Who Could Have Foreseen The Housing Bubble Collapse? Dean Baker, That's Who--In 2002

by: Paul Rosenberg

Sat Aug 29, 2009 at 12:30


As you may have gathered from my earlier diary, "Renormalizing Economics & Politics", I'm going to blogging alot about economics this weekend.  A good part of this revolves around the ongoing economic crisis and the failure to foresee or comprehend it, as part of a larger failure of economic thought.  This in turn is a reflection of the political success and practical failure of conservative hegemony.  Some of the pieces have been in the works some time as part of somewhat different trains of thought, but they dovetail pretty well, nonetheless.

To begin with, I want to start small and simple, with the housing bubble, whose bursting underlay the eventual Wall Street collapse.  But the staggering loss of household wealth since 2007 is reason enough to make this topic vitally important on its own.

In 2002, economist Dean Baker, co-director of the Center for Economic Policy Research, wrote a prophetic briefing paper, The Run-up in Home Prices: Is It Real or Is It Another Bubble? (pdf).

In the end, Baker concluded "bubble".  And bubbles eventually burst:

In the last seven years, home sale prices have increased nearly 30 percent more than the overall rate of inflation. Approximately one-third of this increase corresponds to an increase in the price of rental housing relative to other goods and services. The other two thirds is attributable to an increase in home purchase prices relative to rental prices.

This paper shows that there is no obvious explanation for a sudden increase in the relative demand for housing which could explain the price rise. There is also no obvious explanation for the increase in home purchase prices relative to rental prices. In the absence of any other credible theory, the only plausible explanation for the sudden surge in home prices is the existence of a housing bubble. This means that a major factor driving housing sales is the expectation that housing prices will be higher in the future. While this process can sustain rising prices for a period of time, it must eventually come to an end.

The following chart shows the relative rise in rents and housing prices:

Paul Rosenberg :: Who Could Have Foreseen The Housing Bubble Collapse? Dean Baker, That's Who--In 2002
The fact that this bubble was clearly visible as early as 2002, and that significant negative consequences of a collapse were already foreseeable, is a powerful indictment of the failure of the economics profession as well as the rest of economic establishment--the real estate lenders, the wider financial sector that gobbled up mortgaged-based securities, the regulators, who were busy doing their Rip Van Winkle imitations, the business and financial press--you name it, they were all in fail mode.

While conventional narratives about financial crisis revolve around exotic financial derivatives, and the mathematical models and computer programs that helped create a situation that no one really understood, this early warning about the housing bubble suggests a different story:  It's not that things were so complicated that no one could understand.  There's nothing very complicated about the ratio of house prices to the rate of inflation.  It's simple division.

Nor did the problem originate with sub-prime loans. Although the sub-prime loans were particularly vulnerable, the market for them only heated up in the wake of the broader rise in home prices, which began in 1995.  Indeed, the logic that justified the sub-prime boom--that those with less than conventional credit-worthiness could rationally buy homes with higher interest rates--was completely dependent on the pre-existing housing bubble to get itself started.  Without rapidly rising house prices, none of the logic would have been even remotely plausible--and more importantly, no one beyond the usual marginal grifters would have been motivated to try to make such loans in the first place.

Of course, the housing bubble didn't come out of nowhere, nor did the mindset that failed to see it as problematic, but instead built a giant house of cards atop its quicksand foundations.  We can trace both these at least back to the early Regan Administration, with its embrace of trickle-down/supply side "voodoo economics", and the disastrous deregulation of the savings and loan industry.  But for purposes of this diary, I'll simply note that instead of this past history making people particularly vigilant about real estate bubbles, it seems to have had the opposite effect.

The report takes note of the fact that the bubble is national in scope, but far from uniform, as these two charts clearly demonstrate:

It also underscores that the run-up in asset values has outstripped the amount that people actually own in them, which would only get worse after a bubble:

Combining the information from the charts above, we see a strong potential for extremely sluggish recovery in some parts of the country, even once the economy as a whole has returned to stable growth.  And that's not just a matter of hindsight.  This was visible in the available data at the time.  Yes, it's substantially worse than what could be foreseen then, but the overall shape of things has proven ominously accurate so far.

While Baker's report is 22 pages, the executive summary presents a very cogent overview of the factors considered and their significance:

Executive Summary

In the last seven years home purchase prices have risen nearly 30 percent more than the rate of inflation. This run-up in housing prices has increased housing wealth by more than $2.6 trillion compared to a situation in which home prices had just kept place with inflation. This is an average of more than $35,000 of additional wealth for each of the nation's 73.3 million homeowners. This paper examines whether the increase in home prices can be grounded in fundamental economic factors, or whether it is simply a bubble, similar to the stock market bubble. The paper notes:

    1) There has been no clear upward trend in housing costs relative to other items in the post-war period. In general, housing prices move in step with the overall rate of inflation. This means that the recent spurt in housing prices is a departure from the prior history.

    2) There is no clear link between the pace of income growth and the share of housing in consumption. In the period from 1951 to 1972, when income rose very rapidly (considerably faster than in the late nineties), there was only a very modest increase in the share of consumption spending that went to housing.

