Today, more the two years after the official start of the recovery, we find ourselves mired in slow growth and high unemployment. The majority of Americans cannot distinguish between this recovery and stagnation, if not continued recession. One question is why the economy is performing so much worse than in the previous post-recessionary periods since World War Two. And once we think we have an answer to that question, we have another: What is to be done?
Economics is the obvious place to turn for answers. But, despite the impressive gains in the field over the past century, economic policymaking (like the rest of public policy) remains more art than science. We try to find the best way forward without being certain that our efforts will produce the hoped-for outcome. Even if the weight of evidence, argument, and common sense leans strongly in one direction, skeptics who look for countervailing considerations can almost always find them. So let me begin an argument that will lead to specific policy recommendations by stating as clearly as I can what is most probably true about the circumstances in which we find ourselves.
First, it is likely that Carmen and Vincent Reinhart are right: We are now enduring the aftermath of a financial crisis, which differs qualitatively from cyclical downturns and typically requires much more time to recover. In a recent paper, “After the Fall,” the Reinharts look at 15 post-WWII single-nation financial crises and three global contractions—the Great Depression of 1929, the post-1973 oil shock, and the 2007 U.S. subprime collapse. Their survey includes five advanced economy crises: Spain (1977), Norway (1987), Finland (1991), Sweden (1991), and Japan (1992). Here are their principal findings:
Real growth rates decline by about 1 percent in the decade following financial crisis.
Unemployment rises on average by about 5 percent points and remains high for many years. In fully a third of the cases the Reinharts analyze, the rate never falls to pre-crisis levels.
In the decade prior to a financial crisis, the debt-to-GDP ratio rises by an average of 38 percent. After the crisis, it falls by the same amount, but it takes close to a decade to subside to previous levels. While the debt is being worked down, credit is restricted, slowing growth in output and employment.
Median housing prices fall on average by 15 to 20 percent (and in some cases by as much as 55 percent) and remain at depressed levels for the entire post-crisis decade.
When we place U.S. economic trends since 2006 into this historical context, the current downturn looks about average for financial slumps—less severe in some respects, more so in others. Though alarming, the sharp decrease of 55 percent in stock market indices that bottomed out early in 2009 was par for the course, as is the steep rise in the public debt-to-GDP ratio. And, if history is any guide, we may be only halfway through the period of debt reduction and slow growth.
Second, compared to other financial crises, distorted household balance sheets are more central. Household debt surged from 65 percent of disposable income in 1980 to 133 percent in 2007. At the core of that surge was the enormous escalation in mortgage indebtedness. When combined with a bubble in housing prices, withdrawal of equity from homes enabled a level of consumer spending that could not be sustained and that left household balance sheets in tatters when home prices receded. This effect has been huge: The most recent Case-Shiller index revealed that housing has already fallen as much from its peak as it did during the Great Depression. And there’s no guarantee that we’ve hit bottom yet. Prices could decline another 5 percent to 10 percent, millions of homes remain at risk of foreclosure, and millions of others are in earlier stages of delinquency that could lead down the same path.
Third, the pace and extent of this jarring decline in the housing sector is affected by public policy. A recent paper by Atif Mian, Amir Sufi, and Francesco Trebbi showed that, in states with foreclosure laws that favor creditors, foreclosures occur more frequently and rapidly, more homes are thrown on the market, housing prices decline more, and the pace of new home construction is much slower. In the aggregate, these effects are highly significant: The authors estimate that foreclosures have been responsible for 20 percent to 30 percent of the decline in housing prices, 15 percent to 25 percent of the decline in residential investment, and 20 percent to 35 percent of the decline in auto sales.
Assuming the validity of these three premises, one would have expected the incoming Obama administration to have given the housing sector a high priority and to have offered dramatic proposals for stabilizing it, all the more so because candidate Obama showed an acute awareness of this issue. On September 16, 2008, as the financial crisis intensified, Obama vowed to “change our bankruptcy laws to make it easier for families to stay in their homes.” But, as investigations by ProPublica have shown, both the Obama campaign and his administration missed (critics would say rebuffed) numerous opportunities—including the TARP legislation and the stimulus package—to do what Obama promised. Instead the end, we ended up with all-but-toothless voluntary programs that predictably have fallen far short of their goals for mortgage modifications.
