Former U.S. Treasury Secretary Lawrence Summers began his review in the June 6 Financial Times of House of Debt, by Atif Mian and Amir Sufi, with high praise: “Atif Mian and Amir Sufi’s House of Debt, despite some tough competition, looks likely to be the most important economics book of 2014; it could be the most important book to come out of the 2008 financial crisis and subsequent Great Recession.”
In a year that saw the publication in English of Thomas Piketty’s Capital in the Twenty-First Century, a book that Summers also praised highly, this is a thundering endorsement. In the case of the Mian and Sufi book, however, what Summers really meant was that the book hit a nerve.
Mian and Sufi, professors at Princeton and the University of Chicago, respectively, have two important messages. The first is that the debt contract is a very poor instrument on which to base a stable economy. “If we are to avoid the painful boom-and-bust episodes that are becoming all too frequent,” say Mian and Sufi, “we must address the key problem: the inflexibility of debt contracts.” They propose an alternative that I will discuss later.
Their second message, occupying most of the book, is that the most commonly accepted explanation of the Great Recession is wrong. They call this explanation the “banking view,” which “holds that the central problem with the economy is a severely weakened financial sector that has stopped the flow of credit.” Mian and Sufi show very persuasively that this view is wrong, and they fault the economics profession for the prevalence of this explanation.
Mian and Sufi believe that because the banking view of the Great Recession is inadequate, the solution of saving the banks was bound to be insufficient to forestall a prolonged economic slowdown. Therefore, they argue that much more effort and resources should have gone into the relief of homeowner debt.
This is where their message hits Summers where it hurts. He does give Mian and Sufi enormous credit for their analysis, but then goes on to criticize them severely for being naive about the realities of policy choices.
I will come back to Summers’s reaction, but first let us look at Mian and Sufi’s arguments. Frequently, evidence in economic analyses is little better than anecdotal. Mian and Sufi’s analysis, however, does live up to the higher standard. It could serve as the paradigm of empirically-based analysis to which all economic studies should aspire.
Unraveling the causes of the Great Recession
Mian and Sufi paint the history of the Great Recession in familiar terms. A pattern of low-quality securitized lending caused a housing bubble: “From 2002 to 2005, credit flooded into low credit-score zip codes. Mortgages originated for home purchase grew 30% per year, compared to only 11% in high credit-score areas.” When the bubble burst it wreaked havoc, engendering a prolonged economic slump.
What is unique about the Mian and Sufi analysis is that they take great pains to construct the sequence of events and establish causation. In particular, they rebut the banking view, which states that it was difficult to get the economy moving again after the crisis because banks were reluctant to lend. The consequent drying-up of credit, according to this view, especially to small businesses, put a damper on economic recovery.
Instead, Mian and Sufi argue that the driver of the prolonged slump was a sustained cutback in consumption by homeowners who lost much or all of their home equity. On these points, they couldn’t be more convincing.
Why did the burst bubble of the housing run-up cause such an economic slump when the bursting of the internet stock bubble in 2000 caused a sharp fall in the NASDAQ but little harm to the Main Street economy? The answer lies in the “marginal propensity to consume” (MPC). Poorer people have a much higher MPC than rich people. That means that for each dollar of wealth loss, they reduce spending by much more than rich people do. It was mostly relatively rich people who bought internet stocks and were devastated by their collapse. Those people had a relatively low MPC. When the collapse occurred, they reduced their spending by much less than the poor people who had received mortgages in the early 2000s did when their bubble burst later that decade.
Furthermore, the poorest homeowners, the ones with the lowest credit ratings who had received the bulk of the new mortgages from 2002 to 2005, were much more highly leveraged than wealthier people. Mian and Sufi observe that “the richest 20% of home owners had a leverage ratio of only 7%, compared to the 80% leverage ratio of the poorest home owners.” Hence, when home prices dropped (They had risen in low credit-score areas of Detroit by 80% before the crash, then fell 60% when the bubble burst), those low credit-score homeowners had their wealth virtually wiped out, or worse.
