The unending search for ‘the’ reason

David Altig asks: “Why Was the Housing-Price Collapse So Painful? (And Why Is It Still?)”. 

His considerations:

Foresight about the disaster to come was not the primary reason this year’s Nobel Prize in economics went to Robert Shiller (jointly with Eugene Fama and Lars Hansen). But Professor Shiller’s early claim that a housing-price bubble was full on, and his prediction that trouble was a-comin’, is arguably the primary source of his claim to fame in the public sphere.

Several years down the road, the causes and effects of the housing-price run-up, collapse, and ensuing financial crisis are still under the microscope. Consider, for example, this opinion by Dean Baker, co-director of the Center for Economic and Policy Research:

…the downturn is not primarily a “financial crisis.” The story of the downturn is a simple story of a collapsed housing bubble. The $8 trillion housing bubble was driving demand in the U.S. economy in the last decade until it collapsed in 2007. When the bubble burst we lost more than 4 percentage points of GDP worth of demand due to a plunge in residential construction. We lost roughly the same amount of demand due to a falloff in consumption associated with the disappearance of $8 trillion in housing wealth.

The collapse of the bubble created a hole in annual demand equal to 8 percent of GDP, which would be $1.3 trillion in today’s economy. The central problem facing the U.S., the euro zone, and the U.K. was finding ways to fill this hole.

In part, Baker’s post relates to an ongoing pundit catfight, which Baker himself concedes is fairly uninteresting. As he says, “What matters is the underlying issues of economic policy.” Agreed, and in that light I am skeptical about dismissing the centrality of the financial crisis to the story of the downturn and, perhaps more important, to the tepid recovery that has followed.

At the end David Altig muses that:

A more systematic take comes from the Federal Reserve Board’s Matteo Iacoviello:

Empirically, housing wealth and consumption tend to move together: this could happen because some third factor moves both variables, or because there is a more direct effect going from one variable to the other. Studies based on time-series data, on panel data and on more detailed, recent micro data point suggest that a considerable portion of the effect of housing wealth on consumption reflects the influence of changes in housing wealth on borrowing against such wealth.

That sounds like a financial problem to me and, in the spirit of Baker’s plea that it is the policy that matters, this distinction is more than semantic. The policy implications of an economic shock that alters the capacity to engage in borrowing and lending are not necessarily the same as those that result from a straightforward decline in wealth.

Having said that, it is not so clear how the policy implications are different. One possibility is that diminished access to credit markets also weakens policy-transmission mechanisms, calling for even more aggressive demand-oriented “pump-priming” policies of the sort Dean Baker advocates.

So as not to let any alternative off the table, Altig ‘goes Austrian’:

But it is also possible that we have entered a period of deep structural repair that only time (and not merely government stimulus) can (or should) engineer: deleveraging and balance sheet repair, sectoral resource reallocation, new consumption habits, new business models driven by both market and regulatory imperatives, you name it.

In my view, it’s not yet clear which policy approach is closest to optimal. But I am fairly well convinced that good judgment will require us to think of the past decade as the financial event it was, and in many ways still is.

So there are several theories (or alternative explanations). But a more general explanation – one that ‘contains’ both the “wealth-loss” explanation and the “altered capacity to engage in borrowing and lending” explanation was not considered. The “missing” explanation is that monetary policy failed miserably in providing an environment of nominal stability. Also, while nominal stability remained more or less intact, “sectoral reallocation” proceeded ‘naturally’.

The charts show that it was only after nominal income collapsed that the real economy (reflected in the unemployment rate) tanked. Note also that by that time housing wealth had already been ‘crushed’ and problems in financial institutions had surfaced long before, being made more acute with the complete loss of nominal stability after mid-2008.


And why is it still painful? The reason, which follows from my ‘explanation’, is that nominal spending (income or NGDP) is still way below any reasonable level. Again, more than anything else, that explains the dearth of progress made in a host of metrics.

In a recent post David Beckworth writes: “My Supply-Side Senses Are Starting to Tingle”, and shows that while until recently the biggest problem revealed by surveys of small businesses was “lack of sales” (demand), that has now been surpassed by concerns with “regulation” (affecting supply). I commented:

David, that´s almost the natural consequence of a deep and protracted demand slump. At a minimum, governments itch to legislate a recovery. The unintended consequence is that it works in reverse!

If true, prospects are quickly dimming!

2 thoughts on “The unending search for ‘the’ reason

  1. Mr Nunes, thanks. I believe the key factor in the curtailment of borrowing and lending was simply that the banks got into big trouble, as LIBOR went higher than fixed swaps rates. And so banks could not make money on derivatives which greased lending before the crisis. And they were forced to mark to market so lending in commercial paper was destroyed. So, a financial crisis was the ultimate result of the housing bubble decline and wealth decline. People could no longer borrow when their house prices declined.

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