What the #$*! do we know!?

WhatTheBleep2Didn’t see the movie, but the title is one that any student of economics must ponder on a regular basis. Case in point: our attempts to understand the current crisis, which is the reason I set up this blog in the first place. While there does seem to be a general consensus that the crisis involved the bursting of a bubble of some kind, there seems to be strong disagreement on the specifics, even among economists who are smart, fair, and thorough.

A few weeks ago I noted that there were two basic explanations of the crisis that were both plausible and consistent with each other:  (1) overindebted Americans whose luck finally ran out and (2) a global savings glut. Money inflows from abroad helped fuel the housing and stock-market bubbles, and also made U.S. interest rates cheaper, thus making it easier for spendthrift Americans to keep on borrowing. Americans have been living beyond their means since 1981 (we know this because the trade balance has been negative during that time, meaning that imports have made up the gap between what we purchase and what we produce), and foreigners have been our eager enablers by purchasing U.S. stocks, bonds, property, and other assets. Aggregate statistics show that American indebtedness increased greatly in the past decade — to the highest levels since 1929! — and of course the housing market (and to a lesser extent the stock market) became a historic bubble in this decade. The usual story is that the runups in stock and housing prices encouraged Americans to spend more and more, even to the point of going further into debt, as their equity was rising and in many cases, like home equity loans, they could even borrow against it. Then the housing bubble burst, and the stock bubble followed suit, and suddenly Americans were a lot less wealthy and therefore cut back their spending, causing GDP to fall.

Still sounds plausible, but is it true? Some recent empirical studies cast a lot of doubt on both of those explanations.

While nobody disputes that Americans were highly indebted, there is some doubt over whether consumer spending is responsive to housing wealth (in econ speak, the propensity to consume out of housing wealth may be close to zero). A recent study by economists Charles Calomiris, Stanley Longhofer, and William Miles, described in a WSJ online op-ed, says the actual effect of housing wealth on consumption is very small. This to me seems consistent with common sense — unlike other forms of wealth, I can’t liquidate part of my house and then spend it, and even a home equity loan would have to be paid off out of my future income unless I sell the house — but it is very different from previous studies, which found a large housing wealth effect on consumption and which Calomiris et al. say were misspecified. Dean Baker says most of those studies estimate the effect to be 5-7 cents of extra consumption for every extra dollar of housing wealth.  So, say, a 50% drop in house prices could mean a 3.5% decrease in consumption, which would mean a drop of about 2.5% in GDP (of which consumption is about 70%. Baker adds that standard estimates of the propensity to consume out of stock market wealth is about 3-4 cents on the dollar, so a 50% drop in stock prices could mean a 2% decrease in consumption, and an additional 1.4% drop in GDP.  Add those two together and you have roughly the 4% decline in GDP that actually occurred.) Another recent economic study, also written up in the online WSJ by the authors (Atif Mian and Amir Sufi), says Calomiris, et al. got it wrong and that the housing boom fueled the economic growth of 2002-2006 and the housing collapse was “likely a main contributor” to the current slump. Both the Calomiris et al. study and the Mian-Sufi study look like careful empirical research by top scholars, so confusion seems to be the best available option for most of the rest of us.

The “global savings glut” explanation also has its detractors. Menzie Chinn of Econbrowser all but dances on its grave. Chinn suggests that America’s huge capital inflows since 2001 were not so much a global savings glut as a global savings vortex located in America: a financial mania that lured investors from all over; loosened capital requirements that encouraged foreign financial institutions to do business here; and rising U.S. budget deficits that added directly to the current account deficit (whose flip side is larger foreign capital inflows). Brad Setser of Roubini Global Economics, in a fine summary and exploration of the matter, calls it one of the most polarizing issues among economists. Reading both of these pieces makes me a lot more skeptical of the global-savings-glut story. Perhaps it’s not even that necessary a part of the larger narrative: tens of millions of Americans also got caught up in the housing and stock bubbles. Foreign capital inflows surely inflated those bubbles further, but it’s doubtful that they were the cause of them.


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