Testimony | Economic Growth

Monetary policy as macroeconomic stabilizer during the Great Recession

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Economic Policy Institute economist Josh Bivens’ testimony before the Subcommittee on Domestic Monetary Policy and Technology Financial Services Committee, U.S. House of Representatives

What we now call the Great Recession was a long time in coming. The economic expansion of 2001 to 2007 was dependent to a historically unprecedented degree on a huge increase in private sector debt. This debt was, largely, used to buy homes, which saw historically large price increases. These price increases were borrowed against by homeowners who then used this equity to support consumption – consumer spending as a share of the overall economy rose to its highest level on record during the housing boom of the 2000s.

The bursting of the home-price bubble had straight-forward effects on the economy – residential investment (the act of building homes) inflated to 6% of overall GDP at the peak of the boom then quickly shrank back down below its 3% of GDP average as home-builders realized that they had overbuilt and faced an enormous inventory of unsold homes. This contraction of residential investment reduced overall demand for goods and services in the economy by roughly $420 billion. A similar (though less extreme) dynamic in commercial real estate reduced economy-wide demand by another $140 billion. Further, as households saw their net worth decimated by falling home-prices and realized that they would now have to start saving out of current income to meet long-run wealth targets like providing a comfortable retirement or sending kids to college, consumer spending collapsed. The 30% fall in home prices erased roughly $7 trillion of wealth from American households. The best research indicates that each $1 fall in housing wealth leads (conservatively) to a $0.06 fall in consumer spending through a “wealth effect” on consumption; translating into a $420 billion annual decline in consumer spending.

This $960 billion negative shock to annual demand for goods and services ($420+$140+$420) is the Great Recession. Figure 1 below shows the path of home prices, residential investment as a share of the economy and mortgage equity withdrawals (just one way that households could increase spending through greater housing wealth) during and after the bubble.


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