The Hopeful Science
Did the Poor Cause the Crisis?
Simon Johnson
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WASHINGTON, DC – The United States continues to be riven by heated debate about the causes of the 2007-2009 financial crisis. Is government to blame for what went wrong, and, if so, in what sense?
In December, the Republican minority on the Financial Crisis Inquiry Commission (FCIC), weighed in with a preemptive dissenting narrative. According to this group, misguided government policies, aimed at increasing homeownership among relatively poor people, pushed too many into taking out subprime mortgages that they could not afford.
This narrative has the potential to gain a great deal of support, particularly in the Republican-controlled House of Representatives and in the run-up to the 2012 presidential election. But, while the FCIC Republicans write eloquently, do they have any evidence to back up their assertions? Are poor people in the US responsible for causing the most severe global crisis in more than a generation?
Not according to Daron Acemoglu of MIT (and a co-author of mine on other topics), who presented his findings at the American Finance Association’s annual meeting in early January. (The slides are on his MIT Web site.)
Acemoglu breaks down the Republican narrative into three distinct questions. First, is there evidence that US politicians respond to lower-income voters’ preferences or desires?
The evidence on this point is not as definitive as one might like, but what we have – for example, from the work of Princeton University’s Larry Bartels – suggests that over the past 50 years, virtually the entire US political elite has stopped sharing the preferences of low- or middle-income voters. The views of office holders have moved much closer to those commonly found atop the income distribution.
There are various theories regarding why this shift occurred. In our book 13 Bankers, James Kwak and I emphasized a combination of the rising role of campaign contributions, the revolving door between Wall Street and Washington, and, most of all, an ideological shift towards the view that finance is good, more finance is better, and unfettered finance is best. There is a clear corollary: the voices and interests of relatively poor people count for little in American politics.
Acemoglu’s assessment of recent research on lobbying is that parts of the private sector wanted financial rules to be relaxed – and worked hard and spent heavily to get this outcome. The impetus for a big subprime market came from within the private sector: “innovation” by giant mortgage lenders like Countrywide, Ameriquest, and many others, backed by the big investment banks. And, to be blunt, it was some of Wall Street’s biggest players, not overleveraged homeowners, who received generous government bailouts in the aftermath of the crisis.
Acemoglu next asks whether there is evidence that the income distribution in the US worsened in the late 1990’s, leading politicians to respond by loosening the reins on lending to people who were “falling behind”? Income in the US has, in fact, become much more unequal over the past 40 years, but the timing doesn’t fit this story at all.
For example, from work that Acemoglu has done with David Autor (also at MIT), we know that incomes for the top 10% moved up sharply during the 1980’s. Weekly earnings grew slowly for the bottom 50% and the bottom 10% at the time, but the lower end of the income distribution actually did relatively well in the second half of the 1990’s. So no one was struggling more than they had been in the run-up to the subprime madness, which came in the early 2000’s.
Using data from Thomas Piketty and Emmanuel Saez, Acemoglu also points out that the dynamics of the wage distribution for the top 1% of US income earners look different. As Thomas Philippon and Ariell Reshef have suggested, this group’s sharp increase in earning power appears more related to deregulation of finance (and perhaps other sectors). In other words, the big winners from “financial innovation” of all kinds over the past three decades have not been the poor (or even the middle class), but the rich – people already highly paid.
Finally, Acemoglu examines the role of federal government support for housing. To be sure, the US has long provided subsidies to owner-occupied housing – mostly through the tax deduction for mortgage interest. But nothing about this subsidy explains the timing of the boom in housing and outlandish mortgage lending.
The FCIC Republicans point the finger firmly at Fannie Mae, Freddie Mac, and other government-sponsored enterprises that supported housing loans by providing guarantees of various kinds. They are right that Fannie and Freddie were “too big to fail,” which enabled them to borrow more cheaply and take on more risk – with too little equity funding to back up their exposure.
But, while Fannie and Freddie jumped into dubious mortgages (particularly those known as Alt-A) and did some work with subprime lenders, this was relatively small stuff and late in the cycle (e.g., 2004-2005). The main impetus for the boom came from the entire machinery of “private label” securitization, which was just that: private. In fact, as Acemoglu points out, the powerful private-sector players consistently tried to marginalize Fannie and Freddie and exclude them from rapidly expanding market segments.
