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The US Housing Bubble and Aftermath: Economist Dean Baker's Account of What Should Have Been Done

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Alan Greenspan should have led economists to document the potential harm of the bubble, and burst it early, before it could destroy and/or allow the theft of $7 trillion of wealth, and thereby ruin tens of millions of lives.

What happened is straightforward:   we had a huge run-up in house prices that was anomalous.   After 100 years in which nationwide house prices kept even with the overall rate of inflation, house prices began to sharply outpace inflation, beginning in the late 1990s.

By 2002, when the bubble began to form, house prices had already risen by more than 30% in excess of inflation.   By the peak of the bubble in 2006, the median increase in house prices was more than 70% above the rate of inflation.   This was clearly and pronouncedly a bubble, and should have been publicly labeled as such by those in charge of monitoring, regulating and protecting our economy.   But too many people were making big money from it.

Nevertheless, here was a huge problem and a huge danger  

Why?   Because this bubble was clearly driving our economy.   It drove the economy by creating a boom in residential housing construction.   We were building housing at near record pace in the years 2002-2006.   And this in spite of the fact that we had record levels of vacancies even at the beginning of that period, and an aging population that would soon be able to ill afford the purchase of any of this newly created housing.

The other way in which the bubble was driving the economy was through its effect on consumption.   The growing bubble created more than $8 trillion in ephemeral wealth -- in inflated housing values.   Homeowners thought this wealth was real and spent accordingly, many using their home as a kind of ATM machine.   The result was a massive consumption boom.

When the bubble burst, the building boom went bust.   Construction fell to its lowest levels since the 1950s, as the country waited to gradually work off a glut of housing.   As a result, consumption fell back to more normal levels, as people realized that they had lost tens of thousands of dollars of equity in their home.

The combined effect of:

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a)   this plunge in construction and consumption spending, together with . .

b)   the collapse of a parallel bubble in non-residential real estate,

. . was to lower annual demand in the economy by more than $1.2 trillion .   And this was the reason for the prolonged economic downturn.   There was nothing in the economists' bag of tricks that could allow the economy to quickly and easily replace $1.2 trillion in lost demand.   Here then is the reason we are still 10 million jobs below full employment, four years after the onset of the recession.   It is also the reason that millions of lives are being ruined and will continue to be ruined, as good jobs remain scarce and salaries low.

Why was all this allowed to happen, in spite of all the warning signs?   Answer:   Politically well-connected banksters were making billions.     Countrywide and Merrill Lynch were issuing and packaging fraudulent mortgages because they were making tons of money on them, not because they wanted to make moderate income people and minorities homeowners.   That was just the cover story, peddled by President George W. Bush and others.

Fannie Mae and Freddie Mac deserve plenty of blame in this story as well.   Why?   Because housing is all they do, and so they should have seen the bubble and tried to stop it.   Instead, they simply jumped on the big-money bandwagon, so as to join in on the tremendous profit-making opportunities, even though that profit would ultimately be at the expense of most everyone else in the country.   Fannie and Freddie became followers and profit takers, instead of the leaders and guardians they should have been.  

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The worst loans were securitized (bundled into marketable securities and very profitably sold to suckered investors) by the Wall Street boys.  Fannie and Freddie got into junk mortgages late in the game and did so to regain market share as a profit making business, not out of a concern to extend homeownership.   Once again, that was just the convenient rationalization and cover story.

Meanwhile, the government agency devoted to extending homeownership to moderate income people, the Federal Housing Authority (FHA), became almost irrelevant.   Its market share shrank to less than 2% at the peak of the bubble (compared with around 10% in more normal times).   Why?   Because its lending standards were far stricter than those of the subprime-mortgage pushers, and they were forbidden by law from jumping onto any big-profits bandwagon.  

What could have been done to prevent this tragedy?

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Several years after receiving my M.A. in social science (interdisciplinary studies) I was an instructor at S.F. State University for a year, but then went back to designing automated machinery, and then tech writing, in Silicon Valley. I've (more...)
 

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