Dean Baker's new book, Plunder and Blunder: The Rise and Fall of The Bubble Economy, explores the stock and housing bubbles at the heart of our current economic crisis. This week, we're hosting a two-part discussion of the book, moderated by Ezra Klein. Check back on Thursday for part two.
The country is suffering the worst downturn since the Great Depression for a simple reason: An $8 trillion housing bubble collapsed. The leading lights of economics and finance, with very few exceptions, could not see the largest financial bubble in the history of the world. The result is soaring rates of unemployment and foreclosure, a crippled financial system, and a huge cohort of baby boomers who have seen their home equity and savings vanish and now face retirement almost totally dependent on Social Security and Medicare.
The most infuriating aspect of this disaster is that it was completely preventable. The basics of the housing bubble were straightforward. House prices began soaring in the mid-1990s, hugely outpacing the overall rate of inflation. This followed a 100-year-long trend in which nationwide house prices had just kept even with the rate of inflation.
There was no fundamentals-based explanation for the explosion of house prices on either the demand or supply side. Furthermore, there was no remotely comparable increase in rental prices. If the fundamentals of the housing market explained the run-up in house prices, then there should have been a comparable rise in rents. Instead, rents only slightly outpaced inflation in the 1990s, and inflation-adjusted rents actually fell slightly in this decade.
The huge overvaluation in house prices guaranteed trouble when prices adjusted. Homeowners consumed based on the wealth in their home. When housing prices plunged, so too did consumption. The effect of this plunge in demand has been amplified by the collapse of the huge pyramid of creative financing that grew up in the shadow of the bubble and in turn fed its growth. Ever greater levels of leverage on ever more risky loans were the path to big profits in the boom years. This was the path to bankruptcy following the bubble's collapse.
Not only did Federal Reserve Board Chairman Alan Greenspan and the other leading lights of the economic profession fail to see the $8 trillion housing bubble, they somehow failed to recognize the explosion of risky mortgages and the highly leveraged chain of finances built on top of these mortgages.
It would have been hard even for someone without regulatory authority to fail to notice the explosion of these mortgages: sub-prime went from just 8 percent of the market at the beginning of the decade to 25 percent by 2005, but the Fed chair either didn't see this increase or didn't care. As a result, instead of attacking the bubble, those in positions of authority celebrated the rise in homeownership.
Remarkably, even now, economists and policy analysts still seem determined to make housing and financial policy as though the bubble is not there. They talk about stabilizing housing prices without distinguishing between markets where the bubble is still deflating and those markets in which house prices are consistent with fundamentals.
It would be difficult to believe that our top economists can still be so incompetent, but among economic policy makers, blindly following the conventional wisdom seems to be a job requirement. Even if this policy leads to yet another disaster, those responsible are unlikely to face any serious consequences. The taxpayers, homeowners, and job losers are the ones who pay the price of the economists' mistakes.
Is there any way that economists can ever be held accountable for the quality of their policy advice? And, if they can't be held accountable, is there any reason that the public should ever take these experts seriously?
The optimal use of my space on this topic (like most others) would probably be to quote large chunks of Dean's own writings. Still, for the sake of my own professional ego, I'll go for something slightly more original.
Compare the halting response of elites to the development of the housing bubble with their response to the merest hint of rising inflation. It seems like a distant age, but just six months ago there was an outpouring of concern over rising prices. Bernanke was urged to act by raising interest rates (or at least holding them stable) while the U.S. economy was in recession. This would have slowed the economy down further. It was, not to put too fine a point on it, nuts.
Why were so many influential people ready to give up fighting the recession-in-progress, in fact were willing to actively worsen it, in an attempt to force inflation rates from the middle-low to low-low single digits? Does economic research and data predict utter ruin when inflation rates rise from 2 percent to 4 percent? Well, no. And, it actually does predict such ruin when trillions of dollars of wealth disappear.
So, the upshot is that the economic policy-making elite seemed ready and willing, on the basis of thin evidence as to its actual danger to the economy, to savagely attack inflation. But they also actively denied the very existence of something that was clearly a present danger to the American economy. What gives? It's becoming harder and harder for me to avoid an awfully reductionist conclusion: A problem is only a problem when rich people may get hurt, and solutions are only viable when rich people are not inconvenienced by them.
Take the housing bubble. Why weren't the institutions that enabled it (besides creative financing I'd add in the perverse global financial system that sees poor countries plow trillions of dollars in capital into the U.S.) regulated and reformed? Why wasn't its root cause -- irrational exuberance and myths about how home prices just cannot fall -- addressed squarely by policy makers eager to inform the public they serve that these beliefs would cost them lots of money? After all, it's not in any politician's interest to preside over an economic wreck. So what incentives were there for total inaction? The incentive of a bloated financial sector making a lot of politically powerful people a lot of money, I'd say. What incentives, conversely, made fighting (largely phantom) inflation with interest-rate policy seem so doable? Maybe the fact that rising inflation hurts the rich, but the joblessness that results from inflation-fighting mainly hurts the poor?
To my inner economist, this analysis sounds like something I should be distributing by hand at my local subway station. But, the past year has been awfully radicalizing. Time and again what should be the most technocratic, noncontroversial area of policy -- insuring sound macroeconomic performance and recovery -- has been fatally compromised by class interests and by a host of my peers making silly arguments in support of them. It looks increasingly like macroeconomic policy is something progressives may be fighting over for a long time. This, to me, is the depressing but eye-opening theme of Dean's book.
