False Profits: We Will Be Suffering from Greenspan and Bernanke's Ineptitude for a Long Time

The following is an excerpt from Dean Baker's new book: False Profits: Recovering from the Bubble Economy (PoliPointPress, 2010).

As the nation struggles to recover from the worst economic downturn since the Great Depression, the people who got us here are desperately working to rewrite history. The basic story of this economic collapse is very simple. The Federal Reserve Board, guided by its revered chairman, Alan Green span, allowed an $8 trillion housing bubble to grow unchecked.

Arguably, the Fed even fostered the bubble's growth, seeing it as the only source of dynamism in an economy that was suffering from the aftershocks of the collapse of a $10 trillion stock bubble. Greenspan repeatedly insisted that the housing market was just fine, even as a small group of economists and analysts raised concerns about the unprecedented run-up in house prices. He also dismissed concerns about the questionable mortgages the banks were issuing on a massive scale during the bubble years. In fact, he even encouraged people to take out adjustable-rate mortgages (ARMs) at a time when fixed-rate mortgages were near a 50-year low.

...[T]he devastating consequences for the economy of the collapse of the housing bubble were inevitable. Housing wealth, unlike stock wealth, is relatively evenly distributed among the population. For the vast majority of middle-class families, home equity is their financial asset. When the collapse of the bubble resulted in the disappearance of $8 trillion of housing bubble wealth ($110,000 per homeowner on average), tens of millions of homeowners had no choice but to sharply curtail their consumption.

The wealth that homeowners had taken for granted during the bubble years was gone. This meant that these homeowners could no longer borrow against home equity to support their level of consumption and that they would need to hugely increase their savings to rebuild the wealth they had lost. The rapid falloff in consumption, coupled with the collapse of housing construction, guaranteed the onset of a severe recession. There is no simple way to offset the loss of more than $1 trillion in annual demand in the economy -- $450 billion in lost housing construction and between $600 billion and $800 billion in lost consumption.

A massive wave of foreclosures and mortgage-loan defaults are also an inevitable parts of this story. Millions of people would have lost their homes even without the tsunami of junk loans the banks issued during the bubble years. When house prices plunge below the value of the mortgage, homeowners have less means and incentive to struggle to meet their payments. The huge job loss from the recession also propelled the massive wave of foreclosures.

None of this is complicated or mysterious. Anticipating this disaster didn't require brilliant insights or complex models. In fact, a good student in an introductory economics course would have possessed all the knowledge needed to see this train wreck coming.

However, the political elites do not want the official story to be that simple. They don't want the public to know that the people holding the top economic policy positions are incompetent, corrupt, or both. By burying the story in complexity, these elites are trying to confuse the American public. The confusion begins when the media and the politicians routinely refer to the recession as a "financial crisis."

The implication is that the financial system is at the root of the problem and that fixing the financial system is the way to restore the economy to its normal growth path. Although the failings of financial regulation certainly allowed the bubble to grow much larger than otherwise would have been possible, and the troubles in the financial system have aggravated the downturn, the current economic situation would be little changed if the financial system were instantly restored to perfect health.