Grasping Reality on TypePad, by Brad DeLong

Part III:

Fastest way to end the recession: bailing out homeowners? -- latimes.com: Edward Leamer says the government's focus should be on creating buyers. Brad DeLong says the Treasury ought to bite the bullet and buy up every mortgage.

How Greenspan wanted the boom to go, and how it turned out. Counterpoint: Brad DeLong

Let me start by outlining how the 2000s were supposed to work -- according to former Federal Reserve Chairman Alan Greenspan.

The late 1990s had seen a large technology-led boom that had employed millions of Americans and provided a forced draft that intensified the fire of economic growth. It was accompanied by "irrational exuberance" in the venture capital and stock markets, as investors began to think not just that technological progress in information technology was rapid but that it would be easy for the companies they invested in to turn that technological progress into profits. The first half was true -- technological progress in America's Silicon Valley is still ensuing at an extraordinary rate: I just got a spam e-mail offering to sell me a four-gigabyte USB flash disk for $9.25. In 1987, I paid $900 for a 10-megabyte hard disk.

But the second half -- that it would be easy to turn this progress into sustained profits -- turned out to be false. It's very hard to pay a lot of dividends to your investors if you are selling four-gigabyte USB flash disks for $9.25.

In the early 2000s, investors began to realize that technological progress was easy relative to making profits in a competitive market, and stock prices for tech companies collapsed. The American high-tech industry began to shed workers as firms closed.

Greenspan decided to deal with this situation by lowering interest rates. The enormous flood of savings from Asia seeking investments in America had started, so low interest rates could be sustained because demand for funds would not outstrip supply. And low interest rates meant that lots of long-run durable investments would be profitable; you could, after all, borrow the money to produce or to buy them at low interest rates. The biggest long-run durable investment as a share of the American economy is housing. So Greenspan thought that he could keep unemployment low by generating a housing boom, so that as employment in tech companies (and related occupations) fell, employment in construction (and related occupations) would rise.

Did Greenspan worry about what would happen if the housing boom also succumbed to irrational exuberance? Yes. Did he worry very much? No. After all, when high-tech stocks and venture capital bubbles had collapsed, the systemwide consequences for the economy were small. Lots of over-enthusiastic investors lost their money -- but they were rich grown-ups, and the Federal Reserve doesn't exist to keep rich people from risking their money in silly ways. Lots of engineers lost their jobs, but they had been well-paid during the boom and would not have had nearly as good jobs (or perhaps any jobs at all) were it not for the bubble. American consumers got a lot of cheap computers and a lot of extra fiber-optic cables over which to make our phone calls. The winners were American consumers and (during the boom) American workers. The losers were relatively rich American investors. Overall, it was a net plus.

Greenspan expected something similar to come out of the housing boom. If it did turn into a bubble, then the winners would be homeowners who bought houses on good terms by borrowing at low interest rates and renters who would find after the boom a plentiful supply of houses on the market and be able to bargain for big houses at cheap rents. The losers would be irrationally exuberant investors who had lent their money when it was cheap to borrow or bought expensive properties when prices were high. Once again -- Greenspan thought -- the boom as a whole, even with the likely magnitude of irrational exuberance and over-speculation, would be a net plus.

But it did not happen that way. The housing bust was big enough that, as you calculate, we are now back to having not a plentiful housing supply but rather one that is in line with historical trends. And we are still under-building, which you say is "laying the foundation for the next housing mania." Yet because the bust triggered a financial crisis that triggered a recession, the construction industry is not seeing the kind of rising home values that trigger a recovery. Because of the recession, people are doubling up. And a great many houses are not where they should be -- four bedrooms with swimming pools east of San Bernardino, as you say, when what America really needs is multifamily units in northern Orange County. And you're right, Ed.

Thus there is a strong case for government intervention in housing finance to try to get the construction sector back to where it ought to be. You point to California's and the federal government's respective tax credits for new home buyers and say that you hope they're enough to turn the market around.

I don't think they will be. I think we should face the fact that home mortgage finance is broken, that the risk tolerance of the private financial system is impaired and that we will not get the flow of finance to potential home buyers through private banks working again any time soon.

So I think -- I have thought for a year and a half now -- that it is time to bite the bullet. The federal government has already nationalized Fannie Mae and Freddie Mac. It should stop treating them like private companies and start treating them like arms of the Treasury. They should set an interest rate spread above the 30-year Treasury rate and then buy up every single mortgage and transform them into standard 30-year fixed-rate mortgages. The government may well lose money on the deal, but a lot of homeowners who cannot pay their current mortgages and are about to be foreclosed on could pay 30-year loans at a few percentage points above the Treasury rate.

A lot of construction companies would be willing to start building the multifamily units in northern Orange County that we need if they knew that potential condo buyers could get financing from the government on such terms.

And the government might, after all, make money on the deal.

Then, after the crisis is over, we can think about how to re-privatize the mortgage finance arm of the financial sector.