Millennials, the Housing Crisis, and the Future

On August 29, 2011, in economic theory, housing, by Jon Lewis

Pinched: How the Great Recession Has Narrowed Our Futures & What We Can Do About It. Don Peck. Crown Publishers 2011, pp. 223, $22.00 While many books have been written on derivatives, the housing bubble, and regulatory policy in the wake of the financial crisis of 2008, few authors have yet sought to interpret how [...]

Pinched: How the Great Recession Has Narrowed Our Futures & What We Can Do About It. Don Peck. Crown Publishers 2011, pp. 223, $22.00

While many books have been written on derivatives, the housing bubble, and regulatory policy in the wake of the financial crisis of 2008, few authors have yet sought to interpret how the recession has impacted American culture. Pinched, a captivating and well-written analysis of how the financial crisis and the subsequent recession have already changed American society and may change the American future, is therefore a welcome addition to the growing corpus of literature on the financial crisis of 2008.

Don Peck, an editor at The Atlantic, makes the case that “[t]he crash has already shifted the course of the U.S. economy, and its continuing reverberations have changed the places we live, the work we do, our family ties, and even who we are. But the recession’s most significant and far-reaching ramifications still lie in the future.” He argues persuasively that the recession exposed “deeper economic trends” in American society, including in wealth distribution, class structure, and what he terms “the diverging fortunes of different regions, cities, and communities.” He emphasizes that the current recession is not comparable to the more recent previous downturns. “In its origins, its severity, its breadth, and its social consequences,” writes Peck, “the current period resembles only a few others in American history—the 1890s, the 1930s, and in more limited respects the 1970s.”

Peck devotes Chapter 4 of the work, “Generation R: The Changing Fortunes of America’s Youth,” to how the recession has already impacted the Millennial generation. His outlook, it should be noted, is fairly bleak. He contends that “[m]any of today’s young adults seem temperamentally unprepared for the circumstances in which they find themselves” and that “the fact that so many young adults weren’t firmly rooted in the workforce even before the crash is deeply worrying.” Although these statements might be rather alarmist, it remains the case that the recession has hit recent college graduates fairly hard; many have returned home to live with their parents. It has also impacted their political views; it should be noted that support for the Republican Party has apparently increased among white Millennials.

The Millennials will, of course, eventually grow up and will take their experiences during the past few years with them. Peck rightly notes that, “[t]he changes now taking place in Millennials’ political ideals and social attitudes will shape American politics and culture for decades.” This is the author’s most salient point, and one that can hardly be understated; indeed, as he notes, the longer the economy remains weak, the more likely it will be that the hopes and futures of many Millennials will become, in his words, “irretrievable.” An aspiring presidential candidate for 2012 would be well advised to frame his or her policy proposals in a manner that would appeal to this generation. A focus on jobs, rather than on gay marriage or vague promises of cultural renewal, would be particularly welcomed by college-educated twenty-somethings who are burdened by a weak economy, non-dischargeable student debt, and an increasingly perilous sovereign debt crisis that imperils their future prospects.

The author’s chapter on the housing crisis merits serious consideration. In Chapter 5, “Housebound: The Middle Class After the Bust,” Peck discusses how the housing bubble has negatively impacted the middle class. Not only has owning a home become a liability in many instances, also “everything they thought they were buying along with their house—good schools, a good neighborhood, the good life—is also now in question.” Of course, as Peck aptly notes, there is a distinct geographical component to the worst effects of the housing bust, with the Sunbelt cities of Orlando, Tampa, Phoenix, and Las Vegas affected the worst. In the concluding paragraph to the chapter, he states clearly what too many individuals and institutions in American society are reluctant to admit. “Houses are not magical assets; basic logic dictates that over the long haul, they simply cannot appreciate faster than the incomes of the people expected to buy them.” It is up to some politicians with courage to stress that, contrary to conventional wisdom, housing simply isn’t a good financial investment.

Although Peck qualifies his policy recommendations in Chapter 9, “A Way Forward,” with the caveat that he isn’t a policy analyst by trade, many of his observations and proposals are very much worthwhile. They are also notably refreshingly free from ideological blinders. Indeed, Peck will make no friends on the talking points-oriented Left or Right with the apt observation that “[t]ax cuts and government spending won’t fix the various structural problems that afflict the economy. Simply juicing demand won’t magically turn factory workers into nurses any faster, not will it turn laid-off high-school graduates into more-skilled college grads.” The problems facing the American economy, Peck implies, are complex.

