real-world economics review, issue no. 46

The housing bubble and the financial crisis
Dean Baker [Center for Economic and Policy Research, USA]
Copyright: Dean Baker, 2008

The central element in the current financial crisis is the housing bubble. The irrational exuberance surrounding this bubble created an environment that was ripe for the cowboy financing that got Wall Street and the country into so much trouble. Of course the cowboy financing fed into the bubble, allowing it to grow to proportions that would not have been possible with a well-regulated financial system. This essay first describes the circumstances under which the bubble began to grow. It then discusses how financial innovations and the lack of a proper regulator structure allowed the bubble to grow to ever more dangerous levels and eventually to crash in a way that has placed unprecedented strain on the country’s financial system. The third part outlines key principles for reform of the financial system.

The origins of the housing bubble The housing bubble in the United States grew up alongside the stock bubble in the mid-90s. The logic of the growth of the bubble is very simple. People who had increased their wealth substantially with the extraordinary run-up of stock prices were spending based on this increased wealth. This led to the consumption boom of the late 90s, with the savings rate out of disposable income falling from close to 5.0 percent in the middle of the decade to just over 2 percent by 2000. The stock wealth induced consumption boom also led people to buy bigger and/or better homes, since they sought to spend some of their new stock wealth on housing. This increase in demand had the effect of triggering a housing bubble because in the short-run the supply of housing is relatively fixed. Therefore an increase in demand leads first to an increase in price. As prices began to rise