Many causes have been cited for the financial crisis and the
ensuing “Great Recession.” In a new and important book, two economists, Atif
Mian and Amir Sufi, make a convincing argument that the major cause was a
pull-back in consumption by highly-indebted households when the housing market
tanked. The authors marshal data to make their case about credit scores,
indebtedness, and economic fallout for different types of neighborhoods.
The argument the authors make is for the most part impressive
and persuasive. That mortgage lenders were making imprudent loans and did not
care because of the insatiable appetite of Wall Street for product to package
into collateralized mortgage obligations (“CMOs”), some of whose tranches were
ridiculously rated AAA, is beyond dispute. It also stands to reason that, when
the housing market crashed and joblessness increased, the most affected
households would have relatively high marginal propensities to consume. Consequently,
the effect of the bursting of the housing bubble was direr for aggregate demand
and the economy than the previous bursting of the tech stock bubble. Stock
market investors, in general, had lower marginal propensities to consume than
over-indebted homeowners faced with possible foreclosure.
The policy implications and conclusions that the authors
draw from their work are somewhat more controversial. Lawrence Summers, in his
generally quite positive Financial
Times review of the book, is
somewhat defensive concerning the authors’ arguments about what the Obama
Administration should have done. The authors argue that more should have been
done to help struggling homeowners and that the banks got off too lightly.
Summers, while admitting that the Administration should have done more in this
respect, argues that the authors ignore the political realities faced by the
Administration. For example, it would have been difficult, probably impossible,
for the Administration to have gotten the Congress to pass legislation to give
bankruptcy judges “cram-down” authority with respect to mortgage debt, that is,
the ability to force creditors to accept a reduction in principal or interest
rate on the debt rather than proceeding to foreclosure. Summers, does, though
agree that would have been good policy if it could have been achieved.
Summers also argues that during the crisis that policymakers
had to be concerned about the stability of the financial system and could not
just drain funds from banks in order to help homeowners. Obviously, it is
easier to identify a limited number of banks and other financial intermediaries
and stabilize them than to set up a program on the fly to help out millions of
homeowners. The authors, though, do have a point. The banks and other financial
intermediaries and much of their management weathered this crisis too well with
government help and forbearance. If the objective was to get the economy moving
again and reduce unemployment, doing more to help those with a high marginal
propensity to consume would have been better policy. We can argue, though,
endlessly, about fairness and who was most at fault.As far as one of the book’s main point is concerned, a housing bubble fueled by excessive debt is the primary cause of the financial crisis and the Great Recession when the bubble burst. The debt exacerbated the problem of getting the economy growing at a desirable rate. What the authors’ do not discuss, though, is that there were failures leading up to the crisis at multiple levels.
The financial regulators, for one, could have been tougher.
The regulators were not blind to the fact that inappropriate and risky mortgage
loans were being made. They had authority, even before Dodd-Frank, to do
something about this. For example, they could have ordered certain banks to
stop engaging in certain activities because they were unsafe and unsound
banking practices. The SEC could have required better disclosures and sales
practices in connection with CMOs. Why did they not do this?
The banking regulators and the SEC should also have been
able to see, if they had looked, that an enormous amount of risk was being laid
off by their regulatees and was concentrated at AIG in the form of credit
default swaps. The regulators should have been awake to the dangers this posed
and put a stop to it continuing.
The rating agencies, as is well known, failed in properly
accessing the risk of CMOs. They put a priority in their short-term business
interests at the expense of their reputations, as did the sellers of CMOs.
In other words, if there had been more proactive and responsible
behavior prior to the crisis erupting, the housing bubble and its aftermath
would have been less severe. The authors do not discuss these multiple failures
of financial institutions and their regulators.
