The Secret of the Weak Recovery: We Had a F***ing Housing Bubble

The problem with economics is not that it's too complicated; the problem is that it's too damn simple. This problem is amply demonstrated by all the heroic efforts made by economists to explain the weakness of the current recovery.

We've had economists tell us that the problem is that we are now a service sector economy rather than a manufacturing economy. The story is that inventory fluctuations explain much of the cycle. Since we don't inventory services, we will have a slower bounceback in terms of production and employment. (There is a simple problem, since we don't inventory services, the downturn should also be less severe in a service dominated economy. How does this story fit with the worst downturn since the Great Depression?)

We've also been told that the problem is underwater homeowners who can't spend like the good old days because they are underwater in their mortgages. The problem with this one is that we only have around 10 million underwater homeowners, the vast majority of whom have relatively modest incomes. The emphasis is on "only" because, while 10 million is a lot of people to be underwater, it is not a lot of people to move the economy.

The median income for homeowners is $70,000. (Median is probably appropriate here rather than average, since it is unlikely that many wealthy people are underwater.) Suppose that being above water would increase consumption by each of these homeowners by $5,000 a year. This is a huge jump in consumption for people with income of $70k. (Do we think these homeowners are saving an average of $5,000 a year now?) This would lead to an increase in annual consumption of $50 billion a year or less than 0.3 percent of GDP. This would be a nice boost to output, but it would not qualitatively change the nature of the recovery.

Today we have Robert Samuelson telling us that the reason employers are not hiring is uncertainty:

"Businesses have become more risk-averse. They're more reluctant to hire. They've raised standards. For many reasons, they've become more demanding and discriminating. These reasons could include (a) doubts about the recovery; (b) government policies raising labor costs (example: the Affordable Care Act's insurance mandates); (c) unwillingness to pay for training; and (d) fear of squeezed profits."

Hmmm, they're worried about squeezed profits when the profit share of income is at its highest level in more than 60 years? The story of the Affordable Care Act raising costs could at best only explain the behavior of a small group of businesses (firms with close to 50 employees who do not currently provide health care insurance).

But there is a simple way to test the idea that firms would otherwise be hiring but are deterred due to uncertainty about the future: look at the length of workweeks. The logic is simple; increasing hours per worker and hiring more workers are alternative ways to meeting increased demand for labor. Adding work hours involves none of the commitments that apply to hiring addtional workers. If uncertainty, as opposed to lack of demand, is keeping businesses from hiring, then we should be seeing a big increase in the length of the average workweek.

We don't. The length of the average workweek fell by 0.2 hours to 34.4 hours in April. This compares to an average of more than 34.5 hours in the 2006 and 2007. In short there is no evidence that employers are seeing the sort of demand that would justify increasing the size of the workforce but are being kept from doing so because of the concerns raised by Samuelson.

If none of these stories, or any of the others that economists develop to stay employed, explain the length of the downturn, what does? Well, it's pretty damn simple, we had a housing bubble driving the economy before the collapse and there is nothing to fill the gap created. The bubble led residential construction to soar to more than 6.0 percent of GDP at the peak of the boom in 2005. It is now a bit over 2 percent of GDP implying a loss in annual demand of more than $600 billion. The $8 trillion in housing wealth created by the bubble led the saving rate to fall to almost zero due to the housing wealth effect (people increase annual spending by 5-7 cents for each dollar in housing wealth). With the saving rate hovering near 4 percent, we have lost close to $400 billion in annual consumption demand.

The cumulative loss of annual demand is more than $1 trillion. What did we think would replace this demand? Investment in equipment and software is actually close to its pre-recession level measured as a share of GDP. Furthermore, this component of investment has never been a much larger share of GDP, even in the Internet bubble years. Why would anyone expect it to expand rapidly at a time when many firms still have large amounts of excess capacity? (Structure investment is depressed because there was a bubble in non-residential construction as well, leading to large amounts of excess capacity in most areas of non-residential construction.)

Do we somehow think that consumers will spend at the same rate after they have lost $8 trillion in housing wealth as when they had this wealth? Why? Net exports could fill the gap, but the dollar has to fall. Net exports could fill the gap, but the dollar has to fall. (I repeated that one in case any economists are reading.) The value of the dollar is the main determinant of our trade deficit, if we want a lower deficit then we will need a sharp decline in the dollar, which has not happened.

This only leaves the government sector to fill the gap with deficits, which our Serious People types have demanded that we hold down. So, based on the good old intro econo that tens of millions have been subjected to, we know that this recovery will be slow and weak. We simply lack a component of demand to fill the gap created by the housing bubble.

If it seems absurd that economists can't see something this simple, readers should realize that this is a common problem. Just last Friday Robert Samuelson had a useful column that pointed out the huge imbalances that persist in the euro zone and pointed out that the region's crisis is far from over. While he is exactly right, the amazing part of the story is that competent economists somehow did not see these imbalances developing.

As I pointed out, several of the current crisis countries already had incredible trade deficits long before the crash as the world's leading economists were celebrating the "Great Moderation."

Current Account Balance as a Percent of GDP


Source: International Monetary Fund.

How did the folks at the European Central Bank think that these deficits would fall to a sustainable level without some sort of disastrous crisis? This one should have been simple, but the world's leading economists all missed it.

I recall back in the 1990s and the last decade when both Republican and Democratic economists wanted to invest Social Security funds in the stock market. (Democrats generally wanted to invest the fund collectively rather through individual accounts.) I tried to point out that both were assuming impossible rates of return given the fact that the stock market was at price to earnings ratios that were far higher than historic averages.

When this issue was highlighted in the debate over President Bush's privatization plan (see the No Economist Left Behind test) Brad DeLong suggested that we do a paper on it for Brookings conference. I didn't think that this simple arithmetic could warrant a Brookings paper, even though the issue was hugely important. To get it in Brad (along with Paul Krugman) added a model of optimal consumption paths given a declining rate of labor force growth. While the model was fine, it had nothing to do with the basic issue that the stock market was over-valued at the time that people were thinking of investing workers' Social Security money in it. The model did add sufficient complexity so that we get the Brookings crew to take the simple argument seriously.

The same story held during the housing bubble years. I had many people ask me why I didn't publish anything in journals on the bubble in the years 2002-2007 when I was writing for CEPR's website and popular publications. The reason is that it was too simple a story for any serious journal.

The basic story was that house prices had diverged sharply from their long-term trend and there was no plausible story rooted in the fundamentals of the housing market that could explain this divergence. While this was certainly compelling in my view, the American Economic Review is not going to publish an article that shows house prices just keeping pace with inflation for 100 years and then suddenly rising by 70 percent in real terms from 1996-2006. It would be necessary to somehow make the story complicated to get economists to take it seriously.

To my view this is the fundamental problem of economics. There is a need to find ways to make economic issues complex even when they can be explained by the simple economics that we teach in econ 101. This is not a pretty picture.

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