Very few economists saw the problems in the housing market and financial markets coming. Given that their profession is following the economy, this was a serious failing. Fortunately for them, economists are not like dishwashers or truck drivers, workers who are held accountable for their job performance. While no one expects economists to be accountable for their work, the WSJ does a disservice to its readers by relying exclusively on the economists who missed the crash in the housing market and the resulting financial turmoil in assessing the risks of a recession. If the WSJ had spoken to unsurprised economists they might have emphasized the impact that the loss of $6-$8 trillion of housing wealth might have on consumption. The savings rate out of disposable income remains close to zero. Before the wealth created by the stock and housing bubbles began to depress savings in the 90s, the savings rate was typically close to 8 percent. If the savings rate rose to 4 percent, just halfway back to its historic rate, it would imply a loss of more than $400 billion in annual consumption (@ 3 percent of GDP). If this increase happens over a relatively short period of time, then it would virtually guarantee a serious recession. The continued decline in house prices is also virtually certain to lead to even higher mortgage default rates and sharply higher losses for banks on each default. The larger the drop in house prices, the more homeowners stand to benefit by defaulting on their mortgages, thereby giving them more incentive to give up their home to the bank. When mortgages are further underwater, banks stand to lose more money on each loan. Banks have not written down the losses on defaults that have not yet taken place. When they start to see these defaults and must adjust their books, it will almost certainly lead to a second wave of financial turmoil. Look for more surprised economists in the WSJ and elsewhere in the media.
--Dean Baker
