Why Was the Housing Bubble So Much More Damaging than the Dot.Com Bubble?

January 23rd, 2014 at 6:00 pm

It’s a good question that someone asked me to speak to the other day, and here’s what I’ve got so far:

–Not because it was bigger: according to established bubble-ologist Dean Baker, the 1990s dot.com bubble was, if anything, larger than the 2000s housing bubbles: he has the former at $8-$10 trillion of bubble-induced wealth and the latter at $8 trillion.  I don’t think anyone, including Dean, would swear by those numbers, but I don’t think there’s much of a case that the housing bubble was worse because it was a lot larger.

–Relative wealth effects from the housing bubble: Yes, there are a lot of people who own shares of stock but the vast majority of stock market wealth is concentrated at the top of the wealth scale: 80% of stock market wealth accrues to the top 10%; over a third to the top 1%.  Housing wealth, however, became much more pervasive among the broad middle class as that bubble inflated, so the wealth effect was more diffuse.  Thus, when it fizzled, the demand contraction was more broadly generated across both income and geography.

–Equity bubbles versus debt bubbles: Exploding debt bubbles just take a lot more time to mop up than equity bubbles.  Simply put, “mark-to-market” recognizes asset losses much faster than “extend-and-pretend.”  As I wrote of few years ago, “The fact that your pet rock shares go from valuations of $1,000 on Friday to $1 on Monday rips the bandaid off in a way you don’t get when banks can inflate for months on end their balance-sheet value of non-performing loans.”

As Bob Hall put it recently, in a very on-point discussion of the question of this post:

The contrast between the 2001 recession and the Great Recession in 2007 to 2009 illustrates the difference [of the impact on the US financial system]. In 2001, the value of business assets, especially tech-related assets, fell dramatically, but the financial system showed no signs of stress. Financial institutions had little exposure to business assets. The stock market communicated losses directly to investors with no bank-like intermediation. In the Great Recession, banks and other financial institutions became insolvent or nearly so because of direct and indirect exposure to real-estate values. The stock market fell by about the same percentage in both recessions. In the Great Recession, the fall occurred because the adverse forces from the real-estate crash appeared to threaten a collapse of the whole economy.

It’s a bit tangential, but this also reminded me of a segment in an NYT piece the other day about ongoing weakness in the European economy:

The state of banks in Europe is crucial for the economy because European companies are more dependent on bank credit than American businesses. Unlike the United States, Europe lacks a vibrant market for corporate bonds issued by smaller, riskier companies.

In other words, Europe’s taking even longer to pull out of the last downturn in part because their still-recovering banks intermediate more credit flows to businesses than ours do.

–ZLB and inflation: The fact that the Fed’s main interest rate—the federal funds rate, or FFR—has been at the zero-lower bound since around 2009 has of course been a primary constraint on a policy-driven recovery.  The 2001 recession never hit the lower bound, but the figure below suggests that this was in part due to the fact that it was much shorter.

Since at the ZLB, the real interest rate is the negative of the inflation rate (real int rate=nom rate – inflation rate), another suspect as to why this recovery’s been more of a slog (though see last point below on this) is our low inflation rate.  Though the numbers jump around a bit, there’s something to this.  As the figure at the end shows, inflation (core PCE) looks to be about a point lower now, give or take.  The policy implication is that had the Fed targeted higher inflation in recent years, a lower real interest rate could have hastened the recovery.

Fiscal Policy: That’s monetary policy.  What about fiscal policy?  The output gap was so much larger in this downturn than the last one (see “Part II” here), due in part to the differences noted so far, that you’d expect a lot more stimulus in the recent downturn.  According to (pretty outdated) CBO data on this question, that is in fact what happened, but as I and others (particularly Krugman) has endlessly stressed, our policy makers recently pivoted way too quickly to deficit reduction and that too has made it much harder to repair the damage from the housing bubble.

–It wasn’t! That is, maybe the housing bubble wasn’t more damaging than the dot.com bubble.  Since in many ways, it clearly was (the output gap, job losses), let me explain what I mean here.

The 2000s was a uniquely bad economic recovery—it was the weakest jobs recovery on record going back to the 1940s.  GDP growth was relatively weak, as was business investment (as distinct of course from housing over-investment).  Potential GDP growth slowed significantly.  Productivity growth started strong and ended weak.  Median household incomes for working families fell sharply in real terms.  Larry Summers weaves a compelling story about secular stagnation in these years.

It’s also the case, btw, that the rate of employment growth in this recovery is about the same as that in the last one, though this time, of course, we’re growing out of a much deeper hole (see payroll employment figure here, comparing job growth over past recessions/recoveries; note similar slopes to yellow and red lines).

I don’t want to oversell this point, because of the relative magnitudes of the output gaps: they’re so much larger this time around.  And the differences underscored above regarding debt versus equity bubbles, the scope of the wealth effects, the ZLB and the austerity pivot, are all important.

