Sunday, October 25, 2015

Housing, A Series: Part 71 - Pushing Back against the Moral Hazard Meme

Scott Sumner has a post up at EconLog this weekend about the timeline of the financial crisis.  He brings up the too big to fail / moral hazard issue.  This is something others like Russ Roberts have focused on.

I would like to begin by saying that, in principle, I am completely on board with this issue.  A regime that includes informal and implied subsidies for risky behavior is dangerous.  We would expect that regime to lead to more crises and for there to be indecision and power brokering during those crises.  It's not an ideal set of policies to build a financial sector around.  I don't really have a problem with the historical examples of this issue.

But, on the other hand, my understanding is that the idea of a lender-of-last resort role for central banks is a longstanding legitimate function.  This would especially be the case if the crisis was a liquidity crisis that the central bank is charged with avoiding.  In some ways, there has been an unfortunate standard of using sloppy language to identify all of the Fed machinations toward the end of the crisis as "bailouts", and this has created a climate where legitimate stabilization operations have been tainted with negative semantics.

But, I want to take this even further.  Scott has pushed back against the idea that there was a "bubble".  I have been digging into the evidence all year, which I think confirms his position.  Very little of the rise in home prices (and, the accompanying mortgage growth) requires any demand-side explanation.  The banks weren't systematically pushing mortgages on households outside the traditional population of homeowners, and those households weren't moving into homes with rental values any higher than usual.  The boom was a reaction to supply constraints in favored locations.  The banks weren't the cause, they weren't taking on excessive risks, and the bust was not inevitable.

That last part is key.  Practically all analysis of the crisis begins by begging the question - the bust was inevitable.  And, even though Scott's EconLog post is reasonable, as far as it goes, I think he gives in too much to that notion.

This crisis was not a good example of the problems of moral hazard or of a fragile banking system.  In fact, I think some evidence points to quite the opposite, and instead, we should be surprised by how devastating and persistent Fed policies had to be in order to create broad economic dislocation.

By 2007, there was a strange mood in this country that housing speculators and bankers needed to be taught a lesson.  We assumed that home prices must be based on overly optimistic projections about the risk and reward of home ownership, so watching nominal home prices fall by a proportion unprecedented in modern times was not only acceptable, it was required.  These speculators needed to learn that unprecedented declines in price happen, and asset prices need to reflect these black swans.  But housing wasn't in a demand bubble, so a tremendous amount of damage had to be inflicted on the American economy for home prices to collapse the way they did.

About 1 million units per year has been a post WW-II floor that we generally only hit briefly before recovering - even in the 1950s and 1960s when US population was about half today's level.  By the time Bear Stearns failed in March 2008, housing starts were falling below a 1 million unit rate.  National home prices were down 7% and home prices in the major coastal cities were down 16%.

By September, when Lehman Brothers failed, housing starts were falling below a rate of 800,000 units.  (They would remain below 1 million units for 5 more years.)  Home prices were down 13% nationwide and 25% in the major coastal cities.

Even then, it isn't clear that economic problems would have expanded so broadly, even if the Fed let Lehman enter bankruptcy, if they had simply supported the nominal economy (as Scott suggests they could have done with Continental Illinois in 1984).  But the day after Lehman's failure, the Fed famously took an unnecessary discretionary hawkish position followed by a questionable new policy of paying interest on reserves that they raised briefly to over 1%.  Lehman was not the critical factor in the subsequent collapse.  If they had managed a buyout of Lehman, but had followed it with those same hawkish interest rate policies, it seems probable to me that the outcome would have been very similar to what we experienced.

It took a 13% dive in banks' most stable and extensive base of collateral (25% in the most active real estate markets) to create the financial crisis.  Call me crazy, but if you had told me in 2006 that home prices would need to collapse by that much in order to create a financial breakdown, I would have responded, "Really?  You think our banks are that stable and well managed?"

As I have said before, if home prices had fallen by 5% and a financial panic would have ensued, then, yes, that would be evidence that our financial system had been fragile.  But that is not what happened.  And, given what did happen, the only reason we accept the fragility story is because we assume that a 13% drop in home prices was inevitable.  (This eventually grew to 26% nationally and 34% in the major cities.)

Do I really have to beat back moral hazard arguments to say that it is well within the Fed's mandate to stop home prices from falling 34%, 26%, or even 13%?  Really?  Do we really need to worry about banks being too reckless in the future because they will be blas√© about national double digit declines in real estate values?

