Two years after the collapse of Lehman Brothers, economists are still debating the causes of and villains behind the 2008 financial crisis, whose ongoing fallout can be seen in the weak recovery and stagnant job market that continues to bedevil U.S. President Barack Obama and his economic advisors. In a recent article in the New York Review of Books, Paul Krugman and Robin Wells lay down another marker in this debate, while caricaturing my recent book, Fault Lines, in the process.
The article says a lot about the policy views of Krugman (for simplicity, I will say "Krugman" and "he" instead of "Krugman and Wells" and "they"), with whom I have disagreed in the past. Rather than focus on the innuendo about my motives and beliefs in the review, let me focus instead on differences of substance.
First, Krugman starts with a diatribe on why so many economists are "asking how we got into this mess rather than telling us how to get out of it." Krugman apparently believes that his standard response of more stimulus applies regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates.
My book emphasizes a number of related issues that led to our current predicament.
Krugman discusses and dismisses two -- the political push for easy housing credit in the United States and overly lax monetary policy in the years 2002-2005 -- while favoring a third, global trade imbalances (which he does not acknowledge are a central theme in my book). Focusing exclusively on the imbalances as Krugman does, while ignoring why the United States became a deficit country, gives us a grossly incomplete understanding of what happened. Finally, Krugman ignores an important factor I emphasize -- the incentives of bankers and their willingness to seek out and take the wild risks that brought the system down.
Let's start with the political push to expand housing credit. I argue that in an attempt to offset the consequences of rising income inequality, politicians on both sides of the aisle pushed easy housing credit through government units like the Federal Housing Administration, and by imposing increasingly rigorous mandates on government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac.
Interestingly, Krugman neither disputes my characterization of the incentives of politicians nor the detailed documentation of government initiatives and mandates calling for easy credit for the poor. What he disputes vehemently is whether government policy contributed to the housing bubble, and in particular, whether Fannie and Freddie were partly responsible.
In absolving Fannie and Freddie, Krugman has been consistent over time, though his explanations as to why Fannie and Freddie are not partially to blame have morphed as his errors have been pointed out. First, he argued that Fannie and Freddie could not participate in sub-prime financing. Then he insisted that their share of financing was falling in the years mortgage loan quality deteriorated the most. Now he claims that if they indeed did acquire substantial amounts of sub-prime exposure (and he says they did not), it was because of the profit motive and not to fulfill a social objective.
In a July 14, 2008 op-ed in the New York Times, Krugman explained why Fannie and Freddie were blameless. "Partly that's because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off," he wrote. "Also, they didn't do any subprime lending, because they can't: the definition of a subprime loan is precisely a loan that doesn't meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income. So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works." [emphasis mine]