In a series of blunt interviews, speeches, and op-eds, outgoing FDIC Chairwoman Sheila Bair has cast light on why it turned out this way. The mortgage industry exhibited “disdain for borrowers” and didn’t think they were worth helping. While the president’s heart was in the right place, his economic team was “utterly unwilling to take any political heat to help homeowners. (Her account is bolstered by members of Congress, who characterized senior Treasury and National Economic Council officials as skeptical, dismissive, or outright hostile to mandatory loan modification plans.) As a result, she says, government efforts have remained “behind the curve.” Bair’s conclusion:
It’s time for banks and investors to write off uncollectible home equity loans and negotiate new terms with distressed mortgage borrowers that reflect today’s lower property values. It is true that this would force them to recognize billions in mortgage losses—losses that they stand to incur anyway over time. But it will eventually be necessary if we are to clear the backlog and end the cycle of defaults, foreclosures, and falling home prices that continues to hold back the economic recovery on Main Street.
She’s absolutely right. We either bite the household debt bullet now or face many more years of deleveraging, slow growth, and inadequate job creation.
PRESIDENT OBAMA HAS belatedly recognized that his housing policies aren’t working. In a town hall meeting earlier this month, he said that housing “hasn’t bottomed out as quickly as we expected” and acknowledged that current programs are “not enough, so we’re going back to the drawing board.”
If the administration is serious about taking a fresh look at this problem, there’s no shortage of ideas to consider. A number of these proposals rest on a simple premise: Many foreclosures are occurring even though alternatives exist that would allow both creditors and debtors to do better. The challenge, then, is to realign incentives in the current system to allow these potential win-win outcomes to prevail.
For example, Eric Posner of the University of Chicago Law School and Luigi Zingales of the Booth School of Business have proposed that homeowners in zip codes that have suffered large losses in property values be given the right to obtain a reduction in their mortgage to the current market value, in return for which that creditor would receive a substantial percentage of any future price appreciation. The Posner-Zingales approach would require new legislation but would not expose taxpayers to further risks.
In contrast, a plan proposed by Columbia Business School’s Glenn Hubbard and Christopher Mayer would create a twenty-first century version of the Depression-Era Home Owners Loan Corporation (HOLC), which would offer underwater homeowners the opportunity to refinance into long-term fixed rate mortgages with 95 percent loan-to-value ratios. While this would require upfront public outlays, the HOLC would acquire an equity position in the refinanced properties so that taxpayers would benefit from future price appreciation.
Some finer-grained modifications of the current system might also produce significant outcomes. For example, a Columbia-based team has pointed out that current securitization agreements compensate loan servicers for costs incurred during foreclosures but not during loan modifications. A modest public subsidy to servicers could close this gap and ensure that loan modifications that would make sense for creditors and debtors are considered on a level playing field with the foreclosure option. In addition, servicers face both explicit and implicit legal barriers to modifying mortgages, and fear of costly lawsuits makes them shy away from financially sensible deals. Federal legislation could solve this problem by modifying existing securitization contracts to provide safe harbors for reasonable, good faith deals that raise returns for investors.
Finally, the administration could double back to the road not taken—changing the bankruptcy code to place mortgage-holders on all fours with other creditors, permitting bankruptcy judges to reduce the principal amount that homeowners must repay. In addition, a Federal Reserve Bank of New York study shows that the 2005 “Bankruptcy Abuse Reform Act” had the unexpected effect of worsening the subsequent housing crisis by making it more difficult for homeowners to remain current on their mortgages while discharging credit card and other unsecured debts. If the administration wanted to open up the bankruptcy law, it should address both these issues.
Despite their many differences, all these proposals have something in common: They are bold and entail some political risk. But, if I’m right that addressing the housing crisis successfully could spare us years of anemic GDP and job growth, it seems like a risk worth taking. It remains to be seen whether the timid incrementalists who have dominated the administration’s housing policy are finally willing to do what our current circumstances require.
William Galston is a senior fellow at the Brookings Institution and a contributing editor for The New Republic.