The Housing Bubble involved banks

Two economists from my alma mater have an article on 538 about why the Housing Bubble tanked the economy when it burst in 2008, but the Internet Bubble of 2000 did not.

What explains these different outcomes? In our forthcoming book, “House of Debt,” we argue that it was the distribution of losses that made the housing crash so much more severe than the dot-com crash. The sharp decline in home prices starting in 2007 concentrated losses on people with the least capacity to bear them, disproportionately affecting poor homeowners who then stopped spending. What about the tech crash? In 2001, stocks were held almost exclusively by the rich. The tech crash concentrated losses on the rich, but the rich had almost no debt and didn’t need to cut back their spending.

It pains me to say this, because I love economics and I love Chicago, but Sufi and Mian get this wrong because of the core gap in monetary economics -- they miss the finance system.

In general, economics treats money as an "illusion" in that it facilitates the trade and exchange of real goods and services, but fundamentally does not impact or distort that exchange (at least to no great degree). A rose is a rose is a rose, and therefore a good is a good is a good regardless of whether it's prices in dollars or shekels. Therefore, money in general and banks in particular do not play a central role in macro monetary models, which instead focus on things like time preference, consumer expectations, etc.

In reality, money, or more particularly credit, plays a central role in the economy because of how bank lending works. When banks lend, they lever up their balance sheet, and therefore create money out of "thin air", constrained only by capital requirements on the supply side, and the number of qualified borrowers on the demand side.

Saif and Mian are unaware of this dynamic, as they show in their opening paragraphs:

In 2000, the dot-com bubble burst, destroying $6.2 trillion in household wealth over the next two years. 

Five years later, the housing market crashed, and from 2007 to 2009, the value of real estate owned by U.S. households fell by nearly the same amount — $6 trillion

These two $6T are not comparable. In the dot-com bubble, the loss wiped out venture accounts and household wealth in brokerage accounts, but neither was enabling additional lending (and therefore money supply). In the housing bust, $6T of bank capital (which collateralized the loans) was propping up an additional $120T or so (at a 5% capital requirements ratio) of money supply, so the impact on the economy was over an order of magnitude greater.

Without understanding credit, and the role banks play in the economy, economics will continue to struggle to explain the business cycle, and fall for fads like distributional spending effects.