May 16, 2015
I’m afraid that I have to take some issue with Paul Krugman’s claim that the economic equivalent of accepting nonsense about WMDs to support the war in Iraq was taking seriously the deficit hawks concerns about high interest rates and soaring inflation. While Krugman is right in calling many of these people frauds and cranks, this distracts attention from the real Iraq moment in economics: ignoring the housing bubble.
The accepted view in elite circles is that the crash in 2007-2008 was some sort of natural disaster like Hurricane Katrina. It was impossible to see it coming and only the most astute observers could detect evidence of problems in little things like an explosion in subprime loans and some questionable bank practices in securitization.
This view is very comforting to the elites since almost all of them chose to ignore the evidence that there was a huge bubble and that it’s collapse would be really bad news. But just as it should have been easy to see that the dog and pony show the Bush administration put on about weapons of mass destruction was nonsense, it should have been easy to recognize the housing bubble and to know that its collapse would devastate the economy.
In terms of evidence for the bubble, we had a hundred year long history in which house prices had just tracked the overall rate of inflation. Why did they suddenly hugely outpace the rate of inflation? By 2002, when I first wrote about the bubble, the gap was 30 percentage points. In 2006, at the peak of the bubble, the gap was more than 70 percentage points. If this reflected the fundamentals of the housing market, why wasn’t anything going on with rents, which were just rising in step with inflation? And why did we have a record vacancy rate as early as 2002?
Furthermore, it was clear that the bubble was driving the economy. Residential construction rose to a record share of GDP, peaking at close to 6.5 percent in 2005, up from a long term average of just over 4.0 percent. And the $8 trillion in ephemeral housing equity created by the bubble led to a consumption boom, with consumption spending hitting record highs relative to income. (Those trying to explain weak consumption now are seriously confused. The issue is that consumption was extraordinarily high before the crash. Now that people have lost their housing equity, it should not be surprising that they no longer spend based on wealth that no longer exists.)
Anyhow, it was entirely predictable that the collapse of the bubble would lead to a massive loss of demand. I had put the lost demand in the range of 6-8 percentage points of GDP ($1.0 trillion to $1.4 trillion in today’s economy). What did the elites think could replace this lost demand and prevent a severe recession?
And the financial crisis was also 100 percent predictable, even if the exact course was not. Housing is always a highly leveraged asset even in normal times. But it was widely known that lending standards had been weakened, with large numbers of homes being sold with little or no down payment. How could anyone not expect large numbers of these loans to go bad when prices plummeted? And, how could anyone not expect that this would lead to serious financial stress for whoever had these loans on their books, starting with Fannie and Freddie?
Anyhow, the fact that the housing bubble was a massive time bomb that would at some point wreck the economy should have been apparent to any competent economist, just as the fact that the Bush administration was lying about WMDs in Iraq should have been evident to anyone with any pretense of expertise in foreign policy. The failure to see the housing bubble was the real Iraq disaster for the economy, the nonsense about soaring interest rates and hyperinflation from Paul Ryan and his friends was just kids’ stuff.
Comments