Q. Paul Krugman in a recent article argues that the major reason the economy is stuck in low gear today is that policymakers have used a double standard, helping the banks as needed to restore confidence in financial markets but refusing to provide adequate debt relief to individual borrowers. Do you agree?
A. I agree with Krugman that those in charge during the crisis period, including Timothy Geithner, whose book on the subject was just published, did a good job in preventing a worldwide catastrophe, which could easily have happened; we will never know how close we came.
But keep in mind that Geithner was a central banker and preventing financial crises has always been a major responsibility of central banks. Debt relief for households has never been. More about that below.
The weakness in the economy that Krugman has been writing about for some time is largely a weakness in the housing sector. In contrast to previous periods of economic recovery, in which the housing sector always played a prominent role, in this recovery the housing sector has been anemic.
One reason for this is the loss of the secondary market for private mortgage-backed securities. This is the market that funded all the subprime and alt-A mortgages that were written during the go-go years, but it also financed securities issued against loans that were neither subprime or alt-A, yet were not insurable by FHA or purchasable by Fannie Mae or Freddie Mac. While the market valuations of private mortgage-backed securities have rebounded, there have not been any new securities issued, and there is little prospect that this will happen anytime soon -- or ever.
The loss of this market has limited the capacity of mortgage lenders to meet demands of borrowers who do not meet the specifications of the Federal agencies.
A second source of weakness has been the overhang of foreclosed homes, mortgages in default but not yet foreclosed, and houses worth less than their mortgages, all of which depress home purchases. Trade-up transactions are a particular no-show, because you can't trade up if you have no equity.
A third source of weakness has been the tighter qualification requirements imposed on new borrowers after the crisis. Some of it stems from Dodd/Frank but much of it reflects actions by the regulatory agencies that predated Dodd/Frank. If the rules had been tightened in 2003-4, the crisis might have been averted, but tightening them after the crisis has made a bad situation worse. During the bubble period before the crisis, many loans were made that should not have been made. Today, many loans are not being made that should be made.
The economic policy failure that underlies the current weakness in the economy is a failure to dismantle the dysfunctional rules cited above, and develop expansionary programs to offset what cannot be undone, including the loss of the private secondary market. Therefore, I don't agree with Krugman that the appropriate remedy for current economic weakness is debt relief for households. This would involve extending the government's existing loan modification program in a new direction that has no guideposts or standards.
The existing loan modification program has a standard that bogs the program down in detail and hobbles its effectiveness, but nevertheless is necessary. The standard is affordability of the mortgage payment, based on each borrower's budget and existing obligations. But there is no comparable way to allocate debt forgiveness that is not so arbitrary as to incite widespread cynicism and resentments. Dropping money from airplanes would be viewed as more equitable.
I also don't agree with Krugman that the different treatment of bankers and households reflects a double-standard regarding who is more deserving of help. While none of us is privy to the private emotions that drive policymakers, there are multiple explanations for different treatment that have nothing to do with preferring bankers to households, and are a lot more plausible.
Preventing financial panic by acting as a "lender of last resort" has always been a major function and responsibility of central banks. But this LLR function is not about rescuing banks or bankers that get into trouble, rather, it is about preventing the troubles of one firm from spreading to other firms through a contagious loss of confidence.
The assistance provided by an LLR is directed to wherever it is needed to restore confidence, which may be the firm in trouble or it may be the creditors of the firm in trouble. The firm may survive, as AIG did, or it may not as with Bear Stearns, but the shareholders always lose most or all of their investment, and most or all of the managers who are responsible for the firm's plight lose their jobs. I don't view that as being solicitous of bankers.
• Contact Jack Guttentag via his website at mtgprofessor.com.