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The Crash of the Housing Bubble

Economist Dean Baker on its destructive aftermath

Sep. 16, 2009
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 Back in 2002, Dean Baker, Ph.D., warned that the country was in the midst of a housing bubble that wasn’t going to end well. Baker, co-director of the Center for Economic and Policy Research in Washington, D.C., says that the Federal Reserve could have prevented the bubble from getting out of control simply by being honest about the dangers posed by a runaway housing sector and then taking action. In this Shepherd Q&A, Baker, who will speak at the UW-Milwaukee Union on Sept. 23, discusses how the housing bubble was made even worse by the high-risk behaviors of financial institutions—behaviors that still haven’t been reined in through regulation.

 Shepherd: What created that run-up in housing prices?

 Baker: I think it was a spinoff of the stock bubble. What happens when you have a run-up in stock prices is that you have people spending more based on their stock wealth, their new wealth. And one of the things they look to spend more money on is housing.

 Once you get into a situation where people see the prices of houses rising, they can come to expect them to continue to rise. So they are prepared to pay more for a home. If someone looks at a home worth $300,000, it might be more than they are willing to pay. But if they have it in their head that in five years the same home will be worth $400,000, they will have a different attitude. So they will pay the $300,000 and maybe even more.

 Shepherd: It was also thought at the time that real estate was the safest bet, at least compared to buying tech stocks.

 Baker: I don’t know how many people I came across who said that. “You can always live in your home.” And I’d say, “Yes, but how many of us can afford to live in a own home that we paid $100,000 too much for?”

 Shepherd: What about the slicing and dicing of mortgages into these complex financial products?

 Baker: That’s a central part of the story. You had to have someone buy the bad mortgages. Banks could issue them, but if no one would pay them off, they wouldn't make any money. So the key was to have someone who was prepared to buy them. The reason why the investment banks were so happy to buy them up and securitize them was that they were convinced that they could manage risk and cut them up in so many ways that they wouldn't be so risky once you sliced and diced them and somehow the risk disappeared.

 Shepherd: You’ve said there were some things that could have been done to prevent the housing bubble from spiraling out of control. One was to have then-Federal Reserve Chair Alan Greenspan talk about it.

 Baker: Yes. Economists always ridicule this, but this is one of those questions where we’ll see if it works when someone tries it. If you had Alan Greenspan, or whoever is head of the Federal Reserve, out there laying out the case—and I don’t mean Greenspan’s famous quote about the stock bubble and “irrational exuberance,” kind of a mumbled phrase—I mean laying out the evidence.

 He could have documented that this was a bubble and taken advantage of his appearances before Congress and said again and again and again that the most important problem facing the economy is the bubble in the housing market that’s created this distortion, and then explain how it’s going to end badly. And talk about how people aren’t saving enough, how banks are getting heavily leveraged.

 Shepherd: Have any regulations been implemented to prevent financial institutions from taking the same sort of risks?

Baker: No. It’s really unfortunate. There was a window certainly when President Obama could have acted and I really worry that it’s closed. It struck me that the one clearly substantive change he proposed was the Consumer Financial Protection Agency. That would have been very useful to have in ’04, ’05, ’06, to prevent a lot of bad mortgages and bad credit card [practices]. I would have thought that the banks would have nodded and maybe complained about it and pushed for one or two changes, but instead they’re really resistant. They’re prepared to dig in and do everything they can to prevent it from passing.

 Shepherd: Anything else you’re worried about?

 Baker: What I’m worried about is that you might get a situation like we had in the ’30s when Roosevelt backed away from the stimulus in ’37 and thought everything was going well and we had what’s referred to as a double dip, a second recession. I’m worried that we may see something like that. There’s a lot of pressure here in D.C. about the deficit. I personally find it to be close to crazy. Not to say that you should never be worried about the deficit, but worrying about the deficit in the current environment just seems really off the mark.

 Baker will speak on the crash of the housing bubble at 7 p.m. on Sept. 23 at Ballroom West in the UWM Union. It’s sponsored by the UWM Department of Economics and Progressive Students of Milwaukee and is free and open to the public. For more information, go to www.progressivestudents.org.


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