The Wrong Crisis And The Wrong Solution

Government Regulation
Government Regulation

Dean Baker has provided a provocative and must-read response to the report of the Financial Crisis Inquiry Commission.

His basic response is that the entire premises of the commission was wrong. Instead of focusing narrowly on the “financial crisis” it should have asked how we got into an economic crisis.

“The FCIC investigated risky investments, lax regulation, excessive leverage. And it downplayed the more mundane, but vastly more important, collapse of the housing bubble,” Baker writes.

He continues:

The story of the downturn is the story of the $8 trillion housing bubble and its collapse. This bubble was driving the economy in the last decade in the same way that the stock bubble drove the economy in the late ’90s. Just as the collapse of the stock bubble led to a recession in 2001, the collapse of the housing bubble led to a recession in 2007. Both collapses and the resulting economic fallout were predictable. They also could have easily been avoided if those in charge of economic policy (e.g., Fed Chairmen Alan Greenspan and Ben Bernanke) had been doing their jobs. . . . The reputations of Greenspan and Bernanke should be permanently tarnished thanks to their incompetence in managing the economy. But at the end of the day, the picture the FCIC presents of the economic crisis and the economy is one that is badly skewed toward the finance-centric view that dominates political debate and prevents headway on the economic concerns that matter to the vast majority of working—and out-of-work—people.

The misplaced focus on the “financial crisis” instead of the housing bubble matters because of what it tells us about the future.

The collapse of the housing bubble also reduced consumption through what is known as the “housing wealth effect.” The housing wealth effect is estimated at five to seven cents on the dollar, meaning that homeowners will on average increase their annual consumption by between five and seven cents for every additional dollar of housing they own. This means that the $8 trillion of housing-bubble wealth implied an increase in annual consumption of between $400 and $560 billion. Now that most of the bubble wealth is lost, so is this consumption.

The total reduction in annual demand as a result of the collapse of the bubbles in residential and non-residential real estate is close to $1.2 trillion, or 8 percent of GDP. There is nothing in the economist’s bag of tricks that easily replaces such a large loss in demand.

Baker has a solution ready-at-hand: “The government should spend lots of money.”

Unfortunately, government spending doesn’t go far enough. As Baker explains, government officials were worse than “asleep at the switch” while the housing bubble was inflating—they were actively blowing the bubble themselves. And when the bursting of the bubble threatened Wall Street banks, government officials concocted an end-of-the-world scenario that they used to justify pouring billions of bailout dollars into the balance sheets of those banks.

Now Baker wants these same government officials—literally, the same guys—to “spend lots of money” to get us out of the crisis. I am unable to determine where he has discovered this sudden faith in the competence and loyalty of Ben Bernanke, Tim Geithner, and the countless bureaucrats who brought us the housing bubble, the mortgage meltdown and TARP.

The notion that a financial sector dominated by a few artificially large, mind-bogglingly complex financial institutions is good for us is no doubt mistaken. But the notion that the situation will be improved by the efforts of regulators is without any basis in evidence and heavily counter-indicated by recent history.


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