But the point is that bubbles are deeply damaging.  Some less so than others maybe, but even there, a longer term perspective of the lasting damage is sobering.  No one’s saying we shouldn’t have a business cycle.  They’re endemic.  But there’s no reason why it has to be a shampoo cycle: bubble, bust, repeat.





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11 comments in reply to "Why Was the Housing Bubble So Much More Damaging than the Dot.Com Bubble?"

  1. Robert Buttons says:

    The answer in quotes:

    “To fight this recession the Fed needs…soaring household spending to offset moribund business investment. [So] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.”–Krugman 2002

    “Real interest rates were very low for a long period of time.”–Geithner 2009

    “To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm”–.Hayek 1974

  2. smith says:

    Missing from the explanation.
    If the Fed’s usual primary counter cyclical measure is to lower interest rates to goose housing sales, what good will that do in a housing bust? None.
    Also, the notion of extra or higher inflation as a backstop to recession seems illusionary if not downright whimsical. When the housing market freezes due to a bubble and bust and dramatically falling prices, it won’t matter much if we start at 5% or 3%. The real difference will be homeowners locked into more expensive mortgages, and banks or whoever owns the mortgages making even more money from the larger spreads as the cost of money drops, and more foreclosures occur because of the higher costs of carrying the loans. Meanwhile higher inflation will have eaten at everyone’s wage, except the top 10% who can raise prices and fees to match inflation.

    Again, why does Summers say absent the housing bubble the economy would stagnate, when investing in mac mansions is such a poor and unproductive use of capital?

  3. readerOfTeaLeaves says:

    The housing bubble was (still is) magnitudes more destructive.
    It is, in economic terms, radioactive, because it destroyed trust – which is essential for markets. It created debt that was based on fraud, leverage, and other non-productive uses of capital: it debased the value of money.

    All of us are now legally required to bail out the housing bubble debt indefinitely. Our economy cannot recover, because we continue to underwrite the massive costs of fraud — and at a time when our basic energy costs are rising. Our cities were built in an era of cheap oil. Meanwhile, the people who perpetrated fraud by building all that sprawl and making fraudulent mortgages got to keep millions (thereby exacerbating inequality). Building all that sprawl gave them tax advantages in a tax code that no longer distinguishes between whether capital is productive – or non-productive (rent extraction).

    All that housing bubble fraud continues to erode an economy in which we pay about 150% more for gas and fuel than we paid in 2003. In addition, we put two wars – using a lot of contractors – on the national credit card the past ten years.

    Go back to the dot.com bubble.
    It was a wonderful experience. I stopped reading the sports pages, and read the business and stock pages instead. It was endlessly interesting. Things that had never before existed came into being. The energy and dynamism was fun. Novel things were engineered into existence (voice mail, eCommerce, email, the beginnings of online video…)

    The word ‘invest’ still meant: “To attempt to help create new economic activity by putting capital toward **economically productive** uses that benefit the larger society.”

    Plenty of mistakes were made; there were disastrous business decisions and a fair amount of charlatanry. You had to be wary of people passing off a sow’s ear as a silk purse. Nevertheless, the overriding focus was to create and develop new services and products that have value. People were willing to risk failure.

    If your investment went south, capitalism still functioned: no one was going to bail out your bad judgment. You did not bet money that was not yours. You did not ‘leverage’ in order to invest.

    You did not whine to the government to ‘provide backstopping’ if you made dumb decisions. You were expected to be an adult. You win? Enjoy it. You lose? Congratulations! You’ve now had a Life Lesson in the Importance of Due Diligence. Try again.

    I am increasingly of the view that bankers and traders began to lust after all this excitement. Or more specifically, they lusted after all the potential profit and power they supposed existed. (Barry Ritholtz has a descriptive expression for this phenomenon, but it would violate the OTE commenting guidelines for civility.)

    I assume that the best and finest of the bankers were staid, financially conservative, and tough enough to remain ethical despite temptation. The best among them probably viewed themselves as responsible fiduciary caretakers; they did not take reckless risks, because they knew that people trusted them and depended on them to keep their money safe. Ordinarily, those are outstanding qualities. People with these qualities appear to have been demoted in the lead-up to the housing bubble. Without those solid qualities — as we have now witnessed — society goes to the dogs, and economies go to hell.

    The problem is that banking is pretty much about making money by math: lending out at x% interest.

    Bankers are making money from money. You can dress it up and make it look fancy, but the basic process seems to be: take X amount, multiply it by Y at intervals i1, i2, i3…. iZ. In a sane world, the income this generates is predictable. But it is not innovation.

    And yet, banking co-opted terms like ‘innovation’ and ‘investment’ and sought to camouflage finance capitalism with the patina of dot.com innovation. This is how a wolf attires itself in sheep’s clothing.

