Sunday, August 03, 2014

Anon Explains the Subprime Crisis

Wonder who wrote this excellent Wiki squib:
There are several "narratives" attempting to place the causes of the crisis into context, with overlapping elements. Four such narratives include:

  • There was the equivalent of a bank run on the shadow banking system, which includes investment banks and other non-depository financial entities. This system had grown to rival the depository system in scale yet was not subject to the same regulatory safeguards. 

  • The economy was being driven by a housing bubble. When it burst, private residential investment (i.e., housing construction) fell by nearly 4% GDP and consumption enabled by bubble-generated housing wealth also slowed. This created a gap in annual demand (GDP) of nearly $1 trillion. Government was unwilling to make up for this private sector shortfall. 

  • Record levels of household debt accumulated in the decades preceding the crisis resulted in a balance sheet recession (similar to debt deflation) once housing prices began falling in 2006. Consumers began paying down debt, which reduces their consumption, slowing down the economy for an extended period while debt levels are reduced. 

  • Government policies that encouraged home ownership even for those who could not afford it, contributing to lax lending standards, unsustainable housing price increases, and indebtedness.
  • See Wiki, Subprime Mortgage Crisis.  [I stripped off he numbering; could't make it work  in this format.  Also omitted the footnotes.]  Seems to me pithy and to the point. The whole piece is useful, if a bit diffuse. 


    CrocodileChuck said...

    Subprime itself was < $1.5 Trillion.

    Yet the Crisis caused (at least) $12 Trillion in losses.


    [you're missing something..]

    Buce said...

    Interesting point. I haven't done the numbers myself but how should we account for the lost GDP?

    Larry, The Barefoot Bum said...

    One short answer is the Keynesian multiplier. The subprime crisis was not about lost money per se (who cares about money? the Fed can print as much as it likes), and we didn't lose any actual stuff in the subprime crisis.

    What we lost was confidence, the confidence that we could do things like build factories and manufacture stuff, and that the income from these activities would go to the "right" people. (And we knew we had too much housing, so we more-or-less sensibly slowed way down on making more. According to FRED, Gross Private Domestic Investment (SA) went from $2.7 trillion in 2007Q3 to $1.8 trillion in 2009Q3, a decline of almost 33%. That means that workers receive less money and buy less stuff. Businesses don't want to increase production unless they think they can sell their products. Thus, even when the initial shock has subsided, businesses don't rush to make up lost ground.

    The subprime crisis ended up causing an enormous transfer of wealth from middle-class homeowners to bankers, and dramatic loss of income to a lot of newly unemployed workers. Because home mortgages were filling in the spending gap for mostly stagnant middle-class wage growth, we first lost that source of GDP. Second, as home prices fell, people started paying down debt (i.e. savings) rather than consuming. And, of course, unemployed people don't buy new televisions or cars.

    GDP doesn't revert to a trend; whenever there's a shock (especially a negative shock), that becomes the new normal, and long run growth proceeds normally from there. Industrial Capacity went from a high of almost 81% before the crisis, dropped below 67%, bounced relatively quickly back to about 75% in 2010, and then has been ambling upwards to about 80%. (In the long run, industrial capacity has been steadily falling on average from almost 90% in 1967.) And labor force participation has declined from its pre-crisis high of 83% to 81%.

    (Note, these changes seem small, but remember, 1% of a $13 trillion dollar economy is still a lot.)

    Because GDP doesn't automatically revert to trend, when we have a large demand-side shock, the government can (and I think should) step in to force GDP back to its desired long run trend. Because the government didn't do so, we lost actual production we could have had (by employing unemployed people in idle factories). This lost production has added up over time to the $12 trillion in losses. It's just a waste.

    CrocodileChuck said...

    [you're missing something], cont

    @ Larry: the losses were real.

    the difference between $1.5 and $12T?

    Leverage. All those CDO's had embedded leverage; at the v end, everyone was using it to short the mortgage market.

    Like, Magnetar:

    Larry, The Barefoot Bum said...

    @CrocodileChuck: I mean "not real" in the economic sense: a tsunami, earthquake, or enemy attack did not destroy $1.5T of homes, factories, farms, or inventory.