March 11, 2010

Much as it pains me to do so I fear that I must praise a left leaning economist. Dean Baker, please stand up and take your bow. He’s told the truth, always a bad career move in the political arena, about the current financial crisis and recession.

We’re not deep in the economic doo doo because Wall Streeters are greedy, not because they’re incompetent and not because they’re evil. They may be all of these things but the ordure piled up around our ears is not because of their actions or existence, but because we’ve just had a huge housing bubble. Dean’s right about how we can prove this too, we can prove it in one word: Spain.

Spain, Ireland, the UK, and the US all have deep recessions, this is true. However, Spain, uniquely, does not have a problem with its banks. They didn’t fall over, they had decent levels of reserves and have not needed bailing out by their government. Yet Spain still has a deep recession (a very deep one: unemployment among the young is now rated at 40 percent or so). So it isn’t the financial system that caused the recession.

“€œWe know what happens when people become wealthier. They spend some of that new wealth on current consumption”€”whether it’s houses going up or stocks or the stamp collection from boyhood days.”€

What the four countries do have in common is that they all had a huge housing boom which then burst. In the US, the bubble was $8 trillion in size. That bubble bursting is what has caused the recession: and we’d still be having a recession even if no one had ever securitised a loan, bonuses were not paid on Wall Street and mortgages came only from the neighbourhood Savings and Loan. All of these things describe what happened in Spain and yet Spain still has a recession: so it isn’t the structure of the financial system which caused it then.

For we know what happens when people become wealthier. They spend some of that new wealth on current consumption. This is true whether it’s houses going up or stocks or the stamp collection from boyhood days. This is just something people do. And when bubbles burst, as they all do, people stop that extra consumption and the technical name we give to a fall in consumption is “€œrecession”€. The collapse of the housing bubble blew a large hole in the amount consumers were willing (or able) to spend and that’s what caused everything else following, as sure as night follows day.

The importance of this cannot be understated: I think we’d all like to try and make sure that this doesn’t happen again some day, no? If that’s so, we’ve got to understand why it did happen so that we can take the appropriate steps to prevent a repeat. Which means that if we all hare off after Wall Street, lay all blame at their doors, then we’ll end up trying to reform Wall Street. But if that’s not where the problem started then we’ll not prevent the next recession, will we?

So let’s place the blame where it squarely belongs: on the housing market. Then we can try to do something to prevent the next blow-out. That something would and should be looking at interest rates. For Ireland and Spain their interest rates were way, way too low as a result of being in the Euro where rate were being set of the French and German economies, not those of Spain and Ireland. In the UK and the US rates were also too low but this was a policy choice. In both countries the central bank (Bank of England, Federal Reserve in turn) had an inflation target but that target was aimed only at the prices of goods and services. They deliberately (in the UK example, were told to ignore) ignored inflation in asset prices. So nothing was done to try and prick the bubble before it got out of hand.

Now that we’ve got the correct diagnosis of why the economy fell over we can write our prescription for stopping it happening again. Inflation targets for central banks should include asset prices as well as the prices of goods and services. Thus, in the future, interest rates will rise when a bubble is forming, stopping its inevitable bursting from becoming a system threatening event.

Sure, we might want to reform the financial system, we might be interested in curbing bonuses, restricting the power of Mammon, for all sorts of other reasons. But preventing the next recession just ain’t one of them, for it wasn’t the financial system that caused this one. It wasn’t even the central banks that did: it was what the politicians told the central banks to concentrate on. Or not concentrate on perhaps. By insisting that they ignore asset price inflation the politicians allowed the bubble to grow and made the mess, pain and dislocation of the bursting induced recession vastly worse.


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