Crisis and neoliberal capitalism

The financial crisis and the real economy:

David Kotz

It is impossible to predict the course of the financial crisis. The effects of the crisis on the real economy could be very large, especially if it engulfs more and more of the financial sector. But even if the financial crisis is contained, the bursting of the housing bubble-which began in 2007 and is bound to continue for some time-will have a powerful downward impact on the economy.

A speculative “bubble” arose in the housing sector of the U.S. economy starting around 2002. By the summer of 2007, housing prices had risen by 70 per cent since 1995 corrected for inflation. Yet since 2002 the real value of home rents had been flat.

Housing Price index

By 2006 the ratio of the Housing Price Index to the Homeowners Equivalent Rent had risen sharply to an all-time high of 168.3, compared to 110.0 in 1995. This is clear evidence of a huge asset bubble in the U.S. housing market. This bubble created an estimated $8 trillion in inflated new wealth, which was about 38 per cent of the peak total housing wealth of $21 trillion.

When this bubble started to collapse in 2007, it set the stage for both a financial crisis and a recession in the “real” economy. There are two ways in which the collapsing housing bubble affects the real economy. First, there is a downward wealth effect on housing investment and consumer spending.

The collapse of the bubble in the housing sector has led to a sharp drop in residential investment. Since the second quarter of 2007, it has been falling at 21.6 per cent annual rate. Second, falling home values are causing a reduction in consumer spending. Since 2002 households had been borrowing against their homes to get funds for consumer spending.

Large Drop

One study estimated that during 2004-06 Americans took $840 billion per year from their home equity through borrowing and capital gains from the sale of housing.

This was almost 10 per cent of disposable personal income in the United States. Suddenly, in 2007, people could no longer supplement their income with funds borrowed against their home, which has now led to a large drop in consumer spending, at a 3.1 per cent per year rate in the third quarter of 2008.

This happened before the financial crisis had begun to affect consumer spending. If all of the estimated $8 trillion of inflated home value disappears, the estimated effect on aggregate consumption would be a reduction of about $320 billion to $480 billion per year, or about 5 per cent of total consumption.

Dean Baker, co-director of the Center for Economic and Policy Research and a respected analyst of the financial crisis, estimated the total effect of the collapsing housing bubble to be a decline of between 3.1 per cent and 7.0 per cent of GDP.

The collapse of the bubble also affects investment in new plant and equipment by business.

Ordinary Income

After several quarters of little growth, business investment fell at a 1 per cent annual rate in the first quarter of 2008. The bubble-propelled and debt-financed expansions of 1991-2000 and 2001-2007 produced a growing amount of productive capacity, relative to ordinary income. As the current crash develops, industry will find it has substantial excess productive capacity. As a result, the incentive for business investment may be depressed for some time.

In the last recession in the United States, in 2001, business fixed investment fell for two consecutive years, at an accelerating rate, for this reason.

Housing Bubble

A severe recession was averted in 2001-2002 by the start of the housing bubble. It does not seem possible for a new bubble to arise and avert a serious recession this time. Also, the financial crisis is likely to make the coming recession more severe.

One way this happens is that banks’ reluctance to lend to business due to the financial crisis will worsen the recession. Secondly, the stock market collapse precipitated by the financial crisis will have effects similar to the effects of the housing price collapse-it will tend to reduce consumer and investment demand.

The only bright spot for the U.S. economy has been exports, but they are not likely to continue to do well in the face of a spreading global recession.

To be Continued