The economic crisis was not a Monte Carlo event. My comments on Prof Sufi’s statement to Senate Sub Committee on Banking, Housing and Urban Affairs

I must admit I have not read the House of Debt, but I did read Professor Sufi’s statement to the Senate Subcommittee on Banking, Housing and Urban Affairs Subcommittee on Economic Policy.

While I agree with a lot of what Professor Sufi says about the impact of debt (I also share his concerns about income growth and about the worrying trend in auto loans) I disagree with the angle of a number of his statements:

How did we get into this mess? And why is it taking so long to recover? My research with Atif Mian at Princeton University suggests that the culprit is the devastation of wealth suffered by middle and lower income American households during the Great Recession.  The weak recovery is due in part to the lack of any rebound in wealth among these households since the end of the recession.

It was not the devastation of wealth per se but the accumulation of debt combined with invigorating domestic and global structural imbalances that led to the crisis.  The increase in the value of homes prior to the housing collapse was a consequence of excessive asset focussed money supply growth, lax lending standards and attendant growth in consumer debt.  To pin the blame on asset prices incorrectly ascribes blame to the natural risk and volatility of asset prices.

Asset prices would not have reached the highs they did without the financial tail wind of low interest rates and strong broad money supply growth.  Indeed, the global economy would probably have been better off without the rise in debt and asset values that preceded the crisis.  Yes, growth prior to the crisis would most likely have been lower and asset values likewise, but the blowout and the excessive debt burdens the overall economy is still wallowing in would have been much reduced.

I also have some qualms about the next statement:

Richer Americans save a much higher fraction of their income, ultimately holding most of the financial assets in the economy: stocks, bonds, money-market funds, and deposits. These savings are lent by banks to middle and lower income Americans, primarily through mortgages.

As noted in a recent Bank of England bulletin on money supply and its creation, it is not in fact savings by individuals that are loaned out by banks, but newly created deposits that accompany bank loans.   It is these new deposits that are spent by borrowers that create the revenue from which earnings and other income sources derive.  The deposit created by the loan merely changes hands and is either transacted for consumption (changing hands again) or transacted for assets (changes hands again) with small holdings retained to cover consumption and portfolio needs.  Perhaps it is this perception of savings and loans that causes professor Sufi to miss the asset focussed money supply growth connection with debt and asset values.  Then again, if Banks were forced to have higher equity holdings (a la Anat Admati) , then savings would start to finance a more significant portion of loans, but this financing would be in the form of an equity interest in the returns which may well imply the need for higher interest rates.

Likewise I am not entirely at ease with the portrayal of mortgages as debt contracts exposing the borrower to an unfair share of loss in case of a fall in house prices. 

There is nothing sinister about the rich financing the home purchases of the poor. But it is crucial to note that the borrowing takes the form of debt contracts which leave the borrower with the first losses in case house prices fall….the financial system’s reliance on inflexible debt contracts means it insures the rich while placing an inordinate amount of risk on middle and lower net worth households.

These so called debt contracts are also de facto equity ownerships in assets just as corporations may well finance their own operations from bank loans and corporate debt.  Transferring risk also transfers return and a transfer of return over time means that the providers of capital get richer, so I am not totally sure of the rationale behind this statement.  I think we also need to bear in mind that the risks to which many asset classes have been exposed in recent times is a function of excesses in the system and that insuring the excess is in my opinion not an entirely sensible thing to do. 

As we illustrate in our research, it was the massive pullback in spending by indebted households that triggered the Great Recession. The financial system concentrated the collapse in home values on exactly the households that were prone to cutting spending most dramatically in response.

I think it worth remembering that too much debt was taken on at such low interest rates by many who did not have the financial leeway to accommodate interest rate rises, and that a great many of these may also have become involved in home equity withdrawals to finance consumption.   When interest rates rose and the system creaked under the pressure, it was hardly a revelation that people would curtail spending and find themselves unable to finance their mortgages.  This analysis makes it look like it is part of the natural fabric of economic structures to impale home owners during recessions.  It is not.   But a financial system built on excessive debt and reliant on low interest rates will. 

One other issue that I think is very important to appreciate.  I believe that the strong rate of growth of broad money supply growth during this period, focussed as it was on assets within a low interest rate framework skewed the natural balance of money supply focus further towards assets than would be considered the case in typical economic model constructs that usually validate such valuation shifts.  Note the discounted present value model where a fall in interest rates causes a rise in the present value of an asset: in this equilibrium there is no endogenous money creation and money supply balances would partially shift towards present consumption as opposed to saving for future consumption….

My final concern rests with a theme developed throughout his presentation and which I assume is a central focus of the book “House of Debt” and that is as follows:

This risk must be borne by someone, and the financial system should help Americans share this risk with one another. Those that bear the most risk should be those who have the capacity to bear losses in case the economy crashes.

Part of the reason we are at this juncture is because of the belief that the financial system was capable of sharing risk and this issue of sharing risk (insuring risk events) still, I believe, exposes the fragility of the current system.  We need entities to bear more risk and to bear more responsibility for risk than we have a need for entities to share it and spread it. 

In general those with a large amount of wealth have exactly such capacity. And of course, those that bear the most risk should be compensated for bearing that risk – earning high returns when the economy is strong. Investors should look to the financial system to take risk and earn a return as a result.

What we have here is yet another excuse to heap extra costs onto those with less wealth and income and to transfer return to those who least need it.  And, of course, the financial system already takes too high a cut for intermediation.  In fact, we may need higher income growth just to accommodate the costs of such a risk bearing exercise.  The economic crisis was not a Monte Carlo event whose uncertainty of incidence and impact requires insurance!

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From 2006: “Rises in liquidity and falling risk has allowed many to leverage areas of lower marginal return, possibly to a greater extent, in certain areas, than ever before. As liquidity falls and risk moves back towards equilibrium, either the leveraged positions or the markets underlying these positions will become exposed, or both.”

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