Peck rightly notes that the size of the debt is a serious cause for concern, but notes that these concerns need to be put in their proper context and contends that “[i]n the short run, austerity, not deficit spending, would be irresponsible.” Peck is on target when he mentions that, “[w]e should embark on tax reform to broaden the tax base and close distortionary loopholes.” He also rightly notes the urgency of tackling Medicare, labeling it “the real source of our long-term budgetary problems.” He cites two possible approaches to Medicare reform: either to provide more authority to the Independent Payment Advisory Board established by the Affordable Care Act or convert Medicare into a voucher system. Although he appears somewhat agnostic as to what would be preferable, it should be noted that the latter approach would give consumers far more choice and freedom and would give power to individuals rather than to unelected bureaucrats.

Peck is most persuasive in his discussion of how to fix the housing finance system. While he rightly suggests that, in the short run, the government should get the housing market running smoothly, he noted that, in the long run, “we should reconsider whether the promotion and massive subsidization of homeownership—through mortgage-interest tax deductions and other measures—is doing the nation more harm than good.” Indeed, there is good reason to believe that the mortgage-interest tax deduction has had a distortionary impact on the housing market, causing housing prices to be artificially higher. Most significantly, the mortgage-interest deduction has not increased homeownership rates.

In conclusion, Pinched is a provocative read, rich in anecdotes and with numerous citations to recent economics scholarship. Peck admirably does not shy away from contentious issues. Although the book is not a particularly optimistic assessment of the current state of the American economy and society, it can serve as wake up call for policymakers willing to put aside tired memes and to think seriously about how deep a mess we’re all really in.

Jon Lewis (c) 2011

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Housing and the American Dream

On August 21, 2011, in housing, by Jon Lewis

Regaining the Dream: How To Renew the Promise of Homeownership for America’s Working Families. Roberto G. Quercia, Allison Freeman, and Janneke Ratcliff. Brookings Institution Press, pp. 160, $19.95 Since the Great Depression, and especially since the end of the Second World War, purchasing and owning one’s home has been perceived to be part and parcel [...]

Regaining the Dream: How To Renew the Promise of Homeownership for America’s Working Families. Roberto G. Quercia, Allison Freeman, and Janneke Ratcliff. Brookings Institution Press, pp. 160, $19.95

Since the Great Depression, and especially since the end of the Second World War, purchasing and owning one’s home has been perceived to be part and parcel of the ‘American Dream.’ For decades, the federal government has instituted numerous policies, most notably via spending through the tax code, to promote homeownership rather than renting. Recent scholarship, however, has suggested that tax subsidies for housing have not been economically efficient, nor have they reduced income inequality.

Unfortunately, this has not resonated with the Obama administration. Indeed, despite the fact that federal government support for the housing sector and risky behavior by Fannie Mae played a significant part in precipitating the financial crisis of 2008, President Obama has recently signaled that he would like to see proposals for a plan that would maintain a substantial role for the federal government in the mortgage market. Indeed, it is even possible that Fannie Mae and Freddie Mac, both now in government conservatorship, could be preserved, albeit under different names and in somewhat different forms. It should likewise be noted that any attempt to downscale the federal government’s role would have to be done gradually; the federal government currently backs 95 percent of new mortgage loans.

In Regaining the Dream, Roberto G. Quercia, Allison Freeman, and Janneke Ratcliffe, all affiliated with the Center for Community Capital at the University of North Carolina-Chapel Hill, suggest that “[t]he current crisis provides an invaluable opportunity to regain the dream by expanding access to sustainable and affordable mortgages for American families.” They premise their argument on the notions that homeownership, through the build up of equity, “helps build prosperity” and that it “signals thrift and an intention to provide for one’s own needs.” In their formulation, homeownership has an important collectivist element. “Buying a home signifies a willingness to commit to something larger than oneself—a specific neighborhood or community.” Long-term, civic-minded renters in New York City would naturally contest this assertion.

The authors advocate for community reinvestment programs that allow for low-income individuals to purchase homes. In their book, the authors trace the impact of the Community Advantage Program (CAP), an initiative designed to assist low- and moderate-income individuals to purchase their own homes. CAP was established by Self-Help Ventures Fund, the home and business lending division of a North Carolina-based community development financial institution and was a program that, in the authors’ words, brought “the secondary housing market into community reinvestment lending.”

