Housing vs. Financial Sector

Decomposing the Recession by Yglesias

You see that the back-and-forth swing of business investment has been the main motor of the recession. When it falls off the cliff is when the economy was collapsing, and its comeback has brought the stabilization of growth and return to a steady path. But it's not a steady path of full employment. Why? The way Brad puts it is "Fix spending on residential construction, and you will have fixed the downturn."

But the chart also shows us that contrary to a lot of myth-making, the recession is notidentical to the downturn in housing.

TEACHING THE MACRO HISTORY OF 2005-2012: "LONG RUN" AND "SHORT RUN" by DeLong

Then, in the second half of 2007, things began to change and the balance of probabilities began to shift. Financiers began trying to deleverage and move their assets into safer portfolios--and, in collectively doing so, did nothing but make all of their portfolios more unsafe. Rising credit spreads made risky borrowers think twice about leveraging up, and business equipment investment began to fall alongside the continuing decking in residential construction. By mid-2008 it was clear that we were in for a financial crisis and downturn of uncertain magnitude, and that it was time to start pushing the Big Red Policy Buttons.

Dean Baker has pointed out that in the bubble bust $8 trillion was lost. That's 8 trillion dollars of demand that no longer needs workers to provide. This was partly compensated via exports and business investment from 2009 onwards as economic growth resumed thanks to the stimulus and banking policy like bailouts and stress tests. But there was no catch-up growth as residential construction remains depressed. And government spending has been a drag rather than a stimulus. Baker doesn't really mention the financial system aspect of it and emphases the housing bubble and trade deficit. He says the stock bubble/ housing bubble supplied demand was replacing demand lost by the trade deficit. DeLong rarely mentions trade except to show that exports were going up. He and Yglesias correctly point out that Says law was in effect from 2006-2008 as exports stood up and residential construction stood down. Those obsessed with debt fail to note this (Baker is not one of those.) Then the financial crisis happened and exports and businesses investment declined as credit markets froze.

You don't want another bubble, but you don't want the obverse of a bubble with credit conditions being too tight.

Imagine an alternate universe timeline where there had not been a bubble. What would have followed?