    The new, brash TBTF bankers claimed that they, too, could be ‘engineers’.
    They claimed to ‘engineer’ finance, and new kinds of mortgages.
    But unfortunately, financial engineering can only generate rents; at the end of the day, the bankers attempt to create wealth by manipulating financial assets like a mortgage or credit card contract.
    So the housing bubble generated rents, and increased wealth concentration. At the same time, it destroyed trust and left the economy in the hands of people who understand finance, but not much else.

    A bubble that generates rents is bound to suck the energy and dynamism out of an economy.

    Until the US figures out how to distinguish between economically productive activity, as opposed to rent extraction and spending money in order to reduce tax liability, we are going to wallow in economic dysfunction.

  4. The Raven says:

    Surely it is simply because it threw people out of their homes? The internet bubble mostly affected speculative investment. The housing bubble wrecked lives, and it is still wrecking lives.

    • jo6pac says:

      Thank you for being the only one to point out the human side and it’s way more important than the $$$$.$$. It’s the human bubble that the saddest.

  5. Tom Cantlon says:

    It wasn’t a housing bubble it was a corrupt finance bubble. There was a housing bubble burst but that was just the blasting cap to all the dynamite built up on it, the junk finance based on housing. Even the housing bubble itself was in large part generated by the junk finance which wanted to crank out mortgages, junk or no, to use as fodder. Had junk finance been stopped when small the housing bubble itself would have been much smaller. Don’t call it a housing bubble. That’s like asking why the blasting cap brought the building down.

  6. urban legend says:

    Quick thought: we all knew the stock market was a bubble. We are used to big swings there. The real estate market is supposed to be real and fairly steady.

  7. PeonInChief says:

    Three reasons:

    The first is that the economy was stronger coming into the stock bubble than the housing bubble. The recovery after the stock bubble was weak, so households were less resilient in dealing with the housing bubble.

    Second, the stock bubble was limited to those who either invested in companies that FedEx’ed kitty litter round the country or tried to play the stock market. Most households didn’t participate, as the vast majority of stock is held by the wealthy. The rest of us watched, but didn’t participate. In addition, the jobs created by the stock bubble were relatively limited and in discrete sectors of the economy, while the housing bubble collapse hit multiple sectors and then spread out from there.

    Third, the housing bubble collapse ruined the household economies of millions of people, as the bubble collapse spread beyond those who had purchased real estate to ancillary services,and then to the rest of the economy. For instance, tenants who lived in foreclosed properties, and had nothing to do with the bubble, often ended up homeless because state laws enabled the foreclosing lender to evict the tenants with little or no notice. Most everyone could come up with examples of economic crisis either near or far from the housing center.

  8. Dave says:

    Great post. I agree with most of it.

    However, I think we need to look deeper at the cause of financial stress with each bubble if we’re actually interested in inequality.

    It is true that the housing bubble caused more damage because it was a debt bubble vs. an equity bubble, and that caused a bigger financial problem because banks and shadow banks were more financially exposed to the equity losses of the housing bubble (equity based upon debt x 10).

    However, even during the buildup to the housing bust, most workers looking for housing were having a hard time. It was causing 10x the economic stress before it popped than after it popped, however, the stress was covered. Why?

    Lending. Banks and other institutions could lend more money every time the Fed reduced rates, and this led consumers to feel more confident in borrowing more, but it stressed their actual financial system beyond repair in many cases, and it caused stress for those that didn’t borrow because they felt priced out of the housing market.

    The ‘stress’ just didn’t show up for anyone looking at stats because they didn’t talk to anyone. If they had talked to people, took a reasonably good survey, the stress would have been obvious for 4 years prior to the burst.

    So it was primarily financial in nature this time? Yes, but that view is a top down view. The 2000 bust didn’t cause the same problem because we still had a lot of debt slack to take up with a housing bubble.

    These are not independent events. One caused the Fed to create the other.

    What is the recourse now? If we had other nations to put into debt, like the TPP might be able to do, we can bubble this thing out yet one more time!

  9. Dave says:

    In other words, we didn’t hit the ZLB because of the equity losses of the .com bust. We only hit it because the housing bubble prevented any more consumer stimulus.

    I think an important question is why the .com bubble didn’t cause a consumer stimulus? Was it? Or was it an investment stimulus? Or both?

    Mostly it was an investment stimulus. Losses in investment are expected. They’re a part of the IS-LM system that worked for a long time. So if you lose investment, it carries over to savings. This wasn’t about consumerism very much at all.

    Then we had the bust, and we had stimulate housing, but deregulation and shadow banking allowed housing stimulus to transfer to consumer stimulus at a higher rate than ever before!

    Fed stimulus is supposed to be investment stimulus predominantly. It shouldn’t be consumer stimulus. If it is, it is broken.