In order to maintain an adequate capital base, Self-Help obtained a fifty- million dollar grant from the Ford Foundation. “In essence, the Ford Foundation grant strengthened Self-Help’s capital base so that it could purchase affordable home loans from lenders and then work with Fannie Mae to securitize the loans, using the Ford grant as recourse against losses.” Quercia, Freeman, and Ratcliffe contrast what they perceive to be the successes of the CAP program with the failures of the subprime mortgage industry. CAP’s ability to provide sustainable homeownership for persons who otherwise would not have qualified for a mortgage “was achieved by providing borrowers with carefully underwritten, fixed-rate loans that they could afford to repay over time.” They make the claim that CAP’s success was due to “the careful matching of affordable product with borrower.” Indeed, they argue that, “it was not risky borrowers but rather mortgages with unsustainable characteristics that led to massive defaults at the onset of the crisis.”

The authors argue that CAP can provide a model for rebuilding the American housing system and that it is a model for linking the primary and secondary markets. They put forth the case that “a national credit enhancement fund could play a role like that of the Ford grant within CAP.” In cover the cost for this special insurance fund, Quercia, Freeman, and Ratcliffe contend somewhat vaguely that, because “the market is a continuum,” and because “all industry benefits from systemic stability, then all industry should contribute to achieving the same.”

Unfortunately, the authors are scant on the details of how such a mechanism would work and why private parties should be forced to subsidize an insurance fund to provide housing assistance to individuals who cannot obtain a traditional mortgage. It is somewhat disconcerting that the authors would promote CAP to be a workable national model when they admit that “[u]nder CAP, lenders offered loan-to-value ratios of 95 to 103 percent and flexible ways of considering a borrower’s credit and income” (emphasis added). If the recent housing bubble has taught us anything, it is that the short-term advantages of “flexible” methods of assessing credit are outweighed by the long-term disadvantages.

In a certain sense, the most important facet of this recent work is its title: Regaining the Dream (also, it should be noted, the title of Chapter 8). The authors clearly subscribe to the prevailing notion that promoting homeownership for lower-income individuals is desirable goal of public policy. To that extent, they advocate a larger role for government regulation as a necessary precondition for housing finance system that would allow for community reinvestment lending. “The financial market’s failure to self-regulate,” they write, “provides a strong justification for more, and more effective, government regulation.” A bolder approach to rethinking housing finance, and one that would have utilized the title, Rethinking the Dream, would have been a study that substantially broke from conventional thought and rethought the very premises underlying American dream of homeownership. Indeed, there are indicators that suggest that housing is neither a lucrative investment, nor it is a necessary precondition for good citizenship.

In conclusion, Regaining the Dream offers a model for rebuilding the housing finance system that would necessitate greater government regulation. While the goal of promoting homeownership for lower- and middle-income individuals is a noble one, it is not without cost to responsible taxpayers who can afford traditional mortgages. That fact alone should be enough to promote a national policy debate about the hidden costs of policies designed to foster homeownership.

Jon Lewis (c) 2011

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From Derivatives to Debt Crisis

On August 11, 2011, in derivatives, by Jon Lewis

The Devil’s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again. Nicholas Dunbar. Harvard Business Review Press 2011, pp.291, $27.95. If one were a college student in the mid-to-late 1990s with an interest in working on Wall [...]

The Devil’s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again. Nicholas Dunbar. Harvard Business Review Press 2011, pp.291, $27.95.

If one were a college student in the mid-to-late 1990s with an interest in working on Wall Street, it was likely that one had a fascination with the new complex and mathematically derived OTC (over-the-counter) derivatives and their market. After all, a position in an investment bank and in working in that sophisticated area of finance was perceived to be both lucrative and prestigious. Today, those same derivatives have far fewer champions; one would be hard-pressed to find nearly as many university students today whose dream is to work in trading derivatives. Because of the nature of the global economy and the ever-increasing need to manage risk, however, the market for derivatives is not going away any time soon. End users, in particular, continue to see advantages in derivatives.

In The Devil’s Derivatives, financial journalist Nicholas Dunbar paints a skeptical picture of the growth of the derivatives industry within the financial sector and introduces the reader to the bankers who advocated for, and worked in, derivatives, financial products that “piggybacked on—or ‘derived’ from—those humdrum activities that involved exchanging currencies, trading stocks and commodities, and lending money.” Derivatives, as Dunbar notes, had been around for a long time. What was new about the post-1970s’ derivatives were their highly complex, mathematical nature and the amount of risk that they were designed to manage.

Dunbar, who was trained as a physicist and has written extensively on financial markets, argues that there was a cultural shift in banking that led to both the rise of the new derivatives industry and the subsequent financial crisis. “To truly understand what brought upon the great financial meltdown of 2008,” he writes, “requires a thorough understanding of the men who love to win, and how they came to fundamentally change not just the practice of a financial system that had been in place for centuries, but its very DNA.” Indeed, the greatest strength of Dunbar’s work is that he does not treat the financial crisis as merely the culmination of economic and historical trends, but as the product of real (and, in his opinion, flawed) choices made by real individuals. These individuals, of course, acted in an historical context in which the very business of banking was undergoing fundamental cultural changes.

