Reflecting on the House of Debt

It may not be an overstatement to call Atif Mian and Amir Sufi’s new book the most important economic read this side of the year. Unlike the other two famous and/or acclaimed economics books recently released, The House of Debt is concise and incisively to the point (unlike, I realize, the phrase I just used). Mian and Sufi’s principal charge is that while fiscal, monetary, and financial drama – the stimulus, quantitative easing, and bank bailouts respectively – may have played an important role, they are each subordinate to what has really held recovery back: household debt.

Using granular microeconomic data, Mian and Sufi show that the economy was sputtering well-before financial Armageddon in fall 2007, conclusively invalidating the nonsense view that had we saved Lehman, all would be right with the world. In addition to pages of empirical data proving this claim, the book provides two things:

  1. A levered-loss framework (if not full theory) of business cycles. Since debtors are generally poorer – and almost always liquidity-constrained – falling wealth results in a much more concentrated fall in spending than in a less leveraged economy.
  2. The sketch for a better housing policy through what they call “shared responsibility mortgages” (SRMs for short) which provide downside protection to homeowners, resembling an equity-like claim on the house.

There are several problems with this argument. The book has (rightfully) received critical-acclaim in the liberal blogosphere, and I would like to raise a few questions the book avoided: from least severe to most.

They fall in the same trap I think a number of other critics of bank bailouts fall. Mian and Sufi concede that large-scaled intervention was necessary, but nothing beyond what might be justified by the “Bagehot principle”, in other words that the Fed as lender-of-las-resort should “lend freely at a penalty rate on collateral that would be acceptable in good times”. In its plainest form, this would imply that the Fed should open its discount window and lend to any solvent bank. The problem rests in the last two words.

When a bank is forced to sell its long-term debt immediately to finance its short-term commitments, thereby depressing the value of said assets, the distinction between liquidity and solvency becomes ambiguous. Moreover, the focus of government bailouts were not traditional banks, but other financial institutions that facilitated money market financing of capital market borrowing (i.e. funds that issued bank-like promises backed by commercial paper).

These certainly do not provide the same “main street” value as a traditional bank, but as financial disintermediation increased they played two roles that you may use to define a bank itself: maturity transformation and real lending. In the heart of financial crisis, it makes more sense to provide the liquidity as necessary and regulate these institutions as banks later (in fact, the first money market fund, the Reserve Primary Fund, was formed specifically to evade government-caps on interest rates paid by depository institutions).

More importantly, it is not clear that the extent to which the government provided anything more than liquidity. The most clearly insolvent institution – Lehman – was let go, and the government earned ultimately earned a profit. Marking to market on an institution that transforms maturity during a time of low liquidity is unnecessary.

The next quibble is philosophical. A number of times Mian and Sufi are disdainful of the bailouts because they benefitted those who fell squarely on the right-tail. This is a utilitarian problem, for clear reasons, but also an economic one: in the levered-loss framework increasing the income of bankers is not very helpful. But this is predicated on the assumption that bank bailouts came at the opportunity cost of homeowner relief. Except the government was not capital or liquidity constrained (if anything investors were begging the government to hold their money) – rather, the trouble was political. While high spending on one relief program certainly reduces public appetite for another, the relationship is nowhere near one-to-one. As Mian and Sufi note, bankers had a much stronger lobby than homeowners – so one did not prevent the other.

To the extent there were any distributional concerns, it is the tax system – and only the tax system – that should be responsible. In the same vein as many economists oppose minimum wage as a method of redistribution, neglecting banks of necessary liquidity during the crisis for concerns of equity is short-sighted. Rich people, a group within which bankers certainly rule, may have an unfair share of national income: and to that end they ought to be taxed at a higher rate.

Similarly, the argument for debt relief is strong, but in the House of Debt, it rests too strongly on distributional concerns. Since there is, as the authors themselves note, a very strong correlation between those with high debt and those with low income, targeted stimulus would benefit from a levered-loss multiplier as well. Sure, they don’t insist that recipients pay their debt back down, but the immediate stimulus would have been similar.

I also wish the book considered the very role of debt in recent economic growth a little more. While there is certainly a compelling case that debt fueled an unnecessarily sharp boom-bust cycle, recent concerns – voiced most prominently by Larry Summers and Paul Krugman – surrounding the necessity of debt for any growth at all are important. Note that despite large borrowing collateralized on home equity, the post-Clinton middle-class grew at an anemic pace. Without leverage, living standards would have stagnated and falling investment and growth potential, the accelerator effect would have resulted in slower growth still.

