Four More Years Of "It Could Have Been Worse"

There have been two momentous events in the last week. Of course President Obama's swearing in for a second term is a big deal, even if somewhat less historic than his inauguration back in 2009. The other big event was the release of the Federal Reserve Board's transcripts from the 2007 meetings of the Fed's Open Market Committee (FOMC).

If the FOMC sounds like a nerdy and irrelevant concern, that is a big problem. It is the Fed's job to prevent disasters like the one we are now living through as a result of the collapse of an $8 trillion housing bubble. We already knew from previous years' transcripts that the Fed was almost entirely oblivious to the growth of the housing bubble. It took little notice as house prices grew ever more out of line with fundamentals and mortgage financing became ever more sketchy.

Alan Greenspan, Ben Bernanke (he was governor during most of the run-up), and the rest also seemed oblivious to the extent to which the housing market was driving the economy. There was little appreciation of the fact that an unsustainable building boom and surge in consumption driven by ephemeral housing wealth were the major factors driving the economy in the years 2002-2007.

The 2007 transcripts show that this crew was still oblivious even as the economy was beginning to collapse all around them. This is the captain and crew of the Titanic planning their stay in New York after the ship had already hit the iceberg.

This $960 billion in lost annual demand doesn't even capture the secondary hit to state and local governments due to lost tax revenue or the fact that non-residential real estate was also experiencing a bubble. But the massive loss of demand associated with a collapse of the bubble did not seem to be on the mind of anyone at the FOMC even as the collapse of the bubble was picking up steam and the economy entered the recession at the end of the year. 

Somehow no one ever raises the issue of how the economy will replace the demand created by the collapse of the bubble. If housing construction just fell back to its normal share of GDP, it would have created a hole in demand of more than 2 percentage points of GDP (@$320 billion annually in today's economy). If the evaporation of bubble-generated housing equity led saving rates to return to more normal levels, it would imply a hit to annual demand of another 4 percentage points of GDP (@$640 billion annually in today's economy).

With President Obama beginning his second term, it is a good time to take stock of where the economy stands. In spite of having dropped 2.2 percentage points from its peak, at 7.8 percent the unemployment rate is still as high as the peak in the 1990-1991 recession and more than a full percentage point above the peak of the 2001 recession. We are down almost 4 million jobs from the pre-recession peak in 2007 and more than 9 million jobs below where we would be if the economy had continued its trend growth path.    

The collapse of the bubble wiped out a large portion of the wealth of the baby boom cohorts that are now reaching retirement age. The typical household among the 55-64 cohort has just $170,000 in wealth. This means that if they took all their assets they would have almost enough money to pay off the mortgage on a typical home, which now sells for $180,000. After this they would be entirely dependent on Social Security to support them in retirement. The typical younger baby boomer, ages 45-54, has around $80,000 in wealth. And both groups have to worry about politicians in Washington who want to pare back their Social Security and cut their Medicare.

The cumulative loss in GDP to date compared with what the Congressional Budget Office projected back in January of 2008, before it recognised the recession, is $6.2 trillion. That comes to $80,000 in lost output for an average family of four. This is money that was just thrown in the garbage because the economy was operating below its potential.

The worst part of this story is that there is little prospect that things will get much better. At the current rate at which the economy is adding jobs, we won't make up our jobs deficit until the middle of the next decade. And as long as the labour market is so weak, there is little likelihood that workers will be in a position to get their share of wage gains.

But the weak state of the economy is not even on the agenda in Washington. The national debate is focused like a laser beam on how to reduce the deficit caused by the collapse of the economy. It would be funny if there were not so many people seeing their lives ruined.

In 2008, President Obama ran on a platform of hope and change. After four years, the biggest change is that there is no hope.

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