David Beckworth has an interesting piece up regarding the cause of the recession. He and the other market monetarists have long questioned whether the housing bubble actually caused the current recession. They have also stated that the idea of the balance sheet recession is “inadequate”. They further state that the true cause of the recession was merely a lack of action by the Fed to stabilize nominal spending. He says:
In other words, the Great Recession did not emerge because of the collapse of the housing market in early 2006. Something else had to happen about 2 years later to turn a sectoral recession turn into the Great Recession. As the figure above suggests, I see the evidence pointing toward a failure by the Federal Reserve to stabilize nominal spending and by implication nominal income. This failure meant that nominal income growth expectations of about 5% a year assumed by household and firms when they signed nominal debt contracts would not be realized. A debt crisis was therefore inevitable.
This actually makes some sense, but doesn’t nullify either the cause of the recession or the resulting balance sheet recession. Let’s connect the dots here because Beckworth is entirely accurate that nominal spending declined as a result of reduced consumer uncertainty and a lack of government action. I just don’t believe he’s providing a totally unbiased perspective of how things actually unfolded and what the proper response could have been.
The housing bubble had an enormous impact on the consumer psyche and the economy as a whole. As the consumer’s largest asset and 70% of total private sector debt, the real estate market is an incredibly important component of the US economy. When this market experiences extreme distortions in pricing it causes a massive ripple effect throughout the economy. As prices surged in the early half of the 2000′s American’s felt rich. Their net worth surged and spending was robust as a result. But let’s look at what precisely unfolded as housing began to contract.
The following graph shows household net worth and real estate prices. It’s clear that the housing peak led the total decline in net worth. But that doesn’t tell us much.
What the housing peak did was create uncertainty for consumers. After years of surging asset prices and exploding net worth, their balance sheet was suddenly stagnant. We can very clearly see that there is a correlation between expenditures and net worth. As Americans saw their net worth surge they were happy to spend. But as the housing market peaked in the consumer suddenly saw their net worth dented. Spending slowed with the expansion in net worth. Importantly, it’s the rate of change that matters here. As the bubble slowed, peaked and then declined this slowly worked its way through consumer behavior as can be seen in the chart below:
It’s very clear that real estate led this slow-down in overall expenditures. In fact, the rate of spending declined just after the real estate market peaked and Americans began to feel less wealthy:
This uncertainty in the consumer balance sheet resulted in a slow-down in the rate of overall spending resulting in reduced aggregate demand resulting in a slow-down in corporate revenues resulting in a slow-down in hiring trends. You can clearly see that the rate of non-construction hiring correlated very highly with the peak in housing. This is also consistent with the rate of expenditures as seen in the figures above. In other words, hiring OUTSIDE of real estate started to slow as housing prices peaked. This makes sense as consumer behavior changed, aggregate demand slowed and expenditures began to slow as well. Beckworth uses the headline payroll figure to prove his point that construction employment and real estate didn’t lead to the collapse. It’s misleading at the very least.
This is interesting to me for several reasons. The most glaring of which is the market monetarists disconnection with reality (they claim MMTers focus too much on reality). The idea that the real estate collapse did not have a dramatic impact on the economy defies logic. Perhaps more importantly is the lack of real-world understanding and consumer psyche. This seems to be a common trend in the academic world and not solely a market monetarism problem. Instead of looking at how slowing trends lead to a slow, but certain change in consumer behavior, economists too often look at hard data such as nominal peaks in data. But it wasn’t the nominal peak in spending or housing that necessarily impacted consumer psyche. It was the rate of change! This is very clear in the data above.
More importantly, what this data shows is that it was the change in balance sheets that led the decline in spending and ultimately crushed the economy. As the disease slowly worked its way through the system ultimately poisoning the banking system the collapse was swift. But the cause is clear. Whether the Fed could have materially altered that is up for debate. We know that QE does not alter the net financial assets of the private sector so the argument that the Fed had many weapons at its disposal in 2008 appears fairly weak. If, on the other hand, the government had been prepared to provide a buffer via increased government spending (perhaps tied to the rate of unemployment) then we would have seen a materially positive change in the balance sheets of households which would have aided them enormously during the asset price decline and de-leveraging.
The bottom line – the real estate bubble and the ensuing collapse in household balance sheets mattered – enormously. What is up for debate is whether the Fed could have implemented proactive policy that would have helped avoid the collapse. Considering Fed ops deal in changing the composition of private sector balance sheets (as opposed to amount of net financial assets) I am highly skeptical that the Fed was nearly as powerful as the market monetarists presume….