Opinions

Don't just blame the bankers for the recession

In print | September 10, 2009

H.L. Mencken: “There is an easy solution to every human problem — neat, plausible, and wrong.”

After twenty-one agonizing days of gloom and shadow, the noted American economist Paul Krugman finally split open the clouds of intellectual nothingness and showered His lionizers in glorious light. In the New York Times Sunday Magazine, Krugman writes, “How Did Economists Get It So Wrong?” in which he discusses the consequences of economists misconstruing “beauty, clad in impressive-looking mathematics, for truth.” Following a lengthy discussion about the distinction between Keynesian and Classical economics, Krugman concludes that “economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly.” Underlying Krugman’s argument are two deeply flawed propositions: 1) the contemporary crisis is evidence of irrational market behavior and 2) societies require government intervention to mitigate markets’ inherent irrationality and associated volatility.

Krugman’s first presupposition is actually very popular, but false. The classic story of irrational behavior and the economic crisis goes something like this: Since individuals sometimes act irrationally and aggregate irrational behavior has terrible ramifications, markets require a force à la Richard Thaler’s “libertarian paternalism” to keep economies in line. Although Thaler’s thesis has merit in selected cases, politicians and popular media (mis)construe Thaler’s conclusion as a call for direct market intervention by Uncle Sam.

This brings us to our second problem.

The nearly always well-meaning, bleeding heart progressives of the Ted Kennedy-inspired noblesse oblige mindset suffer no less from seemingly irrational impulses than do market agents. Regulators and technocrats don’t escape the wrath either. Even if we could find some miraculously “rational” economist or group of economists to look for and curtail the development of systemic risk, it’s unlikely this regulatory agency could consistently discern between legitimate periods of growth and market bubbles.

And despite Yale economist Robert Shiller’s criticisms of Alan Greenspan’s contention that predicting “irrational exuberance” is impossible, we’d be wise to remember that even the smartest economists are fallible. Shiller’s colleague, Richard Thaler, wrote in a 1997 Journal of Economics Perspectives paper that investors’ “myopic loss aversion” and cognitive inability to assess total returns over time stop them from optimally allocating enough of their portfolio to stocks. Imagine if Thaler had been a Consumer Financial Protection czar in the early 2000s and had nudged consumers to place most of their wealth in equities! Though this is only one error, the kind of regulation proposed by White House favorites like Harvard law professor Elizabeth Warren do more than harmlessly “nudge” consumers in the “right” direction. Instead, they make all non-government approved choices so unfavorable that the choice with which consumers are left really isn’t a choice at all. Instead of having a crisis result from the numerous freely made decisions of many — even with investor herding, under a supposedly omniscient but invariably fallible regulatory entity — a crisis could develop from the decisions of a few guys chilling in Washington. (The most likely outcome is that the regulators themselves would be too risk-averse to maintain sensible pro-growth policy.)

This leads us to the fundamental flaw in both presuppositions: firms rationally responded to market conditions. Unlike the popular perspective pontificated by pundits at the Post and Times, the current economic crisis evidences a rational response to market distortions comprised of well-meaning “progressive” legislation. So before we lose ourselves in a cloud of marijuana smoke that enshrouds the rhythm of populism as we hang Wall Street bankers by piano wire, let’s get a grip on what actually happened.

The confluence of three individually non-disastrous conditions lead to this crisis. First, the Federal Reserve’s continued low interest rates significantly reduced the cost of borrowing money. Second, credit rating agencies gave far too generous risk ratings to high-risk derivatives because the firms whose products they evaluated paid their salaries. Finally, progressive social and tax policy encouraged home ownership, even for those who couldn’t afford it.

These days, everyone seems to want a piece of Alan Greenspan. But according to Alex Pollock, a resident fellow at the American Enterprise Institute, or AEI, Greenspan’s expansionary monetary policy reflected a view that he could fight the potential recession from the burst tech stock bubble, the industrial sector weakened by overinvestment, and the recent terrorist attacks by igniting a housing boom. Ex post, we see that “Greenspan’s gamble,” as Pollock puts it, produced a bubble that was in part caused by an overextension of credit. But ex-ante, this bet was reasonable and almost worked.

Second, derivative creators essentially colluded with credit rating agencies by financing their remuneration. Government mandates often required that pension funds and other large wealth repositories use credit rating agencies such as Standard & Poor’s and Moody’s to determine the safety of securities in which they invested. Unsurprisingly, bad risk assessments led to bad decisions. When government condones and nearly facilitates collusive behavior, we shouldn’t be shocked by its exploitation.