    3) The sharpest increase in the housing share of consumption spending was associated with the baby boom cohort entering the labor force in the seventies and early eighties. The rate of increase in the housing share of consumption slowed precipitously in the mid and late eighties.

    4) Current demographics suggest that the housing share of consumer expenditures should be falling for the foreseeable future, as the baby boom cohort approaches retirement.

    Two thirds of the run-up in home prices is attributable to a rise in the price of buying a home relative to the cost of renting a home, as shown in Figure 1. [Reproduced above.] This is what would be expected if there is a housing bubble, since it suggests that families are buying homes in large part as an investment rather than primarily as a place to live. A sharp slowdown in the rate of inflation in rental cost index in the last six months, and a record high rental vacancy rate, suggests that demand for rental housing is lagging, which could precipitate the collapse of the bubble.

Of course, the collapse did not come then. In fact, the Fed made sure that it didn't by keeping its interest rates at historically low levels, which in turn helped to fuel the sub-prime part of the housing bubble.  Which only made things all the worse when the bubble finally did burst.  (Baker notes--immediately below--that the low interest rates can't plausibly be cited as the cause of the increased housing prices, but that's a different point.)

Baker continues:

    5) The recent drop in interest rates cannot explain the divergence of home purchase prices and rental prices. Much sharper movements in interest rates in the eighties did not have anywhere near as large an effect.

    6) If low interest rates actually are the main factor behind the run-up in housing prices, then it would support the view that there is a bubble in the housing market, since interest rates are unlikely to remain so low, especially with the government projected to run sizable budget deficits for the foreseeable future

In fact, this is more or less just what happened.  The Federal Funds Rate Target fell from 5 percent prior to April 18, 2001 all the way down to 2 percent as of December 11, 2001, before Baker's paper was written.  It feel further to 1 percent as of June 30, 2004, its lowest point.  It rose back to 2 (in four steps) by December 14, 2004; to 3 (also in four steps) by June 30, 2005; to 4 (again in four steps) by December 11, 2005; and to 5 (likewise in four steps) by June 29, 2006.

In a 2008 article "The Housing Bubble and the Financial Crisis", real-world economics review, issue no. 46, 20 May 2008,  pp. 73-81,  Baker wrote:

These extraordinarily low interest rates accelerated the run-up in house prices. From the fourth quarter of 2002 to the fourth quarter of 2006, real house prices rose by an additional 31.6 percent, an annual rate of 7.1 percent. This fueled even more construction, with housing starts eventually peaking at 2,070,000 in 2005, more than 50 percent above the rate in the pre-bubble years. The run-up in house prices also had the predictable effect on savings and consumption. Consumption boomed over this period with the savings rate falling to less than 1.0 percent in the years 2005-07.

Back in his 2002 article, Baker continues:

    The collapse of the housing bubble, implying a drop of between 11 and 22 percent in the average of housing prices , will destroy between $1.3 trillion and $2.6 trillion in housing wealth.

    7) In the wake of this collapse, residential construction is likely to fall by between 0.6 and 1.3 percentage points of GDP.

    8) The loss of this much housing wealth will reduce consumption by between $80 and $160 billion.

Things have gotten significantly worse since then.  As of 2006, in an oped, "The Menace of an Unchecked Housing Bubble", baker wrote:

"If the full $5 trillion in bubble wealth were to disappear, the implied drop in consumption would be $250 billion annually, or 2 percent of GDP."

A quick phone call to CEPR yielded their best current estimate of housing wealth loss at upwards of $6 trillion.  The corresponding construction loss would be about 3% of GDP.

Baker continues:

    9) The average ratio of homeowner's equity to value, at 55.2 percent, is near its low for the post-war period. A sharp drop in home prices will send this ratio far below its previous low point. Since there are considerable differences in housing markets across the country, if housing prices fall 10 percent nationally, then many regions will see price declines of 20-30 percent. This will create a situation in which millions of families have little or no equity in their homes. This is an especially serious issue with the large baby boom cohort nearing retirement. It will also lead to a surge in mortgage default rates, as many homeowners opt not to keep paying a mortgage that exceeds the value of their home. This could place serious stress on the financial system.

Of course, Baker did not and could not foresee the extent to which the financial establishment speculated on top of the bubble, adding enormous loses above and beyond those that were visible at the time.  Still, if steps had been taken when he wrote to minimize the risk going forward, much of that additional damage would also have been avoided.  Since that did not happen, the losses incurred were substantially greater.  A CEPR report from earlier this year, "The Wealth of the Baby Boom Cohorts After the Collapse of the Housing Bubble" by David Rosnick and Dean Baker had very grim news--substantially worse than what Baker warned of in 2002:

The projections show:

1) The median household with a person between the ages of 45 to 54 saw its net worth fall by more than 45 percent between 2004 and 2009, from $172,400 in 2004 to just $94,200 in 2009 (all amounts are in 2009 dollars). If the median late baby boomer household took all of the wealth they had accumulated during their lifetime, they would still owe approximately 45 percent of the price of a typical house1 and have no other assets whatsoever.

