Thursday, March 11, 2010

Dean Baker: Recession not caused by a financial crisis

Dean Baker, the earliest economist to publicly warn about a housing bubble, argues that the recession was directly caused by the decline of the housing bubble, not by the financial crisis:
Politicians and the media continue to refer to the economic downturn as being the result of a financial crisis. This is wrong. We have 15 million people out of work because the housing bubble that drove the economy since the last recession finally burst. The financial crisis may have been good entertainment for those who like to see huge banks collapse, but it was a sidebar. The real story was the rise and demise of the housing bubble.

Those who claim that the real problem was the financial system and its faulty regulation can be disproved with a single word: Spain.

Spain is noteworthy because it now has an unemployment rate of more than 19%, the highest rate in any of the wealthy countries. Spain did not have a financial crisis. In fact, its well-regulated financial system is often held up as model for the United States.

Spain did have a horrific housing bubble. ... When the housing wealth created by the bubble disappeared people naturally cut back their consumption. ...

This is why Spain's economy is in a severe slump right now. Note that just about all analysts agree, Spain's financial system was well regulated and it had none of the loony loans and outright corruption that pervades Wall Street and the US financial system. Yet, it is suffering from this economic downturn even more than the United States.

The moral of this story is that the problem is not first and foremost a financial crisis. ... The economy's real problem is simply the loss of demand created by collapse of the bubble. ...

We do need financial reform. We have an incredibly wasteful and reckless financial industry. But bad financial regulation by itself did not give us 10% unemployment, nor would good regulation have been sufficient to prevent it. Just ask the workers in Spain.
So, while apparently 71% of Bubble Meter readers blame banks for the U.S. housing bubble (see polls in the sidebar), Dean Baker seems to argue that Spain disproves them.

I still put most of the blame on human psychology. When asset prices are going up, people jump on the bandwagon, which pushes prices up even more. When the bubble finally bursts, people deny personal responsibility by making scapegoats out of people they resent (i.e. those who are "big", rich, powerful, or foreign).

20 comments:

  1. Dear Dean Baker - why after 5 years of renting did you decide to finally purchase in late 2009? And in the immunozone nonetheless.

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  2. But what caused the housing bubble, the financial system, increasing money supply, rise of China?

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  3. Garn-St. Germain Depository Institutions Act of 1982 created Adjustable Rate Mortgages as well as the S&L Crisis. It passed 272-91 in the House of Representatives.

    The Gramm-Leachy Bill of 1999 removed the firewall between commercial and investment banks (which was put into place after the Great Depression) or Glass Stegal Act.

    The Commodities Futures Modernization Act of 2000 created derivatives and allowed for Credit Default Swaps (an unregulated form of insurance used as a hedge for investments i.e. mortgage back securities). Basically, people bought Credit Default Swaps along with Mortgage Backed Securites because if house prices went down they got paid this "insurance". When we got a wave of foreclosures due to the wave of Adjustable Rate Mortgages reseting to an unfavorable LIBOR Index in the Fall of 2008, it was the "Credit Event" which made these Credit Default Swaps come due. It was no different than the insurance companies needing to pay out after Hurricane Katrina, except it was a Nationwide housing correction.

    The Government also promoted Subprime Lending and in the Amendments of the Community Reinvestment Act in the late 1990's they allowed for the Securitization of Subprime Lending and they actually sued banks for not issuing enough Subprime Loans.

    Fannie Mae and Freddie Mac bought Mortgage Backed Securities many of which were Subprime Mortgages that were Securitized. This essentially put the United States Taxpayer on the hook for the Subprime Lending Industry. This implied safety net provided by the US Government encouraged more irresponsible behavior because people knew that the Government would be the safety net.

    What was worse was that many who created the fundamental mistakes by writing the wrong policies were now in charge and controlled the political environment so they could provide cover for themselves and revise the message as to what really happened.

    We need to keep pressing the truth or these bad times will just continue.

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  4. Krugman prefers to compare Spain's housing bubble to Florida's, rather than to the broad housing bubble that existed in the US as a whole. Spain's problem like Florida was rampant speculation fueled by demand for so-called holiday homes.

    The banks have been getting the blame largely because they enabled the insane leveraging that was required to create the bubble to its peak levels. It's no coincidence either that they have both profited during the inflation of the bubble and its subsequent burst.

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  5. Good analysis, you can include Greece, Italy, Portugal, and some other Mediterrenean countries as well.

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  6. Tuskenrayder said...
    "The banks have been getting the blame largely because they enabled the insane leveraging that was required to create the bubble to its peak levels. It's no coincidence either that they have both profited during the inflation of the bubble and its subsequent burst."

    If you think banks have been profiting during the burst then you haven't been paying attention. The banks have been getting crushed during the burst. Numerous large banks have gone under. Citigroup and Bank of America have been losing money hand over fist.

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  7. "people deny personal responsibility by making scapegoats out of people they resent.."

    And what if you are wrong? Might have you just allowed the wrong-doer to have his cake and eat it too, by implying such things so automatically?