Look, in the broad scheme of possibilities, we don't have to base our real estate markets on nominal mortgage contracts.  But we do.  And, as long as we do, banks will have some highly leveraged real assets on their balance sheets.  It would not be realistic to expect them to manage their balance sheets to withstand national 25% declines in real estate values without expecting some nasty system-wide repercussions.  In the previous century, nobody would have even suggested that we should demand that level of safety.

I support the idea of NGDP level targeting, or wage level targeting, as Scott lays it out.  Isn't it funny that nobody worries about the moral hazard of having a policy where aggregate wages never decline by a penny?  I think the main advantage of NGDP level targeting may be that it indirectly leads to stability in capital incomes that we cannot support directly.  In a world where even just implementing stabilizing monetary expansion in the middle of a deflationary shock is labeled by many as a Wall Street bailout and where we are willing to watch millions of middle class households lose their homes without screaming for monetary expansion because the banks had it coming, its clearly not popular to support Bourgeois concerns.  Because of this, I don't think we can fault the Fed too much for the crisis.  If they were blamed for bailouts for their efforts after September 2008, imagine the outrage that would have been aimed at them if they had dared stabilize the economy in 2007.

I would add that securitization had risen until the early 1990's and had levelled off since then.  Securitization was not at the center of the housing boom.  In fact, during the height of the boom, banks were increasing their share of held mortgages outstanding.  Securitization only began expanding again in 2006 and after because the liquidity crisis was hitting bank balance sheets.  So, even the moral hazard issue created by securitization itself is less central to the recent crisis than it is generally made out to be.

And, many small banks failed in the crisis.  Does too-big-to-fail even have that much to do with what happened?

The moral hazard issue is a real issue, but it is the wrong lesson to take from the crisis, and the treatment of Bear Stearns and Lehman Brothers are taken to be larger factors in the collapse than they deserve to be, in my humble opinion.


  1. Very thoughtful piece, as usual.

    But "imagine the outrage that would have been aimed at them if they had dared stabilize the economy in 2007" doesn't seem a big deal.

    Not a lot of outrage I'd guess if they had been more balanced in their assessment of the economy and been clear in their reasoning, or even not clear (like Greenspan) but got to the right answer (like Greenspan usually did).

    As Scott showed, Mishkin understood all the issues and the risks, but the inflation-obsessed majority were biased and can't be forgiven for that. Many other central banks were more relaxed about headline inflation and swerved the worst of the recession.

    1. Thanks, James.

      You make valid points. But, it seems like there is a shared misunderstanding of the Mian & Sufi / Robert Reich sorts of ideas on the left and some of the Ron Paul / Austrian sorts of ideas on the right that Greenspan's stability is led to a debt fueled unsustainable bubble that would only get worse if it didn't pop. I think if they had enacted policies in 2007 that would have led in any way to stable or rising home prices, there would have been op-eds across the major papers accusing them of propping up a bubble economy by piling debt onto unsuspecting low income households.

      I have seen people, even today, cite those sorts of articles from as early as 2001 as evidence that there was a bubble. I think the pressure from that sort of thinking has become so strong that we have internalized it, like a boiling frog, and we have to kind of glove slap ourselves to remember that our pre-2000s selves would have thought it was insane to have a central bank fiddling away with any nominal decline in home prices, let alone double digit. But, this massive case of attribution error led to a sort of consensus that there was virtue in it. A liquidationism so strong it became a financial asceticism.

    2. Maybe. Other countries with as strong housing "bubbles" as the US didn't prick them, but lived with them. And still have the "bubbles" today. It's no big deal. Some take macropru measure like higher risk weights, higher LTVs or banning interest only loans. Or even, God Forbid, urging an easing of planning restrictions.

      There was a real failure at the Fed, allowing hem selves to be pressured by headline inflation. This was only seen also at the BoE in 2007/08 and at the ECB in 2011. Most other central banks were much smarter.

    3. That would be an interesting sort of cultural anthropology study - what differences in Canadian and Australian political cultural helped them to avoid the bust.

    4. About Canada, they don't have a mortgage interest deduction so people actually pay down their mortgages far more than Americans. That is, Canadians tend to have a lot more equity in their homes than Americans. So, falling prices in Canada wouldn't trigger as much of a foreclosures/falling prices/more foreclosures cascade like it did in the United States. Canada's huge amount of home equity (by American standards) would greatly lower the number of foreclosures at every level of price decline and, honestly, it was the foreclosures that tanked U.S. home prices.

