Monday, July 20, 2015

Black September revisited: On planet Earth, 2008 was a credit event, not a housing event

 - by New Deal democrat

In December 2008, I wrote "Black September: Why the economy suddenly went into free fall"  a day-by-day chronology of the events of that month, intending it to be a "first draft of history," and leave a concise record of what happened, and why it happened while it was still fresh in everyone's mind.
Now in 2015, memories have already faded, and there is an internet tussle between Brad DeLong and Dean Baker about whether the Great Recession was primarily a housing event or a credit event. 
In particular, as summarized by Robert Waldmann at Angry Bear, Baker has argued that:
"the decline in construction plus the decline in consumption due to reduced housing wealth explains the decline in aggregate demand (without any need to discuss finance, underwater mortgages, or clogged credit channels...."
Waldmann is inclined to agree with Baker:
"I think his calculations make sense. He gets to his conclusion with simple estimates (no finance included) using data from before the great recession. He has a problem with the timing of the recession which was very mild until Lehman collapsed then very severe. I think he can argue that this was a short run fluctuation with effects which didn’t last ...."
This argument is a variation on the joke about economists that "it works in practice, but will it work in theory?"  Because we have the facts: the anomalous consumer decline between September 1 and October 10, 2008,  during which the shallow recession which had crippled the housing industry and Wall Street, but left Main Street virtually intact, suddenly metastasized into a collapse of the consumer economy that some were beginning to liken to the 1930s, was due to a complete drying up of credit due to a fundamental loss of faith in the financial system.
As I said at the time: 
The decline in housing values did not have a major effect on most American consumers’ behavior. The 30%+ who do not own houses, and the 20%+ who own their houses in full, were completely unaffected. Of the remaining minority, ... although their home equity position may have declined, even now [December 2008] 90% of all homeowners are “above water”, meaning they have positive equity in their houses. 
But the dramatic 45% decline in the stock market from its October 2007 highs is another matter entirely. It [ ] created perhaps the biggest single negative wealth effect ... in all of American financial history....
Below are selections from by "Black September" post.  If you don't want to read the whole edited chronology, skip to September 24 and 30, and you'll get the gist.

[In August 2008,] Despite all of these things, the unfolding events ... [left] Main Street unscathed. For example, Prof. Brad DeLong, who has been an astute observer of the collapse, noted that "The Financial Economy Has Galloping Pneumonia, Influenza, *and* the Grippe, But the Real Economy Just Has a Cold."
.... In short, the August picture of the economy as a whole showed a recession, but so far a shallow one.

[But by] December 3, John Bergstrom of Bergrstrom Automotive, a major auto dealer, appeared on CNBC and said"on about September 10, we saw our business fall off 30-35%."
A similar sudden decline in consumer spending during September was reported by Shoppertrak:
...While the consumer has remained fairly resilient during this time [2008], two very recent events are dramatically impacting mall visits and consumer confidence.-
Once the financial crisis emerged at the beginning of September, retail traffic declined even further. Between August 31 and September 20, SRTI total U.S. traffic fell an estimated 9.2 percent per day….
- After the failure of Washington Mutual, President Bush’s address to the nation, the presidential debate and the initial rejection of the TARP bailout, traffic fell by an average of 10.5 percent (September 21 – 29).
- The day the TARP bailout package was rejected by congress (September 29) and the NYSE Dow Jones Industrial Average lost 778 points, consumers again responded negatively as shopper traffic fell 12 percent as compared to the same day in 2007

  • Sept 7
  • Report that treasury is going to do $500Bln bailout/backstop  of Fannie/Freddie in a “conservatorship"
  • Sept 8
    • Treasury officially takes control of Fannie/Freddie
    • The late Tanta, in one of her last posts, notes that US Today headline says taxpayers on hook for $5.4 trillion, says that’s what average Americans are reading
  • Sept 9 
    • Lehman in imminent peril per news – faills from $13 to $9 in one day – put on “credit watch” by S & P
    • WaMu “cliff diving” credit outlook cut to “negative”
  • Sept 15 
    • Lehman fails
    • AIG seeks $40 Billion bailout, is downgraded
    • Prof. Paul Krugman calls allowing Lehman to fail “financial russian roulette” with entire financial system
    • WaMu bonds cut to junk rating
  • Sept 16 
    • US considering AIG “conservatorship” agrees to inject $85 billion to AIG to avoid collapse. Breadth of AIG failure a complete surprise
    • The NYT reports:
    • rumor that large money market fund has halted redemptions
  • Sept 19 
    • Treasury to insure money market funds possible downgrades of MBIA, Ambac
    • From the NY Times:  Congressional Leaders Stunned by Warnings 
      As the Fed chairman, Ben S. Bernanke, laid out the potentially devastating ramifications of the financial crisis before congressional leaders on Thursday night, there was a stunned silence at first. Senator Christopher J. Dodd [said] the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”
  • Sept 21
    • Paulson announces $700 bln bailout plan
Sept 24 
  • From the WSJ:  Bush Addresses Bailout Plan 
    President George W. Bush on Wednesday warned Americans and legislators reluctant to pass a historic financial rescue plan that failing to act fast risks wiping out retirement savings, rising foreclosures, lost jobs, closed business and “a long and painful recession.”
  • From the NY Times:  President Issues Warning to Americans 
  • From the WaPo: Bush:  ‘Our Entire Economy Is in Danger’ 
    Bush painted a grim picture view of the future if Congress doesn’t act, but he really didn’t address how the plan would work. Bush did comment that the plan was to buy assets “at the current low price”, seemingly contradicting the comments from Bernanke and Paulson earlier today that they would buy at above the current “fire sale” prices.
  • Calculated risk observed, "I’m not sure if this speech will motivate people to call their representatives, but it might motivate people that haven’t been paying attention to say: “Wow, this is bad. Let’s make sure our money is safe, and watch our expenditures.” And that could lead to a deeper recession"
    • Sept 29 
      • House of Representatives votes down [bailout] plan
    • Sept 30
      • Christoph Rieger, a fixed- income strategist at Dresdner Kleinwort, says:
        “The money markets have completely broken down, with no trading taking place at all. There is no market any more. Central banks are the only providers of cash to the market, no-one else is lending.

I concluded:
American consumers sustained two massive shocks as a result of Black September. First, their confidence was shattered ... mo[st] importantly by the magnification of those collapses by the public figures (the President, the Treasury Secretary, the Chairman of the Federal Reserve, Senator and Members of Congress) in statements that quite plainly advised Americans that imminent panic over the fate of the entire economy was a proper reaction. And panic American consumers did, as millions of households listened to a President’s speech telling them that the End was Imminent, and then had sober discussions over the kitchen table in which they decided to drastically pull back on discretionary spending, literally overnight.

The bottom line is that, while economic theory may be able to generate equations which can generally shoehorn the huge decline of the Great Recession into a "decline in housing wealth" story, what factually happened was an abrupt and discontinuous decline in consumer spending and business hiring due to a nearly complete loss of faith in the fundamental financial system.

[Note: updated to better reflect chronology]