Friday, December 03, 2010

Dean Baker describes the housing bubble and how it hammered consumer demand

Economist Dean Baker shares his calculations of how the housing bubble ended up in the current depression (or Great Recession, if you prefer) in Beating Up On Brad DeLong TPM Cafe 11/28/2010:

The story of the bubble is painful, yet simple. Beginning in the mid-90s nationwide house prices diverged from a 100-year long trend. By the peak of the bubble in 2006, house prices were more than 70 percent above their trend level. This created more than $8 trillion in housing bubble wealth.

This wealth drove the economy in two ways. It had a direct effect in propelling construction, which peaked at 6.2 percent of GDP, about 2.5 percentage points above its post-war average. The bubble wealth also lead to a huge surge in consumption -- through the long-known housing wealth effect. With a wealth effect of 5-7 cents on the dollar, the bubble would have been expected to lead to $400 billion to $560 billion in excess consumption demand.

When the bubble burst, consumption predictably plummeted. Throw in another $6 trillion in lost stock wealth and we get a decline of $600 billion to $800 billion in consumption. (The stock wealth effect is estimated at 3-4 cents on the dollar.) ...

This gets a total loss in annual demand of more than $1.2 trillion. Note that the financial crisis appears nowhere in this story. Exactly what mechanism do we have in the private economy for replacing $1.2 trillion in private demand in a short period of time?
If I read him correctly, his point is that the financial crisis of 2008 may have exacerbated the crisis. But the core of it is the collapse in consumer demand caused by the housing bubble. And I think there's a lot to be said for that view.

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