Economics in a Bubble

It is often said that the there are
few forces as destructive as the power of bad economics. Rarely has
this been more clearly demonstrated than in the current crisis.

While
the bankers' greed fed the housing bubble, the incompetence and
corruption of the economics profession allowed the world's largest
financial bubble to grow unchecked, until its inevitable collapse
wrecked the economy. Remarkably, the economists who got everything wrong as the bubble was expanding, are still being given the opportunity to get everything wrong as we try to dig out from the wreckage.

Even though most of the "best" economists in the world did not see it,
the story of the bubble and its collapse was in fact extremely simple.
The recovery from the stock market crash in 2001 was driven by the
growth of the housing bubble.

In the United States,
the unprecedented run-up in house prices fueled the economy by causing
a construction boom, and even more importantly, a consumption boom, as
the saving rate fell to zero. While many prominent economists lectured
the country on the need to save and to end spendthrift ways, those who
knew economics pointed to the well-known housing wealth effect.

Households
spend in part based on their housing wealth. The predictable result of
the creation of $8tn in housing bubble wealth ($110,000 per homeowner)
was a massive consumption boom on the order of $400bn to $600bn a year.
The problem was not people's spendthrift ways; the problem was that
economic policymakers allowed a huge bubble
to develop. People treated this bubble wealth as real wealth, and
responded exactly as economic theory would predict: they spent like
crazy.

With house prices falling rapidly back to earth, the
housing construction boom is now a bust and saving rates are returning
to normal. The economy is also experiencing a collapse in a
non-residential real estate bubble that developed up in the wake of the
housing bubble. There has been huge overbuilding in retail, office
space, hotels, and most other categories of non-residential
construction.

This backdrop in extremely important in assessing
the "fix the banks" battle cry of the economists who did not see the
housing bubble. The word from this distinguished group is that if we
can get the banks lending again, then the economy will be on its way to
recovery. Coincidentally, the central ingredient in their formula is
throwing hundreds of billions, or even trillions, of taxpayer dollars
at the banks. In other words, they want to impose huge taxes on
ordinary workers to give more money to the people who were most
directly responsible for the propelling the bubble.

The elite
economists tell us that even if this idea might offend our
sensibilities, it is the only way to get the economy going again. This
is where a little basic economics would be useful again.

Suppose
we snap out fingers and bring Citigroup, Bank of America and the rest
of the zombies back to full solvency; what would happen? Is there any
reason to believe that consumers will spend more? Remember the housing
wealth effect? The bubble wealth is gone; people are spending less
because they don't have the wealth to justify the spending. We are
seeing the sort of consumer spending levels that we should expect to
see in the absence of a housing bubble. What part of this story can't
the elite economists understand?

Let's turn to construction. If
we fix the banks, will we see more housing construction in a glutted
housing market? Will we see further overbuilding of office space and
retail space? Presumably the answer to these questions is no. Fixing
the banks will have little effect on either residential or
non-residential construction.

Maybe fixing the banks will revive
investment in equipment and software? When considering this
possibility, it is important to remember that large healthy companies
such as Intel, Verizon and IBM are already able to borrow money both
long-term and short-term at very low rates. Therefore, investment by
these companies is not likely to be affected much by fixing the banks.

This
leaves investment in equipment and software by smaller, less
creditworthy companies. Undoubtedly many of these companies are
experiencing difficulty getting access to capital right now. Part of
the problem is due to the fact that these firms look like very bad
credit risks in the middle of a steep recession, but part of the
problem is due to the condition of the banks.

So, if we snap
our fingers and the banks are now fixed, these smaller firms will
suddenly be in a position to invest more. Equipment and software
investment accounts for 7% of GDP. If we generously assume that the
capital-starved small firms account for half of this investment, and
that the bank fix will boost their investment by 50%, then throwing
money at the banks will increase investment by an amount equal to 1.75%
of GDP an amount that is approximately equal to half the falloff in
housing construction, and less than a quarter the total drop in demand
due to the collapse of the housing bubble.

In other words, the
arithmetic shows that a bank fix, while desirable, cannot possibly be
sufficient to offset the collapse of the housing bubble. If our
priority is to save the bankers from suffering the consequences of
their own mistakes, then it makes sense to throw all our money at them.
But if the point is to fix the economy, then we have to look elsewhere.

Those of us who know economics recognise this fact. Those who
insist on the bank-fix route should be asked one simple question: "When
did you stop being wrong about the economy?"