Dean was among the earliest economists, possibly the first, to recognize the housing bubble and sound the alarm. The economic downturn, on track to be the worst since the Depression, is due, as he argues, to the collapse of the housing and stock-market bubbles that wiped out $6 trillion and counting of housing wealth and $8 trillion of stock-market wealth. It is this, and not the mortgage mess or credit crunch that has sent the economy hurtling downward. Dean plays a leading role in providing a clear explanation of the current crisis to millions of people who are at a loss to understand how their house and retirement savings could have disappeared so quickly.
But does Dean do full justice to the role played by financial markets in contributing to the crisis that is upon us -- can the credit markets be characterized simply as a “huge pyramid of creative financing that grew up in the shadow of the bubble”? Or did global financial flows play a more central role in the unfolding drama?
A key part of the story lies in the overvalued dollar -- much beloved by the Clinton administration and then-Treasury Secretary Robert Rubin, but which sounded the death knell for much of domestic manufacturing and the good jobs this sector provided. The trade deficit went from $39.2 billion in 1992 to $379.8 billion in 2000 and continued its ascent during the Bush years, reaching a peak in 2006 at $838.3 billion -- about 5.7 percent of gross domestic product.
This constant flow of financial capital into the U.S. kept interest rates low and facilitated the easy flow of credit to households and businesses. The flood of credit and artificially low interest rates fueled the rapid growth of a financial services industry that made its money by slicing, dicing, repackaging and selling debt – mortgage-backed securities, derivatives, credit default swaps – and charging huge fees for this “service.” On the retail side of financial services, it was all about getting people into cheap-looking mortgages whether or not they could afford the house. Subprime mortgages, alt-A mortgages, liar loans and deceptive practices pushed households to assume too much debt and inflated the housing bubble.
Domestic policies alone -- the economic recovery package even in the unlikely event that it is accompanied by 21st-century regulation of U.S. financial markets -- will not be sufficient to put the economy back on a sound footing. To restore aggregate demand and full employment, the federal government would have to replace lost demand due to the loss of housing and stock-market wealth plus cover the trade deficit. Assuming the trade deficit falls to 4 percent in the recession, this would mean annual budget deficits of 8 percent of GDP.
What are the alternatives? We could join Wall Street in its frantic search for the next new thing -- a bubble to replace the ones that burst. Or we can pursue an international effort to restore balance to global trade -- a tall order because it would require rising wages in chronic-trade-surplus countries and a falling dollar in the U.S.
One of the necessary conditions of recent bubbles is so-called experts to weave what Robert Schiller has called "New Age" stories telling us why this time, it's different. This time, the bubble isn't a bubble. This time, there will be no pop, no pain. And we love to hear these stories. As Americans we believe in the happy ending.
The story Dean told throughout the bubble years was a different story, where history matters, and economic truths don't change so very much. We should expect what goes up to come down. As stories go, this one is something of a bummer. It would not be surprising if given a choice, people chose to believe the more entertaining story.
The question is, did people have a choice about which story to believe? Certain experts are given the megaphone, and for a reason. Many of the experts providing the advice were the same ones making the money. As Dean lays bare, the stockbrokers exhorting you to invest were making a killing off of the fees. The housing experts that received the most press worked for realtors, home builders and financiers. Perhaps most important, the newspapers needed the real estate classifieds to make their business model work. To keep their jobs, all of these folks needed us to keep believing in a better, richer tomorrow. And so they kept the music playing and taking our money long after the party should have ended. As Citigroup's chief executive, Charles O. Prince knew all too well, "As long as the music is playing, you've got to get up and dance."
While there might somewhere be a chance for a real trial where conflicts of interest and criminal intent have a chance of being established, this seems unlikely. There is some chance experts who did get it right will be able to grab the megaphone and expose in a lasting way the failures, deceits, and real suffering caused by the happy stories and the conflicts of interest (how's that working for you, Dean?).
Going forward, the answer, I am afraid, is boring. It is government. We need the return of the government expert. An ombudsman. A professional killjoy. In recent years, we've seen rather little separations between the government's experts and Wall Street's fortunes. Clearly, Hank Paulson came to government from Goldman-Sachs. Robert Rubin left government and returned to Wall Street and used his knowledge that homeownership sells in Washington to guide Citigroup's expansion into subprime lending. At the same time, solid HUD reports showing that "once a homeowner always a homeowner," was a myth were buried.
Instead, as the mortgage securities market began to fall apart, U.S. Department of Housing and Urban Development Secretary Alphonso Jackson was sent to China to tell the Chinese the U.S. housing market was strong in a last gasp effort to drum up business for the industry. The incentives, in other words, all pointed in the same direction. What we need is a storyteller specifically asked to lean against the wind: To tell us what the dangers are. To deliver a report to the president on the weaknesses in the economy, give testimony to Congress on the cracks in our prosperity, and to make both very, very public. But give this doomsayer a good pension. He's going to need it.
"The past year has been awfully radicalizing," writes Josh, and I think he's right. But it's been an ad-hoc sort of radicalization. One week the center is rationalizing buying failed assets, the next week deciding the issue is really capital injections, the next week debating "systemic fixes," and then trying to figure out if we should just go the whole Sweden.
The import of Dean's book, I think, comes in part because he got the problem right before it was politically prudent to do so. But what's been interesting in the aftermath is that, as Dean says, there was no secret information driving his analyses. The problems were known; they just weren't acknowledged. The system wasn't ready to face them.
As such, I think it's time to dismiss worn bonds of "seriousness." The situation is burning through consensus offerings so fast that it's hard to say what will, or will not be, radical next week. We've already identified various culprits: The housing bubble, global financial flows, the political system's lazy and late reaction to problems for the working class. So for Thursday, let me ask this: In 500 words or less, what should be done? Not what can be done, not what we think will be done, but what should be done? In some ways, the problem was obvious, just inconvenient. Is that true for the solutions, too?