Blame It on the Bubble

Politicians and the media continue to refer to the economic downturn as being the result of a financial crisis.
This is wrong. We have 15 million people out of work because the
housing bubble that drove the economy since the last recession finally
burst. The financial crisis may have been good entertainment for those
who like to see huge banks collapse, but it was a sidebar. The real
story was the rise and demise of the housing bubble.

Those who
claim that the real problem was the financial system and its faulty
regulation can be disproved with a single word: Spain.

Spain is noteworthy because it now has an unemployment rate of more than 19%,
the highest rate in any of the wealthy countries. Spain did not have a
financial crisis. In fact, its well-regulated financial system is often
held up as model for the United States.

Spain did have a horrific housing bubble.
As a result, the share of construction in the economy rose from less
than 8% of GDP at the end of the 90s to 12.3% in 2007. By comparison,
it is typically less than 6% of GDP in non-bubble years in the United
States. This rapid rate of construction led to enormous overbuilding,
which meant that a collapse was inevitable with construction falling to
far below normal levels.

The run-up in house prices also had the
predictable effect on consumption. Because people believe that the
run-up in house prices is based on fundamentals, homeowners assume that
their newly created housing wealth is real and they spend accordingly.
Spain's saving rate fell from just under 6% in 2000 to 3% in 2007. When
the housing wealth created by the bubble disappeared people naturally
cut back their consumption.

This is Spain's crisis. According to
the IMF, housing starts in Spain fell by 80% from the peak of the boom.
While total construction has not fallen as much (repairs and
non-residential construction did not decline nearly as much), if
construction in Spain fell by 50%, this would imply a loss in annual
demand of more than 6% of GDP. That would translate into a drop in
demand of more than $800bn in the United States.

Similarly the
loss of housing wealth reverses the housing wealth effect. If
consumption fell enough to return the savings rate to its pre-bubble
level, then this would imply a loss in annual consumption demand of
more than three percentage points of disposable income. In the US this
would amount to more than $300bn in lost annual consumption.

There
is no easy mechanism to replace more than $1tn in lost demand. This is
why Spain's economy is in a severe slump right now. Note that just
about all analysts agree, Spain's financial system was well regulated
and it had none of the loony loans and outright corruption that
pervades Wall Street and the US financial system. Yet, it is suffering
from this economic downturn even more than the United States.

The
moral of this story is that the problem is not first and foremost a
financial crisis. It might be fun to watch the Wall Street and
government boys sweat as they stay up late trying to keep the big banks
from drowning in the cesspools they created. But this is all a
sideshow. No one saved us from a "second Great Depression," they just
saved the jobs and wealth of the Wall Street crew.

The economy's
real problem is simply the loss of demand created by collapse of the
bubble. Throwing even more money at the banks is a way to ensure that
they don't suffer from the consequence of their own greed and
stupidity. It is not a way to restore the economy to health.

Restoring
the economy to health is about finding a replacement for the demand
lost as a result of the collapse of the bubble. In the short-term, this
means increased government spending and tax cuts. Deficits put money in
the economy, and using the old-fashioned view that people work for
money, we can determine how much money we need to spend for the
government to get the economy back towards full employment levels of output.

In
the longer term, we need to move towards more balanced trade, with
higher exports and fewer imports making up for the demand lost due to
collapse of the housing bubble. This will require a lower-valued dollar
- everything else in the trade picture is just for show.

We do
need financial reform. We have an incredibly wasteful and reckless
financial industry. But bad financial regulation by itself did not give
us 10% unemployment, nor would good regulation have been sufficient to
prevent it. Just ask the workers in Spain.