider themselves progressives now view the stock market as a measure of the health of the economy rather than an imperfect measure of the wealth of the rich. These people are also convinced that the world would have ended if the 2008 chain of bank collapses had put Wall Street out of business. This sloppiness of thought radically curtails the room for progressive policy.
The FCIC’s focus on finance contributes to this view. There is a lot of good and important material in the report; clearly there are many rich bankers who belong behind bars. The reputations of Greenspan and Bernanke should be permanently tarnished thanks to their incompetence in managing the economy. But at the end of the day, the picture the FCIC presents of the economic crisis and the economy is one that is badly skewed toward the finance-centric view that dominates political debate and prevents headway on the economic concerns that matter to the vast majority of working—and out-of-work—people.