Dean Baker: Bailing out America's toxic banks won't solve this economic crisis |

Dean Baker: Bailing out America's toxic banks won't solve this economic crisis

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While the bankers' greed fed the housing bubble, the incompetence and corruption of the economics profession allowed the world's largest financial bubble to grow unchecked, until its inevitable collapse wrecked the economy. Remarkably, the economists who got everything wrong as the bubble was expanding, are still being given the opportunity to get everything wrong as we try to dig out from the wreckage.

Even though most of the "best" economists in the world did not see it, the story of the bubble and its collapse was in fact extremely simple. The recovery from the stock market crash in 2001 was driven by the growth of the housing bubble.

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Households spend in part based on their housing wealth. The predictable result of the creation of $8tn in housing bubble wealth ($110,000 per homeowner) was a massive consumption boom on the order of $400bn to $600bn a year. The problem was not people's spendthrift ways; the problem was that economic policymakers allowed a huge bubble to develop. People treated this bubble wealth as real wealth, and responded exactly as economic theory would predict: they spent like crazy.

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So, if we snap our fingers and the banks are now fixed, these smaller firms will suddenly be in a position to invest more. Equipment and software investment accounts for 7% of GDP. If we generously assume that the capital-starved small firms account for half of this investment, and that the bank fix will boost their investment by 50%, then throwing money at the banks will increase investment by an amount equal to 1.75% of GDP an amount that is approximately equal to half the falloff in housing construction, and less than a quarter the total drop in demand due to the collapse of the housing bubble.

In other words, the arithmetic shows that a bank fix, while desirable, cannot possibly be sufficient to offset the collapse of the housing bubble. If our priority is to save the bankers from suffering the consequences of their own mistakes, then it makes sense to throw all our money at them. But if the point is to fix the economy, then we have to look elsewhere. ...