Dunbar contrasts the traditional actuarial approach to credit risk, one traditionally associated with life insurance companies, with the market approach to rating loans and bonds. “Think about owning a bond or loan in this new world. The idea of patiently waiting for years to be proved right by long-term statistics becomes almost absurdly antiquated, even laughable. The uncertainty of market prices now rules.” In Dunbar’s opinion, the actuarial and market approaches to credit risk “have created two distinct cultures in finance: the long-term world of lending banks, insurance companies, and pensions funds, and the short-term world of trading firms and hedge funds.” He is spot on in analogizing credit default swaps to “a bit like buying a life insurance policy on someone else’s life.” It should be noted that credit default swaps (CDSs) are very much like insurance, but have not been regulated as such. Indeed, the concept of moral hazard in insurance regulation stems from eighteenth-century England, when individuals were allowed to take out life insurance policies on other persons, thus increasing the moral dilemma – or hazard – of wishing to see them die so as to be able to collect the insurance payout.

Another quite interesting aspect of Dunbar’s work is his discussion in Chapter 3 wherein he integrates a discussion of Abraham de Moivre, binomial mathematics, and the invention of probability theory in eighteenth-century London with Moody’s, the bond-rating agency. For those readers interested in statistics and Moody’s utilization of the binomial expansion technique (BET) to “convince hate-to-lose investors that a CDO containing a portfolio of risky assets could be much less risky than the individual assets themselves,” this particular chapter is well worth consideration.

In light of the public’s worries generated by Standard & Poor’s decision to downgrade the United States’ debt rating from AAA to AA+, Dunbar’s parting thoughts are worth consideration. Indeed, Dunbar concludes his vast work with a most pessimistic assessment and links the current debt crisis to the derivatives market. “The lesson of history is clear: faced with such debts, either Americans themselves . . . will lose out, or their dollar-owning creditors will—in a big way. What started out as an arcane twist of high finance—derivatives—has now corrupted the entire financial world, and has set a hellish trap for taxpayers and their representatives that offers no way out.”

Although perhaps hyperbolic, it should be noted that as a journalist with a clear mission to convince people of the dangers of the derivative market and contemporary less-risk averse, banking culture, Dunbar is far freer to say such things than a politician is. Indeed, one could hardly imagine an aspiring presidential nominee saying that, even if he or she believed it to be true. Of course, there are ways out of the current debt situation; but all of them would increase great hardship in the short term, something many politicians would rather not do.

In conclusion, The Devil’s Derivatives is a welcome addition to the growing corpus of literature on the financial crisis of 2008. Unlike some of more purely academic and scholarly tomes on the subject, Dunbar’s work is written with a lively journalistic style that combines a first person narrative with a generally accessible introduction to highly technical finance concepts. For readers unfamiliar with seemingly arcane concepts as cross-currency swaps, regulatory capital arbitrage, and special purpose vehicles (SPVs), this recent work is as good as any place to start. Advanced undergraduates and graduate students interested in derivatives would find this recent book particularly compelling.

Jon Lewis (c) 2011

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The Limits of Economics

On August 1, 2011, in economic theory, by Jon Lewis

Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State. Roman Frydman and Michael D. Goldberg. Princeton University Press 2011, pp.285, $35.00. In assessing the financial crisis of 2007-2008, it is important to have a conceptual framework to understand not only what went wrong, but also why it went wrong. Was the [...]

Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State. Roman Frydman and Michael D. Goldberg. Princeton University Press 2011, pp.285, $35.00.

In assessing the financial crisis of 2007-2008, it is important to have a conceptual framework to understand not only what went wrong, but also why it went wrong. Was the crisis a result of a liquidity shock, a herd mentality by investors and speculators overly optimistic about ever rising housing values, or the deregulation of the financial services industry? One’s policy and regulatory recommendations will depend to a large extent on how one views the causes of the crisis. If the crisis was the inevitable result of deregulation, more and better regulation is the logical response. If government intervention, however, prolonged and worsened the crisis, then the rational response is for the federal government to do less when the next, similar crisis comes around.

But what if, instead, economists have been thinking about the financial crisis from the wrong perspective? Indeed, what if the very assumptions underlying contemporary macroeconomics have made it difficult to properly understand what went wrong? In Beyond Mechanical Markets, Roman Frydman (New York University) and Michael D. Goldberg (University of New Hampshire) make the case that “the conceptual framework underpinning the debate triggered by the global financial crisis is grossly inadequate for understanding what went wrong with our economies and what should be done to reform them. The reason is simple: contemporary macroeconomic and finance theory attempts to account for risk and swings in asset prices with models that suppose nonroutine change is irrelevant, as if nothing genuinely new can ever happen.”