This is all to say that variance of income, while non-desirable, is of secondary importance to the mean itself: and explaining why debt caused the crash without acknowledging explicitly it also financed the boom is unsatisfying. (This is no fault of Mian or Sufi – just an question for commentators in general). Of course, the crisis as an event redistributed wealth decisively away from the poor, and that is certainly a detrimental effect. But the world without debt in the last ten years would also have been one without growth and inflation, at least some smart people argue, and that cannot be ignored. (Just think about the employment created by construction and consumption of durables, many from non-tradable sectors).

My final concern is with the viability and unique necessity of a rather complex policy solution, the SRM which would force creditors to take a haircut in the case of falling prices in return for part of realized capital gains. Real estate is a far less lucrative investment than the stock and bond markets, and the poor already hold an inefficiently large portion of their wealth in this form. The SRM would only exacerbate this problem, further reducing the long-run returns for this group. More importantly, the SRM faces problems of adverse selection. Those who know they can pay back their debt, and careful enough not to leverage themselves too much versus future income (in other words, the affluent) would have no reason to take an SRM: they would much rather finance their house via debt (largely risk-free for them) and put everything else in the stock market. This would leave riskier borrowers in the pool for an SRM, naturally increasing the risk premium. The argument holds in much more force for the other suggestion of student loans that require a percent of future income as payment. Of course, debt-financed home ownership is a huge burden on economic growth. And the answer isn’t equity-financed home ownership. It’s less home ownership.

The brings great empirical evidence in favor of a compelling argument to the layman. The theory is far from settled, and has been debated for at least half a century, when James Tobin took a stab at the Pigou Effect – which argued recessions are self-correcting as deflation increases the real value of debt – noting that “debtors are debtors because they have high propensities to spend”.

  1. I think they have it all wrong. They are mistaking saving for borrowing. When middle class Americans save, generally the first thing they do is take out a mortgage worth several times their annual income. So, saving looks like borrowing. I agree, however, that the home equity idea would give Americans the ability to invest in their homes without taking on such heavy financial risks. Details at the link….

    • Great analysis at the link.

      But a few points. Yes, your mortgage can certainly be considered saving, in a sense. However, since all of your imputed returns (by definition) are consumed housing pays no dividends and, more importantly, appreciates less rapidly (especially in non-frothy times) than the stock market. Net of depreciation – and short-term home improvements accounted for a good portion of the spending, not savings by any means – housing is even less lucrative.

      So I think your point is more forceful for land, but not real estate.

      • Thanks for your comment.

        But, I think I would tweak a few things. All savings are eventually consumed, so a homeowner is matching consumption with profit, but it’s not that different than other forms of investing. I would say that the implied rent IS the dividend. I would compare real estate to a high dividend stock or a bond, in terms of asset allocation, so the income from rent, or implied rent, is more important than capital appreciation. And, some of the boom was the result of investors buying multiple properties.

        I don’t know what the exact relationship should be between the gross expenses of mortgaging a home versus renting. But, whatever that balance is, if you price a home as a long duration security that earns rent payments instead of coupon payments, the rise in home prices in the 2000s was not unusual compared to the rise in bond prices. In both cases we are seeing high demand for fixed income – savings. The difference is that we conceive of bond and home prices differently in our mental accounting, and our financial conventions allow investors to buy bonds incrementally while home purchases tend to require the creation of a large amount of debt.

    • bckirkup said:

      I wonder how this compares when there are multiple distortions in created vs captured value – that is, bubbles – for instance, much of the economy being funneled into finance and real estate. Some people are giving up a speculative option in the finance game to put money on big housing bets relative to their personal worth.

      • I know I’m out of the mainstream on this, but I think the idea that the real estate markets were definitively bubbles is a product of these same misinterpretations. Home prices and bonds mostly went up because of a high demand for safe, long term fixed income. These values have a numerator (expected values) and a denominator (discount rate) and, numerous well-known anecdotes about buyers aside, by the 2000s, the denominator was the overwhelming factor in creating an environment that could sustain high prices.

  2. Very interesting post, and I like Kevin’s comment as well.

    “. Those who know they can pay back their debt, and careful enough not to leverage themselves too much versus future income (in other words, the affluent) would have no reason to take an SRM..”

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