Atif Mian is professor of economics and director of the Julis-Rabinowitz Center for Public Policy and Finance at Princeton University. Amir Sufi is the Chicago Board of Trade Professor of Finance at the University of Chicago Booth School of Business and co-director of the Initiative on Global Markets. They are the authors of "House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again," and a blog by the same name.
Tim Geithner has a problem with helping underwater homeowners. We’re
not sure why he hates the idea. He claims he doesn’t like the idea because the economic effects of helping underwater homeowners would have been small. But that is dead wrong.
Here is a paragraph from his book:
“We did not believe, though we looked at this question over and over, that a much larger program focused directly on housing could have a material impact on the broader economy. Jan Eberly, the assistant secretary of economic policy, took a fresh look at these alternatives later, and her analysis concluded that even if the federal government had borrowed and spent $700 billion to wipe out every dollar of negative equity in the U.S. housing market—a “principal reduction” program of utopian proportions—it would have increased annual personal consumption by just 0.1 to 0.2 percent.”
Let’s evaluate this estimate. And to be as charitable as possible to Mr. Geithner, let’s suppose that the only benefit of principal reduction would be the spending by the underwater homeowners.
What would have been the direct spending effect? The answer depends critically on the marginal propensity to consume (MPC) out of housing wealth. That is, if we forgave $1 of debt, how much of that $1 would an underwater homeowner have spent?
This is a very well-researched question. Most place the MPC out of housing wealth between $0.05 and $0.10 per dollar. So if your house value goes down by $100,000, you cut spending by $5,000 to $10,000.
So what is Mr. Geithner’s assumed MPC out of housing wealth? Why does he get such a small effect? Using annual personal consumption expenditure (PCE) as his benchmark, he asserts that a $700 billion principal reduction would increase spending by only 0.1 to 0.2 percent of PCE. We will use the midpoint of 0.15 percent. PCE was $9800 billion ($9.8 trillion) in January of 2009. So some simple math shows that Geithner is assuming an MPC out of housing wealth of $0.02 per dollar, or 0.02.
Now let’s just stop right there. We have an established body of research that suggests that the MPC out of housing wealth is between $0.05 to $0.10 per dollar. And Mr. Geithner’s uses an estimated MPC that is less than half the lower bound estimate from the literature. Without going any further, we immediately know that his estimate is too small.
So let’s try to get the right estimate. Again, let’s start with the very narrow focus on only the direct spending response of the underwater homeowners that get the $700 billion reduction in debt.
We have estimated the housing wealth effect in our own research published in the Quarterly Journal of Economics. Our study focuses on the Great Recession which is the most relevant sample for evaluating Geithner’s assertion. We find an estimated average MPC out of housing wealth between $0.05 and $0.07 per dollar.
Our research also shows that it is crucial to use the MPC for the right population. First, the $0.05 to $0.07 estimate above is an average MPC across zip codes in the United States. And we show in our research that the effect is twice as large for the most leveraged zip codes relative to the median zip code, which puts the MPC estimate closer to $0.12 per dollar for zip codes with many underwater homeowners.
Second, our estimate includes homeowners and renters living in these zip codes. The proposal Mr. Geithner suggests would target only the homeowners. If we assume that the MPC out of housing wealth is zero for renters (because they don’t own a home), we would need to scale up the $0.12 estimate by dividing through with the homeownership rate in 2009, which was 67%. This gives us an MPC for underwater homeowners of $0.18 per dollar. So a program that targeted underwater homeowners would get an immediate spending response of $0.18 for every dollar.
Multiplying $700 billion by 0.18 gives us a spending boost to the economy in 2009 of $126 billion, which is 1.3% of PCE, 10 times larger than the estimate Secretary Geithner asserted in his book. So Mr. Geithner is off by an order of magnitude, even if we narrowly focus on the direct spending consequences of principal forgiveness.
But remember, the effects are far larger than just this direct effect. We know that areas with many underwater homeowners also experienced more foreclosures and higher unemployment. Therefore write-downs of underwater debt would also have had the indirect positive effect of drastically reducing foreclosures and the associated negative effects of foreclosures on the economy. Indeed, followers of our blog know that highly indebted states experienced lower spending, higher unemployment, and even higher usage of food stamps, and many of these effects persist even until today!
In our book, we do a careful calculation quantifying both the direct and indirect effects of debt forgiveness, and we show that debt forgiveness would have had an enormously positive effect on the economy. It would have made the Great Recession far less severe. To be clear, we support write-downs that impose losses on creditors not taxpayers. But the basic point remains – more debt forgiveness would have provided a significant boost to economic activity when we most needed it.
It’s not just us that make this assertion. Economists from all backgrounds overwhelming agree with us, contradicting the claims of Mr. Geithner. Here is an excerpt from an excellent piece by Zach Goldfarb:
"One year and one month before President Obama won reelection, he invited seven of the world’s top economists to a private meeting in the Oval Office to hear their advice on what do to fix the ailing economy. "I'm not asking you to consider the political feasibility of things,” he told them in the previously unreported meeting.
There was a former Federal Reserve vice chairman, a Nobel laureate, one of the world’s foremost experts on financial crises and the chief economist of the International Monetary Fund, among others. Nearly all said Obama should introduce a much bigger plan to forgive part of the mortgage debt owed by millions of homeowners who are underwater on their properties.”
And if you think these are all liberal economists, here is Martin Feldstein, former economic advisor to President Reagan:
"Homes are the primary form of wealth for most Americans. Since the housing bubble burst in 2006, the wealth of American homeowners has fallen by some $9 trillion, or nearly 40 percent. In the 12 months ending in June, house values fell by more than $1 trillion, or 8 percent. That sharp fall in wealth means less consumer spending, leading to less business production and fewer jobs. But for political reasons, both the Obama administration and Republican leaders in Congress have resisted the only real solution: permanently reducing the mortgage debt hanging over America.”
Whatever reasons he had for opposing assistance to underwater homeowners, a careful evaluation of the policy effects was not among them. The evidence is pretty clear: an aggressive bold attack on household debt would have significantly reduced the horrible impact of the Great Recession on Americans.
The fact that Secretary Geithner and the Obama administration did not push for debt write-downs more aggressively remains the biggest policy mistake of the Great Recession.