2) The situation for early baby boomers is somewhat worse. The median household with a person between the ages of 55 and 64 saw its wealth fall by almost 50 percent from $315,400 in 2004 to $159,800 in 2009. This net worth would be sufficient to allow these households, who are at the peak ages for wealth accumulation, to cover approximately 90 percent of the cost of the typical house, if they had no other assets.

3) As a result of the plunge in house prices, many baby boomers now have little or no equity in their home. According to our calculations, of those who own their primary residence, nearly 30 percent of households headed by someone between the ages of 45 to 54 will need to bring money to their closing (to cover their mortgage and transactions costs) if they were to sell their home. More than 15 percent of the early baby boomers, people between the ages of 55 and 64, will need to bring money to a closing when they sell their home.

These calculations imply that, as a result of the collapse of the housing bubble, millions of middle class homeowners still have little or no equity even after they have been homeowners for several decades.

Finally, the 2002 executive summary concludes:

    In the late eighties Japan experienced a simultaneous bubble in its stock market and its real estate market. The collapse of these bubbles has derailed its economy for more than a decade. A similar collapse in the United States, coupled with a poor policy response, could have similar consequences here.

At this point in time, it's not at all clear that we will avoid Japan's fate.  But more troubling, as the February 2009 report makes clear, even if the economy as a whole does recover, the Baby Boom generation will entire retirement substantially poorer than almost anyone could have guessed a few short years ago.

One cannot help but think that at least part of the anger that conservatives and Republicans are tapping into right now derives from these enormous losses in wealth.  Notwithstanding David Lind's repeated assertions to the contrary, it's upper-middle class whites, not working class whites who form the backbone of the GOP, and these are the people who have lost the lion's share of the home ownerships assets.

As this diary shows, they are just as mistaken when it comes to laying blame for their predicament as lower-income whites who follow Limbaugh and Beck. It's just that there's a whole lot more of them.


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Thanks for highlighting Baker (4.00 / 2)
Given his track record, he deserves far more attention.

For anyone who is interested, Baker's book, The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer, is available free online:

In his new book, economist Dean Baker debunks the myth that conservatives favor the market over government intervention. In fact, conservatives rely on a range of "nanny state" policies that ensure the rich get richer while leaving most Americans worse off. It's time for the rules to change. Sound economic policy should harness the market in ways that produce desirable social outcomes - decent wages, good jobs and affordable health care.

This should be required reading for Democratic office holders and candidates. It's unfortunate that even many critics of neoliberal economics often do so taking the terms of the debate for granted.  Laissez-faire is a myth used to justify a particular set of policies, not a coherent description of anything that exists or has existed in the real world. Baker's a good starting point for anyone that wants to break out of that mold. Given the current mess we're in, and the rumblings about Congress and the public reasserting some control over the Fed, that project is increasingly urgent.

Politics is the art of the possible, but that means you have to think about changing what is possible, not that you have to accept it in perpetuity.


I've Been Following Baker For Over A Decade (4.00 / 2)
Back in the 90s he was very first person online to provide regular media criticism, focused on the NYT and WaPo economic reporting.  Every couple of years or so, he seemed to switch venues, but it was always very, very good.  He's not so alone anymore, but still worth following, now at the American Prospect.

He & Mark Weisbrot have just done incredible work at CEPR over the years, and you're right.  They don't get anything like the credit or attention they deserve.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3


[ Parent ]
Weisbrot (0.00 / 0)
has an excellent piece in the Guardian, dealing with the disconnect between elite policy makers and the rest of us poor slobs.

We don't want to rule the world.


[ Parent ]
Well (0.00 / 0)
I don't call 'em "Versailles" for nothing.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3

[ Parent ]
But all we are doing now is re-inflating the bubble. (4.00 / 1)
Look at this past week when Bloomberg reported that leverage is rising on Wall Street.  Nothing has changed. We have protected the financial oligarchy with this bailout - they didn't suffer any consequences to learn from - the ultimate moral hazard.


RebelCapitalist - Financial Information for the Rest of Us.

Which Is Why (4.00 / 1)
the real reckoning is yet to come.

Anyone who thinks we're out of the woods doesn't even know what a compass is.  

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3


[ Parent ]
You are right. (0.00 / 0)
First, there is very little basis for a strong recovery. We are still incredibly leveraged and wages are declining.

Second, can we afford another "jobless recovery"?  If we are talking about a 'new normal' for economic growth of possibly 2% per year.  We are talking about significant structural and long-term unemployment.  We are talking about significant social costs with this 'new normal'.

RebelCapitalist - Financial Information for the Rest of Us.


[ Parent ]
I'll Have Another Diary Relating To This Tomorrow (0.00 / 0)
based on much more recent work from CEPR.

One thing's for certain, the political discourse about this is incredibly far off the mark.

I can understand very well why GOP politicians obfuscate and lie about such matters.  I'm a good deal less clear about the Democrats.

Perhaps they're all just idiots.  Sometimes the simplest explanation is best.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3


[ Parent ]
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