28/9/2018 The housing bubble, the credit crunch, and the Great Recession: A reply to Paul Krugman

Ben Bernanke

The housing bubble, the credit crunch, and the Great

Recession: A reply to Paul Krugman
Ben S. Bernanke Friday, September 21, 2018

W
hy was the Great Recession so deep? Certainly, the collapse of the housing
bubble was the key precipitating event; falling house prices depressed
consumer wealth and spending while leading to sharp reductions in
residential construction. However, as I argue in a new paper and blog post, the most
damaging aspect of the unwinding bubble was that it ultimately touched off a broad-based
nancial panic, including runs on wholesale funding and indiscriminate re sales of even
non-mortgage credit. The panic in turn choked off credit supply, pushing the economy
into a much more severe decline than otherwise would have occurred. My evidence for this
claim is that indicators of panic, including the sharp increases in funding costs for
nancial institutions and the spiking yields on securitized non-mortgage assets, are
strikingly better predictors of the timing and depth of the recession than are housing-
related variables such as house prices, market pricing of subprime mortgages, or mortgage
delinquency rates.

In a recent post, Paul Krugman gave his take on the causes of the Great Recession. His
inclination, contrary to my ndings, is to emphasize the effects of the housing bust on
aggregate demand rather than the nancial panic as the source of the downturn. In a
follow-up response to my paper, Krugman asks for evidence on the transmission
mechanism. Speci cally, if the nancial disruption was the major cause of the recession,
how were its effects re ected in the major components of GDP, such as consumption and
investment? In this post I’ll offer a few thoughts on Paul’s questions.

I’ll start with some observations on the transmission mechanism. Certainly, a reduction in
credit supply will affect normally credit-sensitive components of spending, like capital
investment, as Krugman notes. But a broad-based and violent nancial panic, like the one
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that gripped the country a decade ago, will also affect the behavior of even rms and
households not currently seeking new loans. For example, in a panic, any rm that relies
on credit to nance its ongoing operations (such as major corporations that rely on
commercial paper) or that might need credit in the near future will face strong incentives
to conserve cash and increase precautionary savings. For many rms, the fastest way to
cut costs is to lay off workers, rather than to hoard labor and build inventories in the face
of slowing demand, as they might normally do. That appears to be what happened: Job
losses, which averaged 120,000 per month from the beginning of the recession in
December 2007 through August 2008, accelerated to 670,000 per month from September
2008 through March 2009, the period of most intense panic. The unemployment rate,
which—despite the fact that house prices had been falling for more than two years — was
still around 6 percent in September 2008, shot up almost 4 percentage points over the next
year. These are not small effects. Workers, in turn, having been laid off or knowing that
they might be, and expecting a lack of access to credit, would likewise have had every
incentive to reduce spending and to try to build up cash buffers. Indeed, research has
found signi cant increases in precautionary savings during the nancial crisis for both
households and rms. In Krugman’s preferred IS-LM terminology, the panic induced a
large downward shift in the IS curve.

Although isolating the effects of the credit shock on individual spending components is
dif cult, it’s nevertheless interesting to follow Krugman and examine how key
components of GDP behaved during the recession. The chart below shows real residential
investment and real GDP (all data below are quarterly, at annualized growth rates) for the
period 2006-2009. As Krugman points out, there were large declines in residential
investment in 2006-2007, prior to the major disruptions in nancial markets. That’s
consistent with his “housing bust” theory of the recession. However, note two points. 
First, despite the decline in residential investment in 2006-07, real GDP growth remained
positive until the rst quarter of 2008 and declined only very slightly over the rst three
quarters of that year, giving little hint of what was to come. However, after the crisis
intensi ed in August/September 2008, GDP fell at annual rates of 8.4 percent in the fourth
quarter of 2008 and 4.4 percent in the rst quarter of 2009. That precipitous decline ended
and began to reverse only as the panic was controlled in the spring of 2009.

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28/9/2018 The housing bubble, the credit crunch, and the Great Recession: A reply to Paul Krugman

Second, the pattern of residential investment was itself evidently affected by the panic,
accelerating its pace of decline to a remarkable -34 percent at an annual rate in the fourth
quarter of 2008 and -33 percent in the rst quarter of 2009, before stabilizing in the
second half of 2009 as the panic subsided. That the panic would affect the pace of
homebuilding makes intuitive sense, given the reliance on credit of both construction
companies and homebuyers. Indeed, my research nds that housing-related indicators
like house prices and subprime mortgage valuations predict housing starts reasonably well
through 2007, but that after that, indicators of nancial panic, including the yields on
non-mortgage credit, are actually better predictors of housing activity. In short, absent the
panic, the pace and extent of the decline in the housing sector might itself not have been
as severe.

