It’s the Housing Bubble Stupid!

Casey Mulligan concludes today in his blog and in the New York Times that "a credit crunch is not a fundamental cause of this recession." This seems right to me.

Is there good reason to reject the obvious hypothesis that the fundamental cause of the recession is the housing bubble? If, in round numbers, the US housing stock was worth $20 trillion at its peak and has lost 25% of its value, then that represents a huge hit to the economy. $5,000,000,000,000 to be precise but not accurate.

The negative wealth effects have caused people consume less as they discover they are not as rich as they thought they were. Productive resources (people and capital) formerly used to build housing and to supply items to formerly wealthier people are now lying (relatively) fallow until they find other productive uses. Doesn’t this simple explanation fit with most of what we have seen over the past year or so?

Aside from the freezeup in the fall as financial institutions suddenly focused on counterparty risk, there does not seem to be much to suggest that losses in the financial sector are anything more than the realization of losses from the housing sector. Financial institutions were residual owners of a fair amount of housing and have ended up taking a hit when it declined by 25%. The leverage of many of those institutions meant that equity holders and some tranches of debt holders have been wiped out, but no productive capacity seems to have been destroyed in the process. The decline in size of the financial sector seems like a logical to a decline in the demand for financial transactions, absent evidence the profitable opportunities aren’t able to find funding.

I am sure this simple analysis overlooks many nuances (which is inevitable), but is it fundamentally flawed or inaccurate or does it miss an important part of the story?