With their high MPC, the low credit-score borrowers cut back drastically on spending, causing ripples across the economy. Mian and Sufi show that this spending crash had an immediate effect on localized “non-tradable” jobs such as car dealerships in the locales of the suffering borrowers. In turn, the spending crash had knock-on effects in all areas of the country on non-localized “tradable” jobs such as car manufacturing.
The evidence they present for this reduced-consumer-spending model as opposed to the reduced-bank-lending model is very strong. They point out that purchases of consumer durables had already fallen by 2006, before any signs of banking crisis. They also discussed surveys of small business owners. “The fraction citing financing and interest rates as a main concern never rose above 5% throughout the financial crisis—in fact, the fraction actually went down from 2007 to 2009,” Mian and Sufi write. On the other hand, “from 2007 to 2009, the fraction of small businesses citing poor sales as their top concern jumped from 10% to almost 35%.”
Larry Summers’s sleepless nights
Hence, the cause of the economic slowdown was not a failure of banks to lend; it was a failure of consumers to consume. And to get consumers to consume again and resolve the crisis, the best action – because of low credit-score homeowners’ high MPC – would have been to immediately reduce their mortgage debt.
Mian and Sufi discuss the various ways this could have been done. One was to allow “cram-downs” by judges in Chapter 13 bankruptcies. In a Chapter 13 bankruptcy, a court-appointed bankruptcy trustee must approve an individual’s debt payback plan to reduce that individual’s debt burden. However, Chapter 13 does not allow for reduction of the principal on a home mortgage. A cram-down would be an order from a judge to a creditor to reduce the principal balance of the bankrupt individual’s home mortgage.
If legislation had been passed allowing them to do so, bankruptcy courts could have reduced those highly leveraged low credit-score homeowners’ loan obligations, thus rapidly boosting consumption due to homeowners’ high MPCs.
But lamentably, Mian and Sufi say, “while any policy that would have helped home owners was shelved, governments bailed out bank creditors and shareholders using taxpayer money. Why?”
The reason was the prevailing banking view, for which they blame the economics profession. Mian and Sufi say there were two reasons given for supporting the banking system: first, to protect depositors, and second, to protect banks’ ability to lend.
Depositors and the payment system must be protected, but, say Mian and Sufi, “this does not require any assistance to long-term creditors or shareholders of banks. In fact, it is possible to completely wipe out shareholders and long-term creditors while preserving the integrity of the payment system. The FDIC has done this many times.”
The second, as we have seen, was not a good reason because the banks’ ability to lend was not of great importance in stanching the economic fallout. Nevertheless, as Mian and Sufi say, “Obama’s advisers chose early on not to expend political capital forcing banks to forgive mortgage debt.”
It is undoubtedly these words that raised Summers’ pained ire in his Financial Times review. He responds, “Obviously, as the director of President Barack Obama’s National Economic Council in 2009 and 2010, I am an interested party here.” He then goes on to say:
We all believed in 2009 what Mian and Sufi have now conclusively demonstrated – that reducing mortgage debt would spur consumer spending. And there was intense frustration with how few homeowners our programs were reaching, to the point where I convened all the relevant officials from the Treasury, the Housing and Urban Development department and other agencies every month for two years to challenge them to find ways to accelerate the process and to make sure that they were considering all the various schemes academics and others were suggesting. So Mian and Sufi are not wrong in their dissatisfaction.
Where they do, in my view, go badly wrong is in suggesting that the failure to do more for underwater homeowners reflected a blinkered attachment to an at best incomplete, and at worst harmful, banking-based view of what was happening. Mian and Sufi’s error is a common one among academic economists, many of whom are unwilling to try to understand policy choices that arise from considerations outside simple models.
Summers then recites the Obama team’s efforts and calculations, which ultimately resulted in little to bring about forgiveness of homeowner debt. He admits that “We may well have misjudged some risks or missed important opportunities to carry out effective policy. Certainly, I have stayed up at night while in government and afterwards worrying over these possibilities.”
