The Bubble Boys and the Recession

While the recession is just beginning, it’s not too early to start pointing fingers as to who is responsible. This is not just an exercise in vengeance (although that might be fun); the people who wrecked the economy should be held accountable. We also should be clear about the policies that gave us this mess so we don’t go this route again.

As everyone should know, we are having a recession because the housing bubble burst. This was not an accident or surprise – the housing bubble was clear visible to anyone who cared to look. There was an unprecedented run up in house prices in the decade from 1996 to 2006, which the price of a typical home rising by more than 70 percent after adjusting for inflation. Over the prior hundred years, house prices had just kept even with the overall rate of inflation.

Join Dean Baker, Theresa DiMartino, Al Meyerhoff and Lisa Ransom in a panel at Take Back America 2008 on the housing bubble and a prescription for change.
 
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There was no change in the fundamentals of the supply and demand in the housing market that could possibly explain this sudden surge in prices. Population was growing far less rapidly during this period than it had in prior decades, especially among families in their prime home-buying years. Income growth was healthy in the years from 1996 to 2000, but very weak in the current decade. Clearly no changes on the demand side could explain the run-up in prices.

Similarly, there were no new constraints on the supply-side. Land has always been in limited supply, it did not suddenly become more limited in the mid-nineties. In fact, the growth of the Internet reduced constraints, since it is now possible for many people to do their work from anywhere.

Since there was no explanation for the run-up in house prices based on market fundamentals, then the obvious alternative explanation was that house prices were driven by a speculative bubble, just as speculation drove the stock market to record highs in late 90s. Of course bubbles burst, and when they do, it leads to very unhappy outcomes.

In the case of the stock market, the bursting of its bubble lead to the recession in 2001 and two more years of negative job growth. It also derailed many pension funds, as well as wrecking the retirement plans of millions of families who saw the value of their 401(k)s shrivel.

The story of the collapse of the housing bubble is likely to be even grimmer. The housing bubble created more than $8 trillion of housing bubble wealth, $110,000 for every homeowner. Most, if not all, of this wealth will be eliminated in the crash that is now underway. The result is the recession that we are now seeing, driven first by the collapse of the housing sector and more importantly by the falloff in consumption.

Homeowners had been spending their bubble wealth almost as fast as it was created, pulling money out of their homes through home equity loans or refinancing their mortgages. This massive borrowing drove the savings rate to almost zero. With prices now plunging at double-digit annual rates millions of homeowners no longer have any equity against which to borrow. That means that the music stops and consumption will go into the tank taking the economy with it.

This recession is likely to be painful. The unemployment rate is likely to rise to the highest levels since the early eighties. Millions of people will lose their homes. Tens of millions will see their life’s savings disappear as the money that they thought they had in home equity vanishes in front of their eyes. This will be especially hard for baby boomers at the edge of retirement, many of whom will now be entirely dependent on their Social Security.

The recession is also likely to be long. It’s not easy to recover from a recession brought on by the collapse of a financial bubble. The economy continued to shed jobs for more than two years following the beginning of the stock crash recession in 2001. It was only rescued by the growth of the housing bubble. It is unlikely that the Fed will find another bubble that can pull the economy out of this recession.

The list of villains in this story is long. Obviously the banks and mortgage companies that made predatory loans deserve a special place in hell, but almost all the experts on economic policy (especially those who promoted home ownership) also deserve blame. It is incredible that this crew, after having missed a $10 trillion stock bubble in 90s can miss an $8 trillion housing bubble just a few years later. If the world were fair, every one of them from Alan Greenspan on down would be unemployed for a long time into the future, or at least until they developed useful skills.