The Big Short -- Not the Full Story

The "Big Short" movie presents the popular view that greedy banks and credit rating agencies were behind the housing bubble in 2005-07.   But, this is not the full story from a macro perspective.  From this perspective, policymakers were using easy monetary policy to sustain economic growth in the face of an aggressive Chinese mercantilist policy, and banks were just responding to this policy.   Banks did go overboard in their response, however, and represented a failure on the part of bank regulators to prevent this from happening.  But, the real problem was that the policymakers' reliance on housing demand and household borrowing to lift economic growth was not sustainable.

The macro narrative begins with China's decision to grab market share from the US manufacturing sector by keeping its currency too low in the early 2000s.  China's exports to the US surged but its imports from the US rose only modestly.  As a result, the US was faced with a drag from net exports that had to be offset if GDP Growth were not to slow significantly.

The offset had to come from some sector of the US economy spending more than its income -- a standard Keynesian prescription.  Typically, the prescription entails expansive fiscal policy.   But, in 2005-07, the US relied on the household sector to "overspend," using low interest rates and easier lending standards to boost home buying and consumer credit debt.  What the banks did fit with the macro needs of the time.

Unfortunately, this reliance on the household sector was doomed to fail.   With Chinese net exports widening, housing demand and consumer credit debt had to expand in tandem to offset the increasing drag.  But, there is only so much housing and household indebtedness that is either needed or sustainable.  So, at some point, US GDP Growth would have to weaken, as theses channels to boost spending slowed.

In this light, the expansion of the housing market to sub-prime borrowers -- pushed by Democratic Congressional leaders who pressed FNMA to buy sub-prime mortgages and boosted by banks' overly lax lending and credit rating standards -- helped to sustain the expansion of domestic demand by broadening the demand for housing beyond what had been normal boundaries.  But, it also made the end point come sooner than later, as these borrowers were more susceptible to tightening monetary policy than were prime borrowers.  And, the banks' overly aggressive actions to expand such lending were the culprit here.

The impact of Chinese mercantilist policy on the US economy has receded in recent years.  China has become somewhat less competitive as its currency has risen and wage inflation sped up.   Meanwhile, US labor cost inflation has been stable, and companies have relied more heavily on technology to hold down labor costs.  Other factors have helped to boost US GDP Growth.  The surge in  US domestic oil production has reduced the need for oil imports.  And, capital gains on homes and stocks have substituted for borrowing to encourage consumers spending more relative to their incomes than otherwise.

However, policymakers have moved in ways hurting economic growth   They restrained bank risk taking,  encouraged households to pull in borrowing, and cut the federal deficit.  And, the result is in line with Keynes' Paradox of Saving --  if everyone tries to save more, then GDP and aggregate saving will decline.  The policymakers' actions go a long way in explaining the anemic recovery.