And Summers is convincing in his pleas that he and other of the president’s advisors understood the issues that Mian and Sufi raise and tried to do their best to do something about it. Yet a sense that Mian and Sufi’s criticism is justified lingers, even in Summers’s words. That is why I say that they hit a nerve.
Two examples may suffice. In one, Summers points out that he argued for cram-down. Nevertheless, he says, “the president and his team felt that in a world where many legislative battles lay ahead, a failure on cram-down would be costly in time and political capital.” But enormous amounts of political capital had already been spent on bank bailouts. How is it decided on what to expend political capital?
An even more questionable Summers rebuttal has to do with the proposal that the government buy underwater mortgages from banks. Summers says, “The problem was that in many cases mortgage assets were carried on banks’ books at valuations far above what appeared to be current market value. Buying them at such valuations would have been a massive backdoor subsidy to banks of the kind we would not accept. Forcing writedowns was precluded for regulators who feared what it would do to banks’ capital positions.”
I find this hard to understand. He means that banks’ capital positions were fictional, and regulators feared they would have to face reality? It is hard to escape the feeling that part of the explanation is that a policymaker in Summers’s position is more sensitive to the concerns of banks and the executives of those banks with which he is intimately familiar – one might say captured by banks, even unconsciously – than to the concerns of underwater homeowners.
The long-term solution
The trouble with any rescue operation in a situation like the financial crisis of 2007-09 is that it creates moral hazard, for the creditors, borrowers or both. If a bailout of one or both is the solution, it instills an implicit belief that risks can be taken in the future because a bailout will occur again.
Therefore, the only real solution is to preempt moral hazard before a crisis occurs, and ideally preempt the crisis itself, by designing a contract for investment that cannot create it. The ordinary debt contract, Mian and Sufi argue, is less than ideal for that purpose, especially for home loans. “The culprit is debt,” they say, “and the solution is straightforward: The financial system should adopt more equity-like contracts that are made contingent on risks outside the control of households.”
They propose an instrument they call the shared-responsibility mortgage (SRM). In this mortgage contract, the principal would be reduced by the same percentage if a local house-price index falls. In return, the homeowner would give up 5% of the capital gain to the lender if the house price rises. The reason for using a house-price index on the downside instead of the house price itself is to prevent moral hazard. For example, the homeowner would have no incentive to let the home fall into disrepair to reduce its price. The SRM would be “made contingent on risks outside the control of households.”
Amid today’s suspicion of complex financial contracts, this seems worrisome as compared with the simplicity of the mortgage debt contract. But simplicity is not the only virtue. Einstein said, “Everything should be made as simple as possible, but not simpler.” If this contract or something like it would soften the blow of what Mian and Sufi call levered-losses and not create moral hazard, it should be considered very seriously.
What I didn’t cover
I have not conveyed the additional benefits of reading Mian and Sufi’s book. The book covers a number of topics as readably and as well as anything I have read, including:
- The efforts of the Federal Reserve to increase the money supply and why it is difficult.
- The reasons why the recession was and still is so bad in Spain.
- How “neglected risks” can systematically cause “financial innovation, [which is] just … secret code for bankers trying to fool investors into buying securities that look safe but are actually extremely vulnerable.”
- How the financial crisis in Thailand in 1997 led to the financial crisis in the U.S. 10 years later.
To a mathematician, some of their arguments are almost as tight and satisfying as the proof that the sum of an infinite series of powers of x is equal to one divided by one minus x. The economics profession often prides itself, at least in its rhetoric, on its dedication to rigorous analysis that is solidly backed by data. Unfortunately, this dedication is all too often honored in aspiration more than in reality. I wish that more of economics were like Mian and Sufi’s book. So do many economists, and some delude themselves into thinking that it is, but this is, by and large, a forlorn and hopeless wish.
Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong and a research associate at EDHEC-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, has just been published by Berrett-Koehler.
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