May 23, 2016
Paul Krugman used his column this morning to point out how strong the economy was in the 1990s and how the low unemployment in the second half of the decade allowed for strong wage and income gains at the middle and bottom end of the income distribution. This is all very much on the mark. However, he also distinguished the impact of the stock bubble from the housing bubble by saying that the collapse of the latter had more serious consequences because of the growth of private debt.
There are a few points worth making on this assessment. First the collapse of the stock bubble did have very severe consequences for the labor market. The economy did not gain back the jobs lost in the recession until January of 2005. At the time, this was the longest period without net job growth since the Great Depression. The weakness of the labor market was the reason the Fed kept the federal funds rate at 1.0 percent until the middle of 2004.
If Krugman is pointing to the financial crisis as fallout, then of course the issue of private debt is correct. There were a huge amount of mortgage loans and derivative instruments that could go bad with the collapse of house prices. This was not true in the case of stock prices. It’s much more difficult to borrow against stocks than housing. (The evil regulators at work.)
However, when it comes to the real economy, as opposed to the fun of watching collapsing financial behemoths, we don’t have any reason to look to debt. The investment boom sparked by the stock bubble was much smaller than the construction boom sparked by the housing bubble. The share of non-residential investment in GDP fell by 2.6 percentage points from its 2000 peak to its 2003 trough. Residential construction fell by 4.0 percentage points of GDP from 2005 to 2010.
In addition, the housing wealth effect on consumption is much larger than the stock wealth effect. This is due to the fact that it is much easier to borrow against wealth and also that housing wealth is much more evenly distributed. Bill Gates probably doesn’t increase his consumption much when the value of his stock doubles. Middle income homeowners are likely to spend much more when the value of their house doubles.
In short, while it has become fashionable to cite the importance of debt in explaining the severity of the downturn following the collapse of the housing bubble, it really doesn’t fit. The severity of the downturn can easily be explained by the loss of wealth and the end of the construction boom, debt is at most a secondary consideration.
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