Friday, August 10, 2012

The balance sheet recession hypothesis

I recently read a blog post by Evan Soltas where he looked at the "housing story" of the "Great Recession"/"Lesser Depression".  In his post, Mr. Soltas indicates the contribution of residential construction to GDP, which apparently began to decline in about 2006, well prior to any estimate of when the recession began.  In fact, Mr. Soltas said that, "When problems in housing generate illiquidity problems in the financial system and reduce household wealth and income, the housing story is no longer just about housing."  I agree.  Wealth effects are not purely about houses.
Some media reports seem to indicate a belief that the main way in which housing holds the economy back is about the level of residential construction.  Clearly a low level of residential construction will not help get the economy out of the current depression, but is that what put it there?  My own feeling is that this is not the case.  The following graph was presented by Brad Delong, with no explanation regarding its meaning, except a headline, which read, "FIX SPENDING ON RESIDENTIAL CONSTRUCTION, AND YOU WILL HAVE FIXED THE DOWNTURN."




Clearly if residential construction picked up toward its previous level, the depression would be more or less over, but so would it if net exports, business investment or government purchases picked up by an equivalent degree.  Let's examine the graph somewhat closely.  As one can see, residential construction began falling off from a peak in around 2006 and had more or less reached its trough in early 2009 (okay, it went a little lower, later, but not much lower).  This is odd, since we all think of the recession of being in 2008-2009.    What clearly happened is that, yes, residential construction fell off, but rising exports pretty much picked up the slack.

The following graph which I have made from the FRED website shows nominal GDP in red, Potential Real GDP (chained 2005 $s) in green and Real GDP in blue.  As one can see, Real GDP declined below potential starting sometime in 2008.  As seen in the previous graph, this was pretty much made up by increased exports.


There is was a rise in household debt, which the following graph gives a flavor of.


This, to me, seems a bigger part of the problem: what Paul Krugman has referred to as the "Wile E. Coyote" moment, where debt had gotten to excessive levels, people became aware of it and suddenly, many people try to pay down their debt at once.  I also think one thing which may have happened is that the forward-looking prices that people had been willing to pay for houses because of expected future values began to feel increasingly incorrect, which meant that their attempts at getting out of homes was a rational response to a reassessment of the actual value of them.  This graph from the S&P Case-Shiller Home Price Indices report in May should help indicate what I'm talking about:


But a lot of this would have been a lot better, in my opinion, if the Federal Reserve and/or the United States government would have taken more aggressive action to keep aggregate demand at higher levels, through more expansionary monetary and/or fiscal policies.  At this point, the Federal Reserve keeps saying "if it's necessary, we will act" and the U.S. government seems to be satisfied in sitting idly by while too many people are looking for work when there is not enough work to be had.

For anyone who is interested, I posted before on a similar topic in the past, called "Consumer spending battered by housing market".

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