DRAFT: Did Macroeconomic Policy Play a Different Role in the (Post-2009) Recovery?: Introduction
DRAFT: Did Macroeconomic Policy Play a Different Role in the (Post-2009) Recovery?: Fiscal Policy

DRAFT: Did Macroeconomic Policy Play a Different Role in the (Post-2009) Recovery?: Banking/Regulatory Policy

J. Bradford DeLong
U.C. Berkeley
October 15, 2016

The effects of the housing bubble on the stock of residential capital appear to be a triangle with a base four years wide and a height of 2%-points of GDP. That is 4%-point-years of GDP’s worth of excess residential construction: that is roughly $600B.

Not all of that excess construction was debt-financed. But some of the 16%-point years of GDP’s worth of residential construction that would have been undertaken in any event were financed in an unusually debt-heavy manner given the extraordinary lax housing lending standards of the mid-2000s. And many homeowners with substantial and rising equity took advantage of the configuration of asset prices and lending standards to use their homes as giant ATMs (Greenspan and Kennedy (2005, 2007). But much lending, even at the margin, was of high quality—safe in the absence of a major depression.


Thus it is difficult to see how even a rough estimate more than $1T of “fundamental” debt exposure of the financial system to the fact that the U.S. had become “overhoused” due to the wave of construction, much of it in the desert between Los Angeles and Albuquerque, driven by low interest rates and lax lending standards.

Larger estimates of the triggering exposure soon find themselves relying on a multiple equilibrium story: the amount of risky debt was large because a depression threatened, and a depression threatened because the amount of risky debt was large (Krugman (1999), Chang and Velasco (1998)). Yet such models seem—or seemed—to be fully coherent only when there were hard limits to pick responses, canonically in the case of a central bank managing a weak currency trying to compensate for hard-currency overleverage.

In a world in which U.S. tradable financial assets approach four times U.S. annual GDP, and in which the U.S. is roughly a third of an integrated global economy, such $1T of “fundamental” debt exposure seems, to me at least, an order of magnitude too small to pose systemic risks in an economy that had swallowed the $4T of dot-com bubble equity losses. The conventional explanation is the use of derivatives not to lay off but to concentrate risk, as outlined by Weber (2013):

In Davos, I was invited to a group of banks—now Deutsche Bundesbank is frequently mixed up in invitations with Deutsche Bank. I was the only central banker sitting on the panel. It was all banks. It was about securitizations. I asked my people to prepare. I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers? I got a paper, and they were both the same set of institutions.

When I was at this meeting—and I really should have been at these meetings earlier—I was talking to the banks, and I said: "It looks to me that since the buyers and the sellers are the same institutions, as a system they have not diversified". That was one of the things that struck me: that the industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them…

But why highly leveraged institutions that have tried very hard to develop a comparative advantage in risk assessment and risk bearing would behave this way is a very loose end. I find Gorton (2010, 2012) very insightful on “how?!”, but less so on “why?!”. And Kindleberger (2000):

In my talks about financial crisis over the last decades, I have polished one line that always gets a nervous laugh:

There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich…

does not get us much further. Neither does Greenspan (2008):

Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

The disproportion between the vulnerability, the shock, and the effect on the economy appears even more puzzling with the reflection that the housing bubble of the mid-2000s was not all that large. If one trusts the Case-Shiller composite home price index, only starting in March 2004 would values ever be impaired by more than 10% on a nationwide basis; only starting in January 2005 would values ever be impaired by more than 20%; and housing values today were only exceeded between May 2005 and October 2007 and are within 10% of their all-time April 2006 high.


There was an overshoot of housing prices during the bubble, yes. But there was also an appreciation of fundamentals—the interaction of NIMBYism, the slowdown in infrastructure construction, increasing density and thus central place price gradients, and reduced real interest rates. The view that banking and regulatory policy was not only different but created extraordinarily large vulnerabilities in the housing sector seems to me to be difficult to sustain.

Also difficult to sustain, in my view at least, is the view that the difference was made by the root of all evil that was the repeal of Glass-Steagall. Yes, universal banks that can draw on government-insured deposits to support their high-risk investment banking businesses can and have a strong incentive to play: “heads we win, tails the government loses”.

Yes, the belief now appears naive that what investment banking needed to increase its efficiency and decrease its margins was more competition from other firms funded by insurance companies like Travelers and commercial banks like Bank of America. But it wasn’t the universal banks that took on excessive risk relative to their peers in 2007-2008. The pure investment banks matched them. And of the pure investment banks, only Goldman Sachs and Morgan Stanley survived as independent actors.

Back before 2007, our policy rule as far as prudential banking/regulatory policy was concerned appeared to be one of a policy drift toward “benign neglect”. It is my sense that underlying the policy drift in three areas—relative lack of concern about what willing lenders and willing borrowers wanted to do with each other with respect to making mortgages, relative lack of concern with supervising and enforcing transparency and prudence standards on the rapidly growing derivatives markets, and relative lack of concern with making sure that the risk management departments of major financial institutions were in fact managing risk—were two largely separate beliefs:

  1. Whatever small systemic risks were created by cowboy finance in housing and elsewhere were systemic risks that the Federal Reserve could effectively manage. Largely unregulated financialization and experimentation might well produce substantial benefits in making the mobilization of such risk bearing capacity easier.