The FCIC Republicans are right to place the government at the center of what went wrong. But this was not a case of over-regulating and over-reaching. On the contrary, 30 years of financial deregulation, made possible by capturing the hearts and minds of regulators, and of politicians on both sides of the aisle, gave a narrow private-sector elite – mostly on Wall Street – almost all the upside of the housing boom.
The downside was shoved onto the rest of society, particularly the relatively uneducated and underpaid, who now have lost their houses, their jobs, their hopes for their children, or all of the above. These people did not cause the crisis. But they are paying for it.
Simon Johnson, a former chief economist of the IMF, is co-founder of a leading economics blog, http://BaselineScenario.com, a professor at MIT Sloan, and a senior fellow at the Peterson Institute for International Economics. His book, 13 Bankers, co-authored with James Kwak, is now available in paperback.
Copyright: Project Syndicate, 2011.
www.project-syndicate.org
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Brett 12:47 20 Jan 11
The answer is yes and yes.
Bad loans then dressed up as something different and on sold in a poorly regulated way. Mind you, it has all happened before; Tulips, South Seas, Tech.... This time is was property. You don't have to be a rocket scientist (well, I actually am one), to see the movement of money from the tech bubble to the create the property bubble. (I predict the Green Bubble next).
The best answer to who, Poor People or Rich Market People causing the crisis, is, what headline or what marketing or what spin you want to put on the statistics. All will be right or wrong, or both at the same time.
My money (ha ha, sorry for the pun) is on Bill Clinton wanting more poor people to own their own homes leading to NINJA loans. If this didn't happen, then the Richy Rich and his mates wouldn't have the chance to on sell the bad loans (as something else).
LeroyDumonde 02:52 20 Jan 11
I liken the poor (i.e. blacks and Hispanics http://capitalgainsandgames.com/blog/edmund-l-andrews/1773/sarah-palinization-financial-crisis) caused it meme to something similar that goes on with the drug war.
It is commonly assumed (by both the left and the right) that so many blacks and Hispanics are in prison for drug offenses because they are the ones that do all the drugs (the right blames this on black and Hispanic "family values" while the left blames it on the fact that they're poor).
But the fact is it just doesn't add up. That is, blacks and Hispanics simply don't have enough money to be buying all those drugs. And I, having grown up in the suburbs, can assure anyone that there's lots and lots of drugs being done by white people.
This is just pure crystallized racism.
By the way, for a really excellent cris de cœur against the drug war read Mike Gray's "Drug Crazy" and checkout his website http://drugcrazy.com/index.htm. By the way, by the way I have absolutely nothing to do with Mike Gray or his publisher. I bought the book several years ago and just found it laid out the facts very well (if in a slightly sensationalist style but then he is in showbiz).
Cross posted at: http://economistsview.typepad.com/economistsview/2011/01/simon-johnson-the-poor-did-not-cause-the-crisis.html#comment-6a00d83451b33869e20148c7cb319f970c
eladamsil 04:24 20 Jan 11
Please address the effect of the Community Reinvestment Act on subprime lending by both private lenders and the GSAs.
dionramasami 12:00 21 Jan 11
Thank you Mr Sachs for providing a very insightful look into American politics and economy. It sure does put things into perspective. We need more macro economists like you in this world. Your contribution to making the US and the rest of the world especially the developing world a better place for everyone is highly appreciated.
LeroyDumonde 07:52 21 Jan 11
Uh-oh Simon dionramasami has mistaken you for Jeffrey Sachs. Oh well, Paul Krugman apparently gets mistaken for Tom Friedman (http://krugman.blogs.nytimes.com/2010/12/04/broadway-this-morning/). Which is absolutley absurd. He actually looks like an older, bearded Jim Dangle (http://community.nytimes.com/comments/krugman.blogs.nytimes.com/2010/12/04/broadway-this-morning/?permid=16#comment16).
But at least you can be happy that you're in a higher class of mistaken identity.
