The Great Recession and the Housing Bubble

When the bubble burst housing construction fell back not just to its normal levels, but to its lowest share of GDP on record. The reason is that the construction from the bubble led to enormous overbuilding, which meant record high vacancy rates. The loss of $8 trillion in housing wealth led to an end of the bubble driven consumption boom. Taken together, the falloff in residential construction and the drop in consumption implied a loss in annual demand of more than 6 percentage points of GDP (@ $1.1 trillion in today’s economy).

There was no easy way to replace this loss in demand. Investment was not about to jump by 50 percent. Net exports could and did increase, but this is a slow process. In short, when the bubble burst we were destined to have a serious recession with or without the financial crisis.

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3) The focus on the financial crisis creates a phony story of being rescued from disaster. The banks had put themselves into bankruptcy by virtue of their greed and incompetence. If the market had been allowed to work its magic, Goldman Sachs, Citigroup, and most of the other behemoths would be out of business. We would have been able to eliminate this horrible albatross on the economy with one blow.

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In short, the bailouts were not about saving the country from a Second Great Depression, they were about saving Wall Street banks from the market. Not much to feel good about there.

The Big Short, the Housing Bubble and the Financial Crisis
http://cepr.net/blogs/beat-the-press/the-big-short-the-housing-bubble-and-the-financial-crisis

During the 2000s housing bubble, the market “value” of U.S. homes swelled to about $8 trillion more than it would have been if prices had followed historical trends. To give you an idea of how big a bubble that is, the entire U.S. Gross Domestic Product in 2005 — that is, the value of literally everything produced by the United States that year — was only $13 trillion.

Wall Street joyfully issued bonds “backed” by trillions of dollars of that imaginary wealth, and paid ratings agencies to certify that the wealth was real. The effect on the economy was more or less the same as if Lloyd Blankfein had printed trillions in cash in Goldman Sachs’ basement and somehow persuaded everyone it was real and belonged to them. We all felt richer — for a while. The reason financial bubbles are so common is that they feel so good to almost everyone on the way up. …

But in order to make big money off a financial bubble, it’s not enough to understand that it will collapse. You also have to guess correctly about the timing of its collapse. While in the long run markets have some connection to reality, in the short run they have little connection to anything. If you guess too early or too late, you’ll be intellectually validated but bankrupt. …

The reason it’s important to understand this is that the people most responsible for what happened don’t want you to. Take Alan Greenspan, who as chairman of the Federal Reserve during the bubble’s heyday possessed the most economic power of any single human being on earth, and could have punctured it with one strong speech. …

Moreover, in theory people who short markets perform a valuable function, making bubbles less likely by forcing prices of financial securities to stick tighter to their actual value.

But in practice, that’s only true in heavily regulated, publicly traded areas like the stock market. The characters of The Big Short were shorting housing via bespoke insurance from largely unregulated insurers like AIG Financial Products, which weren’t required to have enough money to pay out on any significant claims. …

So all the money pocketed by the protagonists of The Big Shortcame ultimately from us. Without us, all their cleverly engineered credit default swaps would have been worth as much as a pile of Enron stock. …

Except our own great recession actually began in late 2007. And the people telling us Wall Street’s collapse caused the whole economy to fall apart are the same ones who used to tell us that you could never go wrong by investing in real estate. Maybe it would behoove us, like it did the subjects of The Big Short, to look more closely at their story.

Dean Baker, mentioned above, probably got more right about the housing bubble and its effect on the real economy than anyone else. He makes a strong case that what mattered to ordinary people was simply that the housing bubble deflated, not the intricacies of how bankers inflated it in the first place and subsequently destroyed themselves.

As Baker explains it, our economic catastrophe was straightforward: At its peak, the housing bubble added $1.2-1.4 trillion in annual private sector demand to the economy, or around 10 percent of GDP. Part of this was extra homes being built employing extra construction workers, and part was that homeowners believed they were richer than they were and hence were more willing to spend money. …

This is the true cost of the housing bubble and Wall Street’s looting of our country. You often hear that the financial crisis destroyed, say,$14 trillion in housing and stock market wealth. This is wrong. By itself, the financial crisis destroyed little wealth. The $8 trillion in extra housing bubble “wealth” never existed in the first place; the crisis simply revealed that reality. And the stock market recovered fairly quickly, because that wealth was (mostly) real.

The actual price we’ve paid is that the U.S. economy has been operating far under capacity for eight years. The total value of the goods and services we could have produced but have not is over $7 trillion. That’s more than enough — about $90,000 for every family of four in the country — and as long as the economy remains depressed, it will keep accumulating, along with millions of broken lives.