The Causes and Cures of the Economic Crisis

The Causes and Cures of the Economic Crisis Dean Baker, Co-Director Center for Economic and Policy Research April 13, 2012

Key Points on the Economic Crisis 1) The main cause was the collapse of the $8 trillion housing bubble 2) The financial crisis was secondary 3) In the short-term the government must fill demand gap, in the longer term the dollar must fall to reduce the trade deficit.

Real House Prices Rose by More Than 70 Percent 210 190 150 130 110 Source: Case-Shiller 20 -city index. 2008 2005 2002 1999 1996 1993 70 1990 90 1987 = 100 170

Demand Generated by the Housing Bubble 1) Construction rose to near record levels – more than 2 percentage points of GDP (@$300 -400 billion annually) 2) Consumption soared, based on bubble generated equity, as savings fell to near zero (@ $600 billion annually) 3) Bubble in non-residential real estate led to construction boom (@$150 billion annually)

Lost Annual Demand due to the Recession and the Annual Stimulus, 2009 -2010 1600 1400 Billions of dollars 1200 600 Residential construction 1000 800 500 600 400 250 200 Consumption Nonresidential construction 150 0 Lost annual demand Source: Author's calculations. State and Local Government 300 Stimulus

Elements of the Financial Crisis 1) Issue to fail mortgages – main abusers were lenders, not borrowers 2) Negligence/fraud by securitizers (investment banks) 3) Negligence/fraud by rating agencies 4) AIG and credit default swaps 5) Extreme negligence by regulators, first and foremost the Fed

Choices in the Financial Crisis 1) 2) 3) 4) Bailout banks without conditions Bailout banks with strict conditions Let banks fail Second Great Depression was not a risk.

Route Chosen: Bailout with Few Conditions 1) TARP Money – $700 billion appropriated, less than $500 billion used 2) Fed lending – over $3 trillion 3) Fed, Treasury and FDIC guarantees – many trillion

The Financial System is Not the Problem 1) Homebuyers are able to get mortgages (Mortgage Application Index) 2) Firms can borrow on credit markets at unusually low interest rates (we are not Japan) 3) Even small firms do not consider credit a problem 4) Investment in equipment and software is close to pre-recession levels

Interest rates on Aaa and Baa corporate debt, 1981 -2010 18 Nominal interest rates on Baa corporate debt 16 Nominal interest rates on Aaa corporate debt 14 Real interest rates on Baa corporate debt 12 Real interest rates on Aaa corporate debt Percent 10 8 6 4 2 0 1981 1986 1991 1996 2001 2006 Sources: Board of Governors of the Federal Reserve System (http: //www. federalreserve. gov/releases/h 15/data. htm) and Bureau of Labor Statistics (http: //www. bls. gov/cps/).

Investment in Equipment and Software as a Share of GDP, 2000 -2011 12% 8% 6% 4% 2% Year (Q 1) 11 20 10 20 9 20 0 8 20 0 07 20 6 20 0 5 20 0 4 20 0 03 20 02 20 01 0% 20 Percent of GDP 10%

Ways Out of Current Downturn 1) Stimulus – spend money a) youth jobs programs b) aid to state and local governments c) infrastructure projects 2) Federal Reserve Board 3) Lower valued dollar – move toward balanced trade 4) Work Sharing – fewer hours per job, more jobs

Conclusion: We Must Act Quickly to Restore Economy 1) Long-term unemployment is devastating to workers and families 2) Unemployment is an enormous waste of resources 3) We know how to do it 4) It was not the unemployed who messed up on the job