    When the dot-com bubble burst, market makers from big investment firms were going online and writing personal diatribes about how they were paid to artificially drive stock prices up, in order to ensure the average investor got properly suckered in. Then they intentionally crashed the market. Then these postings quickly disappeared off the Internet and IRC, and it's as if the entire underlying story went away.

    Then we have RE appraisers essentially saying the same thing after the RE crash, and again very little to no coverage of the manipulation.

    Such automatic decision making on your part lends itself to an automatic examination of your intention.

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  8. I think you have to take everything into account and not blame any one industry. One of the main reasons the financial industry took a tumble is because they helped expand the housing bubble by creating these investment vehicles tied to mortgages. Without that, the banks wouldn't have been able to make as many mortgages as they did and people wouldn't have been able to buy as much property as they did. Good insight into this whole issue though...

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  9. James-

    The same investment banks that profited during the inflation of the bubble have also profited during its burst. JP Morgan, Wells Fargo...and yes, BOA and Citi all posted profits. The losses have come at the expense of those whose assets were gambled away by these banks.

    Banks not to blame? Explain Citi's plutocracy memo...then we can talk about blaming gullible masses.

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  10. I blame the banks for failing to enforce reasonable lending standards. I think its obvious that the housing crash caused the broader financial crises, but the bubble enabled and encouraged by the financial industry, including the banks.

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  11. Tuskenrayder said...
    "The same investment banks that profited during the inflation of the bubble have also profited during its burst. JP Morgan, Wells Fargo...and yes, BOA and Citi all posted profits."

    First, JP Morgan, Wells Fargo, Bank of America, and Citigroup are commercial banks, not investment banks. Sure, Citigroup had substantial investment banking operations prior to the crisis, and JP Morgan & BOA acquired bankrupt investment banks during the financial crisis. However, they are all primarily commercial banks. You seem to be throwing around jargon like "investment banks" and "profits" that you don't understand.

    Your claim that Citigroup and Bank of America are profitable makes me think that you don't know how to read financial statements. I challenge you to tell me exactly what Citigroup's profit was in 2009. What was it in 2008? What was Bank of America's profit in 2009? The numbers are right there in the financial statements. Do you know how to read them? Do they support your claim that these two banks were profitable?

    Speaking of investment banks, what was Lehman Brothers' profit during the financial crisis? What about Bear Stearns? Those were actual investment banks. Does their financial performance during the crisis support your claim?

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  12. "First, JP Morgan, Wells Fargo, Bank of America, and Citigroup are commercial banks, not investment banks. Sure, Citigroup had substantial investment banking operations prior to the crisis, and JP Morgan & BOA acquired bankrupt investment banks during the financial crisis. However, they are all primarily commercial banks. You seem to be throwing around jargon like "investment banks" and "profits" that you don't understand.


    It's always someone else who just doesn't understand. They just don't get it. They just don't understand libertarian arguments otherwise they would share your point of view. Well, as it turns out, you're just wrong...not that you don't understand...just wrong.
    http://en.wikipedia.org/wiki/List_of_investment_banks

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  13. Tuskenrayder said...
    "The same investment banks that profited during the inflation of the bubble have also profited during its burst."

    That is simply wrong. At the time the financial crisis began, the top five independent U.S. investment banks in order of size were Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns. All of the top commercial banks had some investment banking operations, but with the exception of Citigroup their investment banking operations were dwarfed by the big five independent investment banks.

    During the crisis, Bear Stearns and Lehman Brothers went belly up and were bought as scrap by JP Morgan and Barclays, respectively. Merrill Lynch sold itself to Bank of America to avoid collapse. So today, if you look at a list of the top 5 U.S. investment banks, you will see Goldman Sachs, Morgan Stanley, Bank of America, Citigroup, and JP Morgan. However, as I said in my previous comment, Bank of America, Citigroup, and JP Morgan are still primarily commercial banks. Their commercial banking operations are a good deal larger than their investment banking operations. That's why in the Wikipedia article you listed, the investment banking operation of each of these commercial banks is displayed in parentheses. So, everything I said in my previous post remains correct. (Some people classify these primarily-commercial banks as universal banks, but that is not a technical term.)

    You claim that the same investment banks that profited during the inflation of the bubble have also profited during its burst, however three of the original top five independent investment banks no longer exist as independent companies. They were bought out on the verge of collapse. Furthermore, a simple check of the financial statements shows that Morgan Stanley, Citigroup, and Bank of America are not currently profitable, yet you insist they are.

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  14. Look,
    The point that banks (commercial or investment) have profited during the bust is perhaps poorly stated, if not altogether incorrect on a technical level. But while the incorporated entity may not have directly profited, its key officers, high-level managers, and almost all of its employees certainly have. We now know (thank you Lehman, Goldman Sachs, Barclays, Credit Suise, JPM, Citi, etc...) via various dubious instruments and mechanisms (Greece, Enron or Repo 105 anyone?) that many of those very same people, under the guise of fiduciary responsibility, sold deception services or raided corporate finances by obfuscating and even falsifying the very financial statements you're extolling ($50B moved off balance sheets, are you kidding me?!?!). Or they exploited banking loopholes, albeit legally, by very own 2009 domestic carry trade (0% loans used to by treasuries.... I'll take 3% of $1T FTW!) And in the meanwhile PROFITED by extracting exorbitant bonuses ($500M over 15 yrs for our good friend Mr. Dick Fuld). Their original contribution of any substance to our society has been to devise means of circumventing laws and regulations.