Frydman and Goldberg argue that, “by ruling out novelty, contemporary macroeconomic and finance models assume away financial markets’ raison d’être—namely, to help allocate society’s capital in the face of nonroutine change and the imperfect knowledge that it engenders in modern economics.” The authors want to place the concept of imperfect knowledge back at the conceptual foundation of macroeconomics. Indeed, they write approvingly of not only John Maynard Keynes and Frank Knight, but also of Friedrich A. Hayek for understanding the limits of knowledge and predetermination when it comes to market prices and risk. The authors, in their Acknowledgements, maintain that they “have likewise been stimulated and sustained over the years by George Soros’s ideas about the role of imperfect knowledge and reflexivity in the workings of financial markets and historical change.” It should be noted that earlier this year Soros wrote an op-ed in which he praised Hayek for the Nobel Prize winner’s belief that imperfect knowledge leads to unintended consequences.

With the premise that economic knowledge is imperfect, the authors propose a different macroeconomic framework – Imperfect Knowledge Economics (IKE). In their view, IKE both incorporates the notion of imperfect knowledge and rejects the notion that knowledge of the (economic and market) future can be fully captured and predicted by rigid mechanistic rules. Their approach should be contrasted with variations of the widely accepted Rational Expectations Hypothesis (REH) framework. Frydman and Goldberg contend that “[r]egardless of their informational assumptions, Rational Expectations models assume away the importance of nonroutine change and the imperfect knowledge that it engenders.”

Given the authors’ emphasis on imperfect information and nonroutine change, it is not surprising that their policy prescriptions would be somewhat different from that of other economists. While they are very critical of the Soviet experiment in central planning and make the case that “the ultimate reason that central planning was impossible is that it supposed that a group of individuals – the planners – could predict and shape the future,” Frydman and Goldberg do not accept a purely laissez-faire approach to the economy either.

Their primary concern is with excessive upswings in asset prices that are followed by prolonged downturns and provide an alternative approach for state intervention. “Because price swings are inherent to how markets help society search for worthy investments, IKE-inspired policy reform suggests that so long as swings in broader market indexes or in key sectors remain within a guidance range of reasonable values, the state should limit its involvement to setting and enforcing the basic institutional framework for market transactions.” They propose that central banks could announce a range of non-excessive values in certain markets as “[a] first step in dampening excessive asset-prince swings.”

Frydman and Goldberg’s contention is that “[t]he need for state intervention in key asset markets arises not because policy officials have superior knowledge about asset values, but because the profit-seeking market participants do not internalize the huge social costs associated with excessive upswings and downswings in these markets.” This certainly merits further consideration. They are certainly correct that policy makers do not have, in their words, “superior knowledge.” Indeed, the assumption that a centralized government agency can have such knowledge belies the conceit of central planning that they criticize earlier in their book. With regard to their view that market participants do not internalize the social costs associated with upswings and downswings, one must question whether it is the appropriate role of the state to protect the wider public from these costs.

While on the one hand, the bidding up of stock prices and the subsequent downswing in a market will have a great social cost to the American public (i.e., the unemployment that followed the dot-com boom and bust), the question of how far (and for some readers, if) the state should go to protect the public from market participants is not easily answered. That said, those concerned that Frydman and Goldberg are merely seeking excessively intrusive state intervention into the financial markets would be heartened to know that their “policy measures based on Imperfect Knowledge Economics are not designed to prevent excessive price swings in key asset markets but to reduce their frequency and dampen their magnitude.”

Although Beyond Mechanical Markets is not an easily accessible work for the non-specialist, the authors utilize a clear writing style. This makes it possible for readers to better understand the complex philosophical notions about the role of (imperfect) knowledge underlying contemporary macroeconomic thought. For policy makers and those concerned with the recent dismal news about lagging growth, Frydman and Goldberg’s approach provides a different way of thinking about not only asset prices and markets, but the role of the state in the economy. Even if one does not necessarily subscribe to the authors’ thesis or their policy recommendations, their argument should remind us that there is a different way to look at markets than from the prevailing REH approach.

In conclusion, Beyond Mechanical Markets is a thought-provoking philosophical critique of much of contemporary macroeconomic thought. Those readers interested not only in economics, but also in the history of economic thought will find much of interest in the work.

Jon Lewis (c) 2011

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