The next chart shows the growth of nonresidential xed business investment, whose
behavior Krugman also cites in favor of the housing bust view. But here again, the timing
is key to the interpretation. Unlike residential investment, which began contracting early
in 2006, business investment did not start to decline until well after the bursting of the
housing bubble. From the start of 2006 through the third quarter of 2007, as house prices
fell, nonresidential xed investment growth averaged almost 8 percent, in line with or
even above pre-crisis norms. From the beginning of the recession in the fourth quarter of

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2007 to the third quarter of 2008, average investment growth was slow but positive.
However, from the fourth quarter of 2008, when the panic became intense, through the
end of the recession in mid-2009, the rate of business investment growth fell
precipitously, to an average annualized rate of -20 percent. Essentially all the decline of
business investment took place during the period of most intense panic.

The next two charts show the growth of (1) real personal consumption expenditures for
durable goods and (2) the components of the US trade balance. As with business
investment, the worst declines in these series took place during the period of extreme
panic.  In particular, consumer durables spending remained healthy throughout 2006 and
2007, despite declining house prices and home construction. However, in the fourth
quarter of 2008, durables spending declined at a 26 percent annual rate, recovering in
early 2009 as the panic ended. Likewise, over the fourth quarter of 2008 and the rst
quarter of 2009, real exports and real imports both fell at average annualized rates of close
to 24 percent, as global trade contracted sharply.

Because both exports and imports fell, the net contribution of trade to U.S. aggregate
demand was modest. The behavior of the components of trade shown in the gure is
nevertheless interesting for this discussion. Trade is particularly credit-sensitive, because
importers and exporters rely on trade nance and because a signi cant portion of trade is
in durables, a credit-sensitive category. The collapse of trade in late 2008 and early 2009 is

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therefore a reasonably good signal of disruptions in credit supply. Likewise, improvements

in trade in 2009 likely re ected policies that ended the panic. Expanding on the
international theme, note also that the global nancial crisis can explain, in a way that the
U.S. housing bubble cannot, the depth and synchronization of the worldwide recession of
2008-2009. (See for example, recent analysis by the Bank of England.)

To be clear, none of this disputes that the housing bubble and its unwinding was an
essential cause of the recession. Besides their direct effects on demand, the problems in
housing and mortgage markets provided the spark that ignited the panic; and the slow
recovery from the initial downturn likely was due in part to deleveraging by households
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28/9/2018 The housing bubble, the credit crunch, and the Great Recession: A reply to Paul Krugman

and rms exposed to the housing sector.[1] Indeed, my own past research argues that
factors related to balance sheet deleveraging and the so-called nancial accelerator can
have important effects on the pace of economic growth. I do claim, though, that if the
nancial system had been strong enough to absorb the collapse of the housing bubble
without falling into panic, the Great Recession would have been signi cantly less great. By
the same token, if the panic had not been contained by a forceful government response,
the economic costs would have been much greater.

One more piece of evidence on this point comes from contemporaneous macroeconomic
forecasts. Forecasts made in 2008, by both government agencies and private forecasters,
typically incorporated severe declines in house prices and construction among their
assumptions but still did not anticipate the severity of the downturn. For example, as
discussed in a recent paper by Don Kohn and Brian Sack, the Fed staff’s August 2008
Greenbook report included economic forecasts under a “severe nancial stress scenario.”
Among the assumptions of this conditional forecast were that house prices would decline
by an additional 10 percent relative to baseline forecasts (which had already incorporated
signi cant declines). As a result, the assumed declines in house prices in this projection
were close to those that actually would occur. However, even with these assumptions, Fed
economists predicted that the unemployment rate would peak at only 6.7 percent,
compared to its actual peak of around 10 percent in the fall of 2009. This conditional
forecast would have taken full account of a sharp expected decline in housing construction
and the wealth effects of falling house prices. The fact that forecasts still badly
underestimated the rise in unemployment and the depth of the downturn suggests that
some other factors—the nancial panic, in my view — would play an important role in the
contraction.

The failure of conventional economic models to forecast the effects of the nancial panic
relates to another point made by Krugman in a more recent post, in which he argues that
the experience of the crisis and the Great Recession validates traditional macroeconomics.
On many counts—such as the prediction that the Fed’s monetary policies would not be
in ationary — I did and still do agree with him. However, as I discuss in my paper, current
macro models still do not adequately account for the effects of credit-market conditions or
nancial instability on real activity. It’s an area where much more work is needed.
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*Sage Belz and Michael Ng contributed to this post.

[1] Other factors likely contributed to the slow recovery, including the attenuated scal response and the

constraints put on monetary policy by the zero lower bound on nominal interest rates.

Ben Bernanke

Ben S. Bernanke is a Distinguished Fellow in Residence with the Economic Studies Program at the Brookings
Institution. From February 2006 through January 2014, he was Chairman of the Board of Governors of the
Federal Reserve System. Dr. Bernanke also served as Chairman of the Federal Open Market Committee, the
System's principal monetary policymaking body.

The Hutchins Center on Fiscal and Monetary Policy provides independent, non-partisan analysis of fiscal and
monetary policy issues in order to improve the quality and effectiveness of those policies and public
understanding of them.

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