It's the Housing Bubble, Stupid

After all that's happened in the past half-decade, why can't economists look around? The housing bubble took an extraordinary toll on American households, but economists have yet to meaningfully grapple with its impact.
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Caroline Baum at Bloomberg summed up economists' bafflement with our economic stagnation in an article last week titled "Why Can't Anyone Explain This Economy?" We just finished our second straight year of record corporate profits, yet employment is stalled and overall growth is anemic. According to Baum, one of the insights experts offer to explain the U.S. economy's strange failure to thrive is weather. It's the kind of sentiment from professionals that leaves you weeping in frustration.

After all that's happened in the past half-decade, why can't economists pry themselves out of their spreadsheets, open a window, and look around? The housing bubble took an extraordinary toll on American households, but economists have yet to meaningfully grapple with its impact.

The Federal Reserve's survey of consumer finances released yesterday lays out the damage in gory detail. The Bubbletron 2000 zeroed in on the middle class, taking average household wealth back down to 1992 levels. Meanwhile, the richest 10 percent of Americans saw their net worth increase. That divergence in wealth was mostly due to the real estate collapse.

Four years after the crash we're still waiting for signs of a bottom. There is no historical precedent that explains what happens when one-third of all mortgage holders are underwater, but it has clearly left households in a pattern of de-leveraging that has potential to continue for many years.

We've never seen a market in which average home prices were off by more than a third nationally. The private mortgage market is ruined, replaced almost entirely by federally-backed lending. No one knows how or when a private mortgage market can re-emerge.

The housing bubble was uniquely broad and destructive because a series of structural factors:

- For middle earners and the working class the bubble was practically inescapable. Unlike stock speculation, a home is a pretty common purchase that people actually need. A housing bubble is tough to dodge.

- Cultural forces make home ownership extremely important. Yes, it is possible for a family of four to simply opt out of purchasing a home based on a hunch that the market is over-valued,* but the culture makes that difficult.

- Housing is a slow market. Dealing with a bad home purchase is only slightly easier than dealing with a bad marriage. Homeowners will cling to a failed real estate investment like a drowning man on a chunk of wreckage. A stock market crash can come and go in a few months, but unwinding the damage from the mortgage collapse could take a generation.

- Homeownership has arguably been a good way for middle earners to build capital. The unquestioned reasoning behind that assumption kept drawing buyers in right to the bitter end.

- Generations of homeownership incentives have created a difficult environment for renters. If you want the conventional middle-class lifestyle with some sort of a yard, a place to park a car, and access to decent schools, you pretty much have to buy a home.

The housing crisis was unique not just in its scope, but in the fact that it hit ordinary people particularly hard in ways that were very difficult to avoid. By the time this disaster has run its course we will probably recognize that almost everyone who either bought or refinanced a home between about 2001 and 2008 got caught in a financial trap built by derivatives traders. That's a lot of people.

When Morgan Stanley makes a bad bet on a real estate deal, it defaults, gives the property back to the lender, and lives to make another million. When a middle-income homeowner gets suckered on a real estate deal, he guts it out, drains the kids' college fund, cancels vacations, stops contributing to his retirement, and spends the next decade or more pouring every available dollar into keeping himself in that house. In other words, the mortgage crisis will take its cruelest toll on those who otherwise meet the highest standards of our culture. This is an ugly disaster.

What could Washington have done? Make the bailout conditional on some form of rent-to-foreclosure program. Allow principal cramdowns in a Chapter 13 bankruptcy. Initiate a Swedish-style wind-down of the weakest banks. None of things happened and there is little that Washington can do now. The window for action is probably closed.

It would be nice if economists and other financial experts would acknowledge the reason for the gaping hole in aggregate demand instead of consistently calling false bottoms. They may not be able to fix the problem, but a reality check might at least prevent them from making it worse and give the public a better sense of what to expect from their future.


*Disclosure: We sold our house in Houston and moved to Chicago in 2004. We expected the move to be temporary, so renting was a natural choice. When we decided to stay in 2005, the housing bubble was relatively obvious, but it was still a tough decision that flew in the face of all advice we received, even from professionals. We rode out the worst of the crash in a rental, finally purchasing a home here in 2011.

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