Finally, market distortions in housing policy have consequences eerily similar to popular beliefs about irrational market behavior.

Tax code favors homeownership and encourages Americans to allocate wealth to their homes, based on the belief that homeownership is a public good. John Makin, an AEI visiting scholar, summarizes the subsidies for homeownership, which come “in the form of full deductibility of mortgage interest, lower borrowing rates derived from government guarantees for mortgage lenders like Fannie Mae and Freddie Mac, and deductibility of local real-estate taxes.”

The supposed benefits of homeownership, however, don’t exist. In a 2002 Harvard Institute of Economic Research paper, Glaeser and Shapiro show that the positive externalities associated with living near homeowners are too small to justify the deduction. In fact, the deduction most benefits rich people who are in the highest tax bracket and own expensive homes.

And in 1997, a change in the tax code eliminated the capital-gains tax on the first $500,000 of profits made from the sale of a flipped property. This made real estate speculation a profitable pastime for many Americans and set the stage for the next decade’s crisis. Following the dot-com bubble bust, these tax benefits conferred to homeowners and real estate speculators distorted market behavior by making housing artificially attractive.

After decades of failed public urban housing initiatives, progressives sought to bring private housing to the poor and underserved. In 1977, Congress passed the Community Reinvestment Act, or CRA to curtail discriminatory lending practices in low-income areas by tasking regulators with determining whether banks were serving the, vaguely defined, “whole” community. CRA had little impact until 1993, when regulators responded to a 1992 Boston Fed study that suggested that banks gave preferential treatment to white borrowers.

Under the 1994 “National Homeownership Strategy,” the Clinton administration advocated the use of “financing strategies fueled by the creativity and resources of the private and public sectors” to help “households [that] do not have sufficient available income to make the monthly payments on mortgages financed at market interest rates for standard loan terms.”

In 1995 regulators beefed up their demands of bankers, requiring that banks employ “innovative and flexible” methods to make a certain number of loans available to low and moderate income, or LMI, borrowers. Of course, once these standards were loosened for LMI borrowers, regulators had no choice but to extend these standards to prime borrowers as well. In addition to the Fed’s expansionary monetary policy and the government’s distortionary tax code, loose regulations brought easy credit to speculators who helped blow up the housing bubble.

Government sponsored enterprises Fannie Mae and Freddie Mac also got busy in the early 1990s. In 1992, the two modified their directives to include an affordable housing priority. In 1997, an Urban Institute study found that local lenders served LMI and minority loan applicants better than did the GSEs. Eager to impress the Congress, the GSEs modified their automated underwriting programs to accept low quality loans they had previously rejected. According to analysis by AEI fellow Peter Wallison, GSE leverage ratios averaged 75:1, flooding the housing market with liquidity. These reduced lending standards and high leverage ratios made way for loan originators like Countrywide, which by 2006 financed a fifth of all mortgages in the United States.

In 1997, Fannie was offering to buy mortgages with nearly no money down (97% loan to value). And ten years later, Fannie and Freddie were forced to hold no fewer than 55 percent LMI loans, 25 percent of which had to be for low- and very low-income borrowers.

As the GSEs increased their demand for subprime loans, private-label issuers like Bear Stearns and Lehman Brothers increased their demand for subprime mortgages as well, keen to maintain their market share. The competition for subprime mortgages among the GSEs and private enterprises increased the value of subprime mortgages and decreased the risk premium that had kept subprime originations at bay. So from 2003 to 2006, conventional loans declined while subprime loans increased.

When former White House economist Gregory Mankiw called for greater regulation of the GSEs in November 2003, as reported by the Washington Post, Rep. Barney Frank (D. Mass), the ranking Democrat on the House Financial Services Committee said that the “[Bush] administration’s position [was] driven by concerns about the financial safety and soundness of the companies ‘to the exclusion of concern about housing.’” Frank and other Democrats’ opposition to more strictly regulating Fannie and Freddie show how the complex, Wall Street-engineered mortgage backed securities that were propagated by low interest rates and faulty derivative risk ratings were actually favored by much of the political class.

Although Krugman is right to remind readers about the nuances of microeconomics, he’s wrong to ignore the distorted market conditions that led to what he and other writers mistakenly call “irrational behavior.” Economists’ “romanticized and sanitized [models] of the economy” didn’t fail; we can assuredly use them to explain this crisis. So to prevent a future housing bubble, we should dismantle our distortionary housing policies.

Soren is a junior. You can reach him at slarson1@swarthmore.edu.