Paul Krugman and Mike Konczal on the Political Economy of the Lesser Depression
Hoisted from Comments: Risk Controls at Fannie Mae During the Mid-2000s

Three Flavors of the Economic Crisis

The smart Tyler Cowen gets one very wrong:

How much did Fannie and Freddie cause the financial crisis?:

(1) It is not denied that the mortgage agencies were guaranteeing about half of all U.S. mortgages right before the crisis  (Yet somehow they had not so much to do with the crisis?)  And the crisis was not just about subprime.  The mortgage market remains screwed up to this day, with no clear end in sight.

(2)There is also the more ambitious claim — not necessarily true but not obviously dismissable either — that leverage would have been much, much lower in American real estate markets without the mortgage agencies.  It is hard to judge such counterfactuals, but arguably lenders would have demanded more money down and offered fewer 30-year fixed rate mortgages.

(3) Arnold Kling has a good response to the delinquency chart which is circulating.

(4) Following the crisis, banks recovered and paid back virtually all of their bridge/bailout.  The mortgage agencies remain hundreds of billions in the red.  And yet the agencies had not much to do with the crisis?

(5) It is wrong to suggest that the agencies caused the crisis in the sense that I will cause myself to eat breakfast cereal this morning.  One can debate which weaker notion of cause might be appropriate, but I will just say that the mortgage agencies made the crisis much, much worse...

The problem, I think, is that Tyler is playing three-card monte with the word "crisis". In this context, "crisis" means three different things:

  • crisis1: organizations whose debts have an explicit or implicit government guarantee play heads-we-win-tails-the-government-pays, flip tails, and the government has to pay out a lot of money.

  • crisis2: the web of financial trust and leverage collapses, risk premia on all assets spike, and the ability of the private market to intermediate between savers and investors collapses.

  • crisis3: unemployment remains at 9% even four years after 2007.

Let's go in order of Tyler's points:

(1) The non-subprime mortgage market remains screwed up to this day because of crisis3: household formation is way down and the overhang of foreclosed houses remains unsold because unemployment remains at 9%. If unemployment were right now down at 6% and if everybody's sister were moving out their basement and buying a house, the non-subprime mortgage market would be fine. You can't blame Fannie and Freddie for crisis3.

(2) The collapse of the web of financial trust and leverage that was crisis2 did not come about because Fannie and Freddie guaranteed mortgages. It came about because Countrywide, AIG, Bear Stearns, Lehmann Brothers, Merrill Lynch, Morgan Stanley, Citigroup, Deutsche, a host of others--and, yes, Morgan Stanley, JPMorgan Chase, and Goldman Sachs too--lost control of their derivatives books and had no effective risk controls. You can't blame Fannie and Freddie for crisis2.

(3) Arnold Kling's response is simply not good. It is silly enough to make me think he has not thought the issues through. a 7% delinquency rate on a mortgage portfolio is horrible in normal times, but is actually very good if you are in a depression--ever our Lesser Depression. For an investment with a 15-year duration that's a cost of less than 50 basis points in a "black swan" near worst case scenario. A portfolio that does that well under such conditions is a solid gold one.

(4) The mortgage agencies remain hundreds of billions in the red because of crisis3 and because of crisis1. You can blame Fannie and Freddie for crisis1--and you should. But the fact that Fannie and Freddie have been playing heads-we-win-tails-the-government-pays is not the cause of either crisis2 or crisis3. The S&L's played heads-we-win-tails-the-government-pays in the 1980s, generated a crisis1 at the start of the 1990s, the government established the RTC to clean up the mess and pay through the nose, and the economy grew. There was no crisis2 or *crisis3 at the start of the 1990s.

(5) Fannie and Freddie did not make the crisis worse but rather made it better. The really bad parts of the crisis--crisis2 and then the subsequent failures of political economy that have given us crisis3 started with the uncontrolled bankruptcy of Lehmann Brothers, in which it was all of a sudden no longer clear where the government stood and which financial assets had value. But people knew one thing at least: they knew that the government stood behind Fannie and Freddie. If every Fannie and Freddie bond and mortgage guarantee had suddenly dropped to the quality of Lehmann Brothers' liabilities--as would have happened if they had not been GSE's--things would have been much much worse. Crisis1 phenomena encourage overleverage during the boom, but they are a fountain of confidence and stability and make crisis2 much less severe when the crunch comes.

The fifth point is, I think, the most important. What Fannie and Freddie created was a crisis1--like the S&L crisis of the late 1980s. But S&L crisis-like crisis1s do not create Little Depressions. They create embarrassments for the government, and bills for the taxpayer to pay, but because the government is on the hook and will pay there is no collapse of trust, no flight to quality, no persistent high unemployment. It's only the failure to distinguish between the meanings of "crisis" at play here that allows fuzzy thinkers to even advance the idea that an institutional flaw that creates a crisis1 is in some way responsible for our crisis2 and crisis3.

Tyler is smart. This isn't rocket science. So why doesn't he see that "crisis" has three meanings here, and that they are not synonymous?