Background for the Wall Street Meltdown a Decade Ago

The economist Dean Baker was among the only people who saw the housing bubble and recession years before it happened. Ten years later, this article is his analysis of its background and what the elites have learned since then.

Pedantically, I think that an event similar to the Great Recession would have probably happened sometime in the early 21st century anyway, even if the housing bubble was much less significant. When there’s greatly dysfunctional deregulation and regulation while Wall Street largely runs the federal government, I think a major crash was inevitable. Maybe some other disaster would have been less severe, but I think there would still have somehow been a major crash nonetheless.

“…the financial crisis was first and foremost the story of the housing bubble. If mortgage debt had not been tied to an asset that was hugely over-valued, there would not have been a crisis shaking the financial system. This is true even if we recognize the corruption of the financial sector and the number of people who were dealing in complex financial instruments they did not understand.

It is understandable that economists and economic reporters would like to turn attention away from the housing bubble since it was easy to see for anyone paying attention at the time. The country had an unprecedented nationwide run-up in house prices, as house sale prices rose far faster than the overall rate of inflation across most of the country. This was a break with the usual pattern where nationwide house prices just tracked inflation.

This should have set off alarm bells, not only because the run-up was extraordinary, but because there was no remotely corresponding change in rents. The rental indexes barely outpaced the rate of inflation in these years. Also, even as house sale prices were going through the roof, the vacancy rate for housing was reaching record levels.

The fact that houses were being purchased with dubious loans was also hardly a secret. It was common to refer to “NINJA” loans, which stood for “no income, no job and no assets.” Banks were happy to make loans to anyone who would take them since they knew they could resell these loans almost immediately in the secondary market.

A survey by the National Association of Realtors found that 43 percent of first-time buyers in 2005 had a down payment of zero or less on their mortgage. The “or less” refers to the fact that some homebuyers actually borrowed more than the sale price in order to get money to cover closing costs, renovations or moving expenses.

The housing bubble was also the story of the Great Recession. The housing bubble was driving the economy in the years leading up to the crash. Soaring house prices lead to an unprecedented boom in construction, which peaked at just under 6.5 percent of GDP. This would be more than $1.2 trillion annually in today’s economy. After the crash, the glut of housing led construction to fall to less than 2 percent of GDP. Anyone have a quick way to fill a demand gap of $800 billion a year?

But it was actually worse than this. Soaring house prices led to an unprecedented consumption boom as people spent against the bubble generated equity in their homes. When prices came back down to Earth and the equity disappeared, people cut back their spending accordingly. We lost the equivalent of more than $500 billion in annual demand due to the fall in consumption in the wake of the crash.

In all, we were looking at a demand gap on the order of 7-8 percentage points of GDP, or $1.4 to $1.6 trillion in today’s economy. The Obama stimulus, which was less than 2 percent of GDP in 2009 and 2010, was helpful, but nowhere near large enough, nor did it last long enough. The result was the slow and weak recovery that we have seen.

The economic disaster that cost millions of people their jobs and/or their homes, and forced tens of millions to accept lower wages, was 100 percent avoidable if the people responsible for making economic policy had been awake. Turning the story of the housing bubble into a story about the financial crisis is an effort to make issues that are quite simple seem very complicated.