DeLong and Baker discuss two bubbles and two recessions

Here is an interesting (as always) cyber discussion between Brad DeLong and Dean Baker.

DeLong asserted (as he often does) that the great recession was so severe because of finance and “clogged credit channels”

Baker argued (as he often does) that the decline in house prices alone was sufficient to explain the downturn.

In particular he argues
1) that the housing bubble was larger than Brad calculates because Brad used 2002 as his base year and the bubble was already well inflated by then.
2) that the decline in construction plus the decline in consumption due to reduced housing wealth explains the decline in aggregate demand (without any need to discuss finance, underwater mortgages, or clogged credit channels).
and finally that
3) The 2001 recession which followed the bursting of the bubble was also severe if one considers employment not GDP.

For what it’s worth, I agree with Baker’s first point (and would go even further). I don’t have a firm view on the second point, but I think I agree with Baker. I don’t agree with Baker’s third claim.

DeLong responded

I would (and do) say: yes, you have a problem. You need to rebalance, but competent policymakers can balance the economy up, near full employment, rather than balancing the economy down. And from late 2005 to the end of 2007 the balancing-up process was put in motion and, in fact, 3/4 accomplished.

There is no reason why moving three million workers from pounding nails in Nevada and support occupations to making exports, building infrastructure, and serving as home-health aides and barefoot doctors needs to be associated with a lost decade and, apparently, permanently reduced employment.

I think Dean Baker agrees with Brad Delong that competent (Keynesian) policymakers could have handled the large problems.

I comment in more detail on the discussion after the jump.

Of course your time is better spent reading their posts than reading this comment.

First my comment at Brad’s blog (I didn’t cut and paste an earlier comment and the confession that I was wrong)

Dean Baker isn’t too thrilled by Mian & Sufi household debt based stories, but household debt levels were quite different in 2001 and 2008. If, pace Baker, debt and wealth have asymmetric effects, there is less need to bring high finance (as opposed to consumer finance) into the picture.

I am not so convinced that 2001 was a big deal. Baker looks at the change of employment to prime age population from the peak. The 2000 peak was very high. The level is much lower now than the low point between 2000 and 2008. There is also the fact that some prime ages are primer than others — that’s why he uses prime age not working age, but the 21st century decline in employment to prime age population could be partly explained by more detailed consideration of demography.

Oh I have another problem with Baker. His story is about aggregate demand. It seems to me that if output is demand limited, high productivity growth would cause low employment growth. I think the standard use of GDP compared to the last peak when one is talking about aggregate demand is standard for good reason.

I’d consider other explanations for what was worse this time. The decline in construction employment was larger than the decline in .com and cable laying employment — so the amount of rebalancing (and the amount of stimulus required to keep employment up) was much greater. Also housing wealth has a much larger effect on consumption than the value of stock portfolios because much of stock is owned by the very rich.

OK now in more detail

On Baker’s point 1, I entirely agree that the housing bubble was very large. Brad only considers the increase in prices and construction during the period in which the bubble was obviously a bubble. But, especially with the benefit of hindsight, it is clear that it started sooner and therefore was larger. Baker uses 94-96 as his base period “The problem with this assessment is that 2002 was a year in which we were already well into the bubble. If we use the period 1994-1996 as a base, construction was already 10 percent above its population adjusted trend path by 2002.” I would at least consider going much much further back. Robert Shiller has argued that there has long been a widespread and erroneous belief that the ratio of house prices to the consumer price index has an upward trend. He (and many research assistants) calculate that there was no change in the relative price of houses over the 20th century as a whole. If he is right, then the bubble is as old as the belief that houses are good investments. I think this dates from the 70s when they were (due to inflation and the huge nominal rigidity of 30 year fixed nominal interest rate mortgages). Baker notes data (click on the Baker link then at “data showing that vacancy rates were already at a record high in 2002” and a spreadsheet will download) on the housing vacancy rate. It rose dramatically from 96 through 2002 (and reached an extremely high level in 2008). Empty houses are a sign of excess supply possible due to overly high estimates of relative home price appreciation. The housing vacancy rate increased from below 10% to around 13% during the period which even Baker considers pre-bubble.

I think the low construction post 2006 might be the new normal based on realistic assessments of relative house price appreciation. Now Shiller et al might be wrong — others argue that house price inflation has really been greater than consumer price inflation. Also if he is right, the illusion might return. My point (if any) is that models of bubbles, including models with irrational agents, always include the assumption that people know the true history of asset prices. If they don’t then a bubble can last forever without growing to an extreme level and bursting. The assumption that those who buy assets know the time series of prices makes sense for stocks and bonds, but not for houses.

On Baker’s point 2 I think his calculations make sense. He gets to his conclusion with simple estimates (no finance included) using data from before the great recession. He has a problem with the timing of the recession which was very mild until Lehman collapsed then very severe. I think he can argue that this was a short run fluctuation with effects which didn’t last and that the overall decline would have been about the same without the financial crisis. As I typed, I don’t know if I agree with him. I do think the current gap between GDP and its old trend is largely due to low residential investment (which I ascribe to low expected home price appreciation which demonstrated by survey data) and low government consumption and investment. I think it is necessary to appeal to the liquidity trap, but I’m not convinced that credit channels are still clogged.

On the other hand, on his point 3,I don’t think it makes sense to look at employment when discussing aggregate demand. US aggregate demand is a number of dollars. Baker says the 2001 recession was severe, but high productivity growth caused decent GDP growth. Keynes would say that the GDP of an economy with insufficient aggregate demand is determined by that aggregate demand and higher productivity growth would just cause lower employment growth. There isn’t any particular reason why high productivity growth would cause high nominal aggregate demand. Inflation was slightly higher then than in the great recession. So I think one has to argue (as I do above) that the dot com sector (including hardware especially fiber-optical cables) was smaller than the housing sector and that the wealth effect on consumption of stock prices is smaller than the wealth effect of house prices (because shareholders are on average richer than homowners).