I have some other quibbles with the book. First, it would have
been helpful to discuss more thoroughly the motivations of the mortgage
borrowers rather than just the lenders. For example, the stagnation of incomes
and growing income inequality could have been more explored. A likely explanation for why homeowners (as the
commonplace jargon of the day termed it) took equity out of their homes through
borrowing is that in many cases the motivation was an attempt to maintain or
improve living standards when that could not be accomplished via the job
market. Growing inequality, of
course, has been analyzed in the recent, very long book by Thomas Piketty, Capital in the Twenty-First Century, but
discussing it more specifically in relation to the housing bubble fueled by
excessive debt would have been helpful.
Second, if the authors want to bring in actors such as the
central bank of Thailand into the story, they should have explained more their
role. For example, how were central banks in Asia able to pile up dollar
reserves after that region’s financial crisis and what does the data, if
available, show about their investments in securities other than Treasuries?
Were they reaching for yield in buying supposedly AAA mortgage related
securities, if that is what they did? What were they hearing from the
investment banks advising them and selling them product? Was the Federal
Reserve concerned?
Third, while the recommendation for a different kind of
mortgage products for which borrowers give up a small portion of their
potential capital gains in order to get an automatic principal reduction when
housing prices fall makes sense, there is no discussion of how to make this a
reality. Unless faced with the necessity for creative financial products because
of economic conditions, Americans can often be quite conservative. This is not
easy to overcome.
As an aside, I had experience while working at Treasury, to
research this conservatism. Inflation-indexed bonds were a hot topic that it
was my job to research. One of the reasons proponents of Treasury issuing
inflation-indexed bonds was that these securities could act as a catalyst for
other inflation-indexed products, such as inflation-indexed annuities and mortgages.
In fact, inflation-indexed mortgages had been attempted prior to Treasury
issuing inflation-indexed bonds. They were called price-level adjusted
mortgages (“PLAMs”). PLAMs made a lot of sense, since it is an answer to the
problem that the inflation component of interest rates in a conventional
mortgage is front-loaded. For young people buying their first house, it makes
sense to take out a mortgage with lower initial nominal payments which then
grow with the rate of inflation. Their nominal incomes presumably will increase
with the rate of inflation, if not more as they progress in their careers.
However, the product was not successful and now, I assume, there is still no
interest in an environment where inflation is currently relatively low.
Finally, a certain sloppiness appears in a few places. At
one point, for example, the authors write: “When the banking system is under
severe threat, the price for commercial paper may be much higher than the price
for Treasury bills.” They actually mean “yield” rather than price. At another
point, they oversimplify the way stocks are priced in a discussion of an
experiment conducted by Vernon Smith. They state, and give a numerical example
without any caveat, that “at any point in time, [the stock price] should equal the
expected future dividends from the stock.” They should have mentioned somewhere
that these expected future dividends should be discounted by an appropriate
interest rate in order to determine their present value. Finally, in a
discussion of money market mutual funds, the authors argue that investors know
because of government actions in 2008 that there is an implicit government
guarantee of these funds that makes them attractive. While this is true, it is
a little behind market developments. Money market mutual funds currently have
very low yields and it is easy to find bank deposits, which carry an explicit
government insurance for up to $250,000, that yield more than money market mutual
funds.
The authors are convincing that
excessive mortgage debt was at the root of the problem and that the failure of
the federal government to take significant actions to ameliorate this lengthened
the recession and contributed to the slow growth we continue to experience. The
authors are also correct about the limits of monetary policy action, when substantial
increases in the monetary base do not lead to substantial increases in the money
supply. They are somewhat less convincing in their criticism of fiscal
stimulus, especially since the government could, if there were the political
will, spend money in areas likely to increase employment, such as infrastructure
spending. That does not appear likely at the moment though, but their preferred
solution of giving mortgage relief to distressed homeowners is even less
likely.
The book is well worth reading,
because it gives a different perspective on what happened and why we are
continuing to feel the aftermath of the 2008 financial crisis and Great
Recession. It is an important book. One hopes, though, that the authors take a
broader perspective on economic problems and policy recommendations in their
next book.