EMichael 05:50 21 Jan 11
But in stopping a fraud such as this in the future, the important thing is to understand the sectors most responsible, Investment banks and rating companies.
Without them, the crisis does not happen.
The thought that the GSEs were responsible is inane when you understand that in the largest housing boom in US history they LOST 40% of market share.
http://cop.senate.gov/documents/testimony-102710-cecala.pdf
The thought that government programs to increase homeowners(like the CRA) were responsible is ludicrous when you understand that the amount of CRA loans decreased for the 10 years prior to the boom and right through the boom.
http://www.jchs.harvard.edu/publications/governmentprograms/n08-2_park.pdf
No question there was fraud in many sectors, but the investment banks and ratings companies led the way and committed the most fraud.
"Citicorp's key mortgage credit guy testified many months ago before the Financial Crisis Inquiry Commission (FCIC) that 80% of Citi's mortgages sold to Fannie and Freddie were sold under false "reps and warranties."
http://neweconomicperspectives.blogspot.com/2011/01/economic-philosophy-that-has-completely.html
" Wall Street's pooling and packaging loans didn't involve due diligence on the underlying quality of the loans. Since underwriting standards by mortgage lenders had dropped precipitously, many of these complex deals given top ratings went bust within months in 2007.
That alone is evidence of the industry's falling standards. Prior to these problems, the mathematical chances of a default on a top investment grade rating were less than 1 percent. What changed is that structured finance became popular _ the practice of pooling together loans and offering slices to investors at different risk levels....
In another bit of explosive evidence, the panel on Friday will release an e-mail from a Standard & Poor's employee acknowledging complicity in building up a doomed market.
"Rating agencies continue to create an even bigger monster _ the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters," the employee wrote on Dec. 15, 2006."
http://www.mcclatchydc.com/201...
And guess what?
We are stuck with it. We cannot prosecute the thieves and fraudsters. Because they are too big to fail, and they would fail if we ever made clear the truth and prosecuted the bankers and raters.
There is not a single major bank in the US(and Europe) who could survive being forced into taking back the fraudulent bonds they sold. And that will be true for another decade or two.
And one day the problem will be "fixed". All the forclosures will be done. All the losses taken by the investors will be taken. All the investors will settle forpennies on the dollar for the fraud the banks and rating companies committed. And everything will be back to normal.
Unless they do it again....
kentwillard 06:05 22 Jan 11
No one gets the irony of the accusation that housing goals or CRA requirements caused the housing bubble. One simple fact is needed; during the peak bubble years most high risk mortgages (subprime, neg-am ARMs, Alt-A, and many jumbo primes) did not require income to be documented. Thus the borrowers' income was whatever they stated it to be, and it was often significantly above their actual income. Of course this overstatement of income created both higher housing demand, and then higher defaults.
What does overstating income do to Fannie & Freddie's goals for low-income and low-to-moderate income lending? It hurts it. I know because I used to work at Fannie Mae. Fannie & Freddie probably actually did a lot more low income lending than they knew about or could prove. But they didn't guarantee those Alt-A loans, (which had horrendous losses and are mostly responsible for their downfall) in order to hit housing goals. They guaranteed those loans because they thought they would increase profit and market share. And they were terribly wrong.
And of course, most subprime mortgages weren't even originated through a bank, or guaranteed by Fannie & Freddie, so there was no CRA of HUD lending goal. Again, they were made because they were believed to be profitable. And for a while, they were. The mania of an asset bubble blinds many people.
cheeheongquah 02:45 22 Jan 11
IS not Wall Street protected by the government? So how can you vindicate governemnt as one major cause of the crisis? Remember also the Fed which was and is under pressure to comply with the goals set by Congress and the government.
Quah, Chee-Heong
joebhed 03:31 23 Jan 11
Speech Governor Randall S. Kroszner , Board of Governors of the Federal Reserve System, Washington, D.C. December 3, 2008
The Community Reinvestment Act and the Recent Mortgage Crisis
Evidence on CRA and the Subprime Crisis
Over the years, the Federal Reserve has prepared two reports for the Congress that provide information