    5. One more thing about Canada that's probably more important than not having a tax deduction on mortgage interest, the book, "Fragile By Design," says that historically Canada's banking sector has been unusually robust while the U.S. banking sector has been unusually fragile. Something along the lines of the United States has had twelve systemic banking crises since 1840, while Canada has had none.

  2. Great post.

    By the way the large publicly held banks do in fact face hazard. Their shareholders get wiped out even in a bailout, if properly done. The Board of directors and management is supposed to look out for shareholder interests. A bank in which equity is wiped out has not represented shareholder interests.

    I suppose we could compel bank bondholders to face risks as well, perhaps through mandatory convertible bonds.

    Underlying much of modern-day macroeconomic problems is the hysterical prissiness of central bankers regarding inflation. Forgotten today is that in 1992 Milton Friedman chided the Fed for being too tight when inflation was at 3%. This fetishizing of 2% or less inflation is new.

    Oddly enough this perennial monetary macroeconomic suffocation is polarizing the voting public, some of whom are leaning left.

    Like I always say, if there are chronic labor shortages, the public will love free enterprise.

    1. Thanks Benjamin.

      All good points.

      I would add that by far the largest class of creditors to commercial banks are depositors. Replacing FDIC with private deposit insurance would help get all of this out of the political realm, too.

  3. In theory, I like private deposit insurance.

    In practice, the private sector's idea of financial insurance is AIG.


    1. Ha!

      Haven't you heard? AIG didn't have a credit risk problem. They had a numeraire problem.

      But, you're right. There are many ways to do it wrong.

  4. Excellent post. My recollection of the autumn of 2007 was that the bubble pundits were certain that the bubble would really burst once interest rates ROSE due to all the high LTV Arms. Somehow they still congratulate themselves on their prescience.

    1. Yes. Great point. It's such a huge problem that a crash fed confirmation bias for so many people. There are a thousand ways to destroy an economy, yet everyone so confidently says, "yep. The crash proves we were right about the bubble." Even Bernanke says the Fed expected a correction. So policy makers actually were favored for destructive policies. Crazy.

  5. "Do I really have to beat back moral hazard arguments to say that it is well within the Fed's mandate to stop home prices from falling 34%, 26%, or even 13%? Really?"

    As James Alexander mentioned, some central banks types talk about this, macroprudential regulations. In housing it would probably be the Fed putting caps on loan-to-value or loan-to-income ratios, or something.

    Here's a think piece on macroprudential regs from the Bank of England,

    1. Thanks for all of your recent comments, John. I think there is probably a lot to learn from the difference between Canada and US experiences on a lot of these historical episodes. The lower leverage levels in Canada that you mentioned in another post are an interesting factor, and I think you're right that it would have helped, whether it is related to the lack of a mortgage tax deduction or not.

      I believe central banks caused the crisis. I also think there is little evidence that low risk premiums are related to excessively loose monetary policy. It surprises me how this has become a part of the consensus view. So, I find the support for macroprudential regulations to be disconcerting. As with your Canadian comments, there is a clear path to a more stable economic cycle, which would be to remove the tax benefits of debt in general. I would call the entire Great Recession one big episode of failed pro-cyclical macroprudential regulations.

      I don't think loan-to-income ratios had anything to do with the crisis. Loan to value did, since we used policy postures to pull real estate values into a tailspin. But, even there, I think it is important to remember that the decline in home values had to collapse far outside any historical range before defaults rose to unprecedented levels. Home price behavior was some kind of multi-sigma event. I don't think it's crazy to say that the banking system actually seemed pretty resilient.

      All of the complaints about banking rest on the assumption that housing was in an unsustainable bubble. Once I came to the conclusion that it wasn't, all of the consensus opinions about the housing boom and bust fell like dominos. Once you take away that assumption, then you rub the sleep out of your eyes and look up and think, "Why in the world did we all think it was acceptable to let home prices drop by 1% per month without any monetary support until it created an economy wide crisis?" If you think it was a bubble, then everything gets laid at the feet of the banks. But it wasn't. And if you take that step, then the horror of what we let happen takes on a whole new focus. There is no middle ground.