    Let's be clear. Banks alone are not to blame. Gov, populace, etc have some difficult questions they need to answer (dealers vs users). But as we look back on what has happened in the last two years, on average, individuals in many of these banks and financial institutions are faring far better than one would think. So while you might argue the semantics, you ought to put that i-bank funded Kool-Aid down for a sec, step back, and take in the big picture.

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  15. Anonymous said...
    "The point that banks (commercial or investment) have profited during the bust is perhaps poorly stated, if not altogether incorrect on a technical level. But while the incorporated entity may not have directly profited, its key officers, high-level managers, and almost all of its employees certainly have."

    That's certainly a fair point, although overstated a bit. Keep in mind that the CEOs of the financial companies that screwed up have pretty much all been fired, although they did generally leave with golden parachutes. Also, despite the general belief to the contrary, many financial industry employees did lose their jobs. When your employer goes belly up, it's pretty hard to remain employed. When your industry is shrinking, as the financial industry did in a big way over the past 2-1/2 years, you've got a good chance of losing your job. I have a co-worker who's brother-in-law worked at Wachovia. When Wachovia went under, he lost his job and most of his 401(k) -- which was foolishly invested in Wachovia stock.


    "and even falsifying the very financial statements you're extolling"

    Keep in mind that when falsifying shareholder financial statements, the goal is always to make profits look BIGGER than they actually are. That's because bigger profits push up the stock price. You guys may want to be careful about arguing that "They made massive profits! ...And they falsified their accounting!"

    Falsifying shareholder financial statements to make it look like you lost money when you were actually profitable is like lying to your wife by telling her you cheated on her, when in fact you were completely faithful. (The opposite is true when reporting profits to the IRS, but that's a separate set of books.)

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  16. When we think of i-banks and such, we normally associate the institution with the upper echelons of its management (oh, I don't know, maybe 15% of its workforce?). So while I certainly feel for your BIL, two facts remain: Wachovia survived by being bought by Wells and its workforce did NOT experience a 100% turnover. Heck, did it even have 15%? The point is NOT that the little guy made it out with big pots of money. I think we all know that hasn't happened. Its that the same 1% of the population that controls 99% of the country's wealth has once again used disguised criminality to make big wealth transfers through complex means... real estate being the lynchpin this time but ENABLED and EXECUTED by financial firms that created the MBSs (and their subsequent friends CDS's and CDO's).

    Regarding falsification of docs, I think we have not begun to learn the full truth. And I think the point about profits-only motivation for falsification is completely off the mark. Falsification was used by Lehman to show smaller LOSSES. If ever the Fed releases the AIG docs and we continue to hear about all that's been happening with the gov bailouts, falsification to show profits will be a quaint concept.

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  17. James-

    All this commercial bank vs. investment bank nonsense and can you read a financial statement taunts (which I can BTW) have little to do with the point that those banks that profited from the inflation of the housing bubble also profited from its burst. I was mainly speaking of Goldman with this comment. I do put blame on the banking industry for enabling the excessive borrowing, but assign ultimate blame to the deregulation that allowed them to bring down the financial system.

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  18. Anonymous said...
    "So while I certainly feel for your BIL,"

    My CO-WORKER'S brother-in-law.


    "Falsification was used by Lehman to show smaller LOSSES."

    OK, larger profits or smaller losses. Either way, the goal of accounting fraud is to make financial performance (reported to shareholders) look better than it actually was. That's still the opposite of the original suggestion, which was that financial companies may have made profits but reported losses to shareholders.

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  19. Tuskenrayder said...
    "All this commercial bank vs. investment bank nonsense and can you read a financial statement taunts (which I can BTW) have little to do with the point that those banks that profited from the inflation of the housing bubble also profited from its burst."

    It does matter when you claim they profited, but the record shows that they actually had losses or declining profits.

    "I was mainly speaking of Goldman with this comment."

    That criticism of Goldman Sachs would be fair. It's clear they played a big role in causing the financial crisis. But let's look at what you actually said in your second comment:

    "The same investment banks that profited during the inflation of the bubble have also profited during its burst. JP Morgan, Wells Fargo...and yes, BOA and Citi all posted profits."

    I don't see Goldman Sachs listed. However, specifics aside, I agree with you on your general point.

    Anyway, I'm sorry to have gotten into such a hostile debate with you. You just hit one of my pet peeves when you claimed financial companies were profiting at a time when they were falling like leaves.

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  20. What existing government agencies which could have provided sufficient oversight and regulation to avoid, or at least minimize, the collapse of the real estate market in 2008 resulting in a world-wide recession are considered at fault.

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