Thomas Jefferson on Wealth Inequality
DeLong Smackdown Watch: Nick Rowe Metaphysical Necessity of Monetarism Edition

DeLong Smackdown Watch: Dean Baker on Origins of the Present Crisis


Dean Baker believes that even if the financial crisis of 2007-8 had been handled perfectly, we would still be in a deep recession:

Beating Up On Brad DeLong: [DeLong]ees the core problem as a loss of $500 billion in housing wealth from excessive exuberance in a few markets pushing house prices too high. Due to poor regulation, this triggered the financial earthquakes of September 2008, putting us where we are today. My arithmetic is a bit different. I see the collapse of an $8 trillion housing bubble that was driving the economy. The collapse of this bubble cost us more than $1.2 trillion in annual private sector demand (@ 9 percent of GDP).... There is nothing in our economists' bag of tricks that gives us an easy mechanism for replacing 9 percent of GDP quickly, which leaves me wondering what the reality grasping Mr. DeLong been smoking?...

By the peak of the bubble in 2006, house prices were more than 70 percent above their trend level. This created more than $8 trillion in housing bubble wealth. This wealth drove the economy in two ways. It had a direct effect in propelling construction, which peaked at 6.2 percent of GDP, about 2.5 percentage points above its post-war average. The bubble wealth also lead to a huge surge in consumption -- through the long-known housing wealth effect. With a wealth effect of 5-7 cents on the dollar, the bubble would have been expected to lead to $400 billion to $560 billion in excess consumption demand.

When the bubble burst, consumption predictably plummeted. Throw in another $6 trillion in lost stock wealth and we get a decline of $600 billion to $800 billion in consumption. (The stock wealth effect is estimated at 3-4 cents on the dollar.)...

The huge overbuilding of the bubble years meant that there was an enormous oversupply of housing. Residential construction has fallen back by more than 3.0 percentage points of GDP or close to $500 billion a year.... Add in the loss of another $100-$200 billion in annual demand from non-residential construction.

This gets a total loss in annual demand of more than $1.2 trillion. Note that the financial crisis appears nowhere in this story. Exactly what mechanism do we have in the private economy for replacing $1.2 trillion in private demand in a short period of time?...

Frankly, I am at loss to understand the fixation on financial markets as an explanation for the crisis. Large firms are sitting on more than $2 trillion in cash. Furthermore, they can borrow much more at historically low interest rates. If there are good investment opportunities out there, we should expect these highly liquid large firms to be running wild taking advantage of them while their smaller competitors are crippled by a lack of access to credit. We don't see this. In fact, Wal-Mart, Starbucks and the rest of scaled back their expansion plans in recognition of the weak economy. Let's get this discussion back to reality. The problem was and is the housing bubble, let's not muddle the picture...

I think I differ from Dean in two big places:

First, the stock market decline is a consequence of the financial crisis--not of the housing bubble. And there is some double-counting in the wealth-effect-of-the-housing-stock, for one thing that people were buying with their housing wealth was bigger and even more leveraged houses. And I am inclined to see a 4% marginal propensity to consume out of housing wealth than a 7% one. So my point estimate of the housing-bubble-collapse-induced fall in the flow of nominal demand is not $1.2 trillion/year but rather $800 billion/year.

Second, the Federal Reserve saw the fall in demand from the collapse of housing wealth coming and took steps to offset it: it dropped the Federal Funds rate by 400 basis points from the winter of 2007 to the winter of 2008. The back-of-the-envelope number I have in my brain is that each basis point of decline in interest rates boosts nominal demand by $1.25 billion/year through the exchange-rate exports, the interest rate-investment, and the interest rate-wealth channels.

Thus as of the spring of 2008 I was looking at a demand shortfall of not $1.2 trillion/year but rather $300 billion/year--which is a one-year pause in growth and a 1% rise in the unemployment rate. It would have been one of the smaller post-WWII recessions. But then came the financial crisis, which turned a small post-WWII recession into the worst post-WWII recession.