  2. The large profits apparently earned from bearing risk suggested that anything that promised to mobilize more risk bearing capacity and bring it to the financial markets should be encouraged. The continued existence of a substantial equity return premium implied that there was a substantial market failure involved in the difficulty financial markets had in mobilizing anything like society’s total potential risk bearing capacity.

And there were believed to be few risks generated by such benign neglect of systemic financial risk. The power of the Federal Reserve’s monetary policy tools meant that it could, afterwards, neutralize and clean up and thus handle the situation.

As former Federal Reserve Bank of New York Vice President Charles Steindel commented on my website: “Remember that Ned Gramlich's book [on housing and subprime] did not raise any macro alarms…” and “we foolishly did not believe that any mess being created in the mortgage market would have profound macroeconomic consequences…” Given the small size of the subprime market relative to global financial flows and assets, and given the success of the Federal Reserve at constructing its firewalls in episodes like the 1987 stock market crash, 1990 S&L, 1995 Mexico, 1997 East Asia, 1998 LTCM, 1998 Russia, 2000 dot-com, and 2001 9/11, it is hard to see how the judgment could have been very different ex ante as far as housing is concerned. The Fed had managed to handle all of these: why should the aftermath of a housing bubble have different consequences?

Derivatives and the balance sheets of systemically-important financial institutions is a different matter.

More worrisome to my mind is the difference between actual crisis policies on the one hand and those that would have been appropriate according to standard yardsticks on the other. Back before 2007, I at least had policy rule as far as banking/regulatory crisis management was: In the event of a financial crisis, the Federal Reserve, the other banking regulatory agencies, and if necessary the Treasury—after seeking Congressional approval—should follow Walter Bagehot (1873), as interpreted and recommended by Kindleberger (1979).

The Bagehot Rule is: In a financial crisis, (1) lend freely, (2) to institutions that are solvent but illiquid, but (3) lend at a penalty rate. No institution that receives financial support should, after the crisis is over, feel that it came out of the situation well. No institution should feel that the positions they adopted that created systemic risk still look like they were worth running.

No executive should get rich as a result of the government’s lender-of-last-resort activities. And if an institution is (a) insolvent but (b) systemically important? Resolve it immediately, zeroing out the equity, options, and mezzanine holdings of stakeholders.

Certainly during the resolution of Bear-Stearns the Federal Reserve and the Treasury, with their insistence that the price of Bear-Stearns equity in the resolution be not the $60-$70 a share at which it had been trading before the weekend but rather first $3 and then $10 certainly counts as a “penalty rate”. And nobody can say that the failure of the lender-of-last-resort to appear for Lehman was in any sense enabling and encouraging moral hazard for the future (cf. Ball (2016)).

But after that concern that those who had created systemic risk not emerge from the crisis whole seemed to fall by the wayside. Even replacement of the most senior executives by their juniors as a condition of institutional survival—something that would have been relatively popular among the former-juniors-now-seniors—was not enforced. And the spectacle of the U.S. Treasury lending at 5% per year with no control rights at at moment when Warren Buffett is getting 10% per year plus substantial equity kickers and potential control rights appeared distinctly odd.

A great many questions are still unanswered, or at least not fully answered to my satisfaction: Was legal authority to resolve Lehman in September 2008 really absent? If so, then was it not gross central banking malpractice not to have resolved Lehman at the last moment that legal authority existed—at the instant, whether it was in April or June or August, that it crossed from being solvent and liquid but potentially illiquid to insolvent? Why did so many institutions evade temporary receivership and then sale to a new set of equity holders when for a year or more their equity value was merely the fumes from expected government support? Was not further shaking the confidence of bankers truly such a necessary priority? Or is the “penalty rate” part of the Bagehot Rule playbook unattainable in practice?

The disturbing thing is that I do not feel qualified to judge these issues, even now.

There is one additional area in which regulatory policy during the crisis and recovery has been different than I did or would have back in 2007 have expected it to be: the regulatory structure of housing finance and the role of the GSEs in it.

The structure of housing finance back before 2008 pleased nobody save the high executives and lobbyists of FNMA and FHLMC, and perhaps their congressional partners. It is now more than eight years since they were put into receivership. Yet if there is a plan for the long term institutional structure of mortgage finance in the United States and for their role in it, I am not aware of that plan. It is difficult to imagine how many private financial institutions would feel confident extending market share or placing large bets in a market where the typical instrument has a thirty year lifetime and the only certainty is that the future institutional structure of the market is uncertain. It is difficult for me at least to look at the cost of capital as measured by interest rates today, at the level of housing prices, and at the level of residential construction and see the current situation as a reasonably healthy one.


Even if America was substantially “overhoused” as of the end of 2007 by the yardstick of the share of potential GDP devoted to residential construction during the pre-2004 Great Moderation era, it is by that or any other yardstick “underhoused” today. Regulatory uncertainty here with respect to the long run cannot be good. Back in the mid- and late-2000s Phil Swagel (2010) and many others (cf. Treasury-HUD (2011)) had many ideas, many of them good, for a better housing finance infrastructure. Why does there not seem to be even a plan today?