What caused the housing bubble?
This is a different, though related, question from what caused the collapse of the financial sector or why unemployment is sky-high right now. Why did housing value skyrocket and then collapse? More broadly, why did all kinds of consumer debt expand so greatly over the past decade?
There are plenty of arguments out there, each with its proponents and its books. There’s the argument that the bubble is primarily the result of an out-of-control Wall Street, which was capable of getting money into housing by convincing investors that it was safe (while betting against it). There’s an argument it was the result of government policy and activism, of Community Reinvestment Acts and mortgage subsidies. There’s another approach which thinks it was the result of “irrational exuberance” on the part of homeowners, who all chased rising home prices which kept blowing air into the housing bubble.
But there’s another argument, which looks at the explosion of international lending and the indebtedness of the United States by foreign investors. Normally capital runs from rich countries to poor countries, but something changed where it reversed as capital went rushing to the United States. This exposed the United States to the same kind of risks developing nations usually face. And the new book Lost Decades by Menzie D. Chinn and Jeffry A. Frieden, economists at the University of Wisconsin, Madison and Harvard, is the best book-length treatment of this argument.
Lost Decades looks at why the explosion of debt happened through the traditional lens of supply-and-demand. It examines the motivations and situations of people on both side of this debt. Why did demand for debt increase in the United States? The first reason Chinn and Frieden identify is the huge deficits run during the George W. Bush years. These are the trillions spent on the Bush tax cuts, the expansion of Medicare part D, and wars in Iraq and Afghanistan that weren’t paid for.
The second is the massive expansion of debt among private households. This was the result of “debt fever spread[ing] to the private sector.” “Americans began borrowing to supplement their incomes, in expectation of future economic growth.” This led to “debt-financed” consumption” which helped to deal with the problem of “working-class and middle-class Americans [seeing] their incomes stagnate.”
This led to an explosion in the measure for a country’s foreign borrowing, the current account deficit. What was around $100 billion a year in the 1990s averaged $600 billion a year during 2001-2008. Nearly one-third of all the country’s home mortgage debt was owed to foreigners.
On the flip side of demand is supply. Where did all this money come from? Lost Decades looks at three major culprits on the supply side. The first is the traditional kind, wealthy individuals in an age of rocketing inequality. The second are the oil-exporting Middle East countries and their “sovereign wealth funds.” And the third are East Asian countries holding huge currency reserves, particularly China which maintained a weak currency to keep a manufacturing edge.
Why is this bad? The first reason was that the debt wasn’t going to productive uses. As the IMF pointed out, a huge rise in federal deficits, housing debt and residential construction “does not raise US productive capacity.” Second, and more important, this exposure to foreign debt puts the United States at risk of debt crisis that was familiar to people studying developing countries. The comparisons the authors draw are between the United States and 1970s-80s Latin America or 1990s East Asia. Or 1990s Russia. Or Turkey. Or Mexico. Money flows into the region rapidly, which then leads to spectacular rises in housing prices, stock prices and the financial sector which stands in the center. When it stops, it all comes crashing down.
The book lays out how the financial sector reacted to this newfound debt situation, low interest rates from Alan Greenspan and a flattening of the yield curve. All these situations were ones where the “search for yield” caused Wall Street to go to further lengths to pack in leverage in order to try and amplify profits. This all came crashing down when the music stopped, giving us the alphabet soup of Wall Street bailout programs that characterized 2008 financial policymaking.
The story about CDOs, subprime mortgages and TARP will be familiar to those who have read other books about the financial crash. This book is unique for putting the situation in a similar one to England and Ireland, both countries that also increased their debts massively throughout the 2000s and now have to deal with the consequences. Their solutions are also broader than most other treatments. Though they understand and acknowledge the need for larger short-term federal deficits to deal with the current weak economy, getting the long-term fiscal picture into health, through raising revenues and restraining spending, is front and center in their solutions. So are re-regulating the financial system to combat Too Big To Fail and keeping self-interested agents from hiding leverage to unsuspecting customers. In addition to this, increasing exports, a smaller trade deficit, reducing oil imports and dealing with China’s trade policies are also on their policy agenda.
Economic blogosphere readers will recognize Chinn as one of the brilliant masterminds of the must-read blog Econbrowser, and the rigor yet accessibility of that blog is on display in this book. The book is capable of dealing with some of the most complicated economic arguments about the crisis in a way that is straightforward and capable of being understood by its audience.
And it is important to emphasize how much this is not on the radar of most discussions of the crisis. The crisis discussion usually creates stories out of the greed of the deregulated financial sector, the implicit and explicit goals of government, and the Federal Reserve for a host of reasons, without even touching on the issues of international capital flows. That this book gets this topic onto the agenda makes it a worthwhile enterprise.