A Recession’s Import

May 1, 2009 • Commentary
This article appeared in National Review on May 4, 2009.

Much unnecessary confusion arises from using such phrases as “housing crisis” and “financial crisis” to mean “recession.” That confusion is compounded by wrongly equating the phrase “financial crisis” with the alleged contraction of bank loans.

Conventional wisdom has it that the world recession was precipitated by the unexplained collapse of a U.S. housing bubble, which resulted in massive loan foreclosures, thereby turning mortgage‐​backed securities into toxic assets that, in turn, caused bank loans to dry up.

There is some truth in all that, but there are also some glaring omissions.

Consider, first, the infamous housing bubble: The latest Organisation for Economic Co‐​operation and Development “outlook” calculates that inflation‐​adjusted U.S. housing prices rose by 5.4 percent a year in the U.S. from 2000 to 2006 — meaning 5.4 percent on top of the general rate of inflation. This rapid escalation of home prices produced ephemeral windfalls for those selling or refinancing homes, but rising prices became increasingly problematic for new‐​home buyers. Yet that 5.4 percent U.S. figure pales in comparison with housing inflation in other countries during the same years: 6.7 percent in Canada and Sweden, 8.8 percent in Britain, 9.5 percent in France, 8.3 percent in Ireland, and 11.2 percent in Spain. By Dec. 6, 2007, The Economist feared that “America’s housing malaise is slowly spreading.” Strangely, The Economist tried to blame falling home prices in Ireland, Britain, and Spain on the far‐​less‐​boomy U.S. market — a marvelous example of the trend to blame all the world’s economic troubles on the United States in general and on U.S. bankers in particular.

Some economists boast of having been quick to notice that the real‐​estate market was overpriced and overbuilt in Las Vegas, Phoenix, and the exurbs of California and Florida. Seeing that required little prescience, though, since housing starts had already fallen by more than half — from an annualized rate of 2.3 million in January 2006 to 1 million by late 2007 — before the recession began. Shrinking home construction subtracted only a bit more than half a percentage point from GDP during the last three quarters of 2008, compared with a full 1 percent loss during much of 2006 and 2007.

Auto sales too were falling long before the recession began — from an annualized rate of 17.5 million in January 2006 to 15.3 million in January 2008 (and, lately, to below 10 million).

Growing U.S. exports kept real GDP increasing through the second quarter of 2008, but this could not be sustained, since the economies of our major trading partners were falling sharply. Indeed, by 2008’s fourth quarter, real GDP was just 0.8 percent lower than a year before in the U.S., but 1.7 percent lower in Germany, 2.9 percent in Italy, 4.3 percent in Japan, and 4.9 percent in Sweden. Only one of those countries (Sweden) was among those with roaring housing booms before 2006, so housing busts were not the fundamental problem. And neither were the subsequent bank troubles: Very few of the hardest‐​hit economies (aside from those of the U.K. and Ireland) were plagued by serious bank failures. Unlike China, Canada, and Mexico, whose downturns have been fairly mild, many of the most depressed countries were not terribly dependent on exports to the United States. The U.S. now accounts for a smaller share of Japan’s exports — 20 percent — than does China. Besides, U.S. exports had been growing faster than non‐​oil imports. What appears to have happened is that the deep decline in foreign economies spread to the U.S. through trade, not vice versa.

There was also a horrible series of financial crises last September, but that was to some extent the consequence of a global recession that began much earlier, not the source of the recession. Although many now claim credit for having predicted the 2006 collapse in housing starts a year or so before it happened, I have not discovered anyone who anticipated before 2008 the extent to which investment banks and commercial banks around the world had misused short‐​term debt to invest in mortgage‐​backed securities.

The recession worsened an ongoing housing contraction and thereby reduced the value of mortgagebacked securities (MBS). This precipitated a financial crisis that, in turn, worsened the recession. The causality runs both ways. Bank stocks collapsed because of fears of incremental nationalization through TARP’s preferred shares, as well as fears (alleviated in March by Ben Bernanke and the Financial Accounting Standards Board) that regulators might require banks to hold additional capital simply because their MBS portfolios had declined steeply in value.

A financial crisis means a crisis for financial institutions, such as Wall Street’s former investment banks, and for financial instruments, such as AIG’s unsecured guarantees of mortgage‐​backed bonds. It does not mean, as many supposed, a big drop in bank lending. As the table shows, bank lending has grown surprisingly well since the recession began — not at the 10 percent pace of previous years, but the excessive borrowing of those years will not be fixed through more borrowing.

Last fall’s unnecessarily abrupt bankruptcy of Lehman Brothers scared money‐​market funds away from commercial paper for a while, because the Paulson‐​Geithner‐​Bernanke team neglected to inform the markets that Lehman’s commercial paper would be guaranteed by the firm’s assets. But that problem has dissipated.

The recession did not begin with the U.S. and spread like an infection to other countries. On the contrary, the 2008 downturn in GDP and industrial production was least severe in the U.S. and Canada and most severe in Europe, Scandinavia, Japan, and the “Asian Tigers.” Most of these countries had no significant exposure to the U.S. mortgage market and no abnormal spate of bank failures. What they had in common was what ten of the eleven post‐​World War II U.S. recessions had in common: vulnerability to sudden increases in the price of crude oil.

An unduly optimistic 2006 Commerce Department study estimated that if oil rose from $50 to $70 a barrel, the increase would shave half a percentage point from real GDP. But crude didn’t just rise to $70; it hit $100 in late 2007 and then $145 in 2008. The effect of soaring gasoline prices was seen in declining home sales as early as 2006–2007, particularly in distant exurbs of Los Angeles and Silicon Valley, and in fewer vacations that required expensive driving trips, such as ones to second homes in Las Vegas, Phoenix, and Florida. The effect was also seen in declining sales of cars and trucks in 2006-07, particularly those thirsty for fuel. Meanwhile, the rising cost of energy in general, and petrochemicals in particular, reduced the profitability of producing and transporting a wide variety of goods around the nation and around the world. The drop in corporate earnings, in turn, was reflected in falling stock prices and therefore household wealth and spending.

There has been a global recession, a set of domestic and foreign housing crises, and a largely Anglo‐ American financial crisis affecting securities more than bank loans. Those are three distinct events with different timelines that happened to overlap. The recession did not begin in the U.S.; it clearly preceded the financial turmoil of last September; and it had virtually nothing to do with the alleged scarcity of bank loans (but much to do with prior excesses of debt). The prolonged downturn of housing starts and auto sales in 2006-07 was not sufficient to sink the economy, but did so when combined with the closely related global impact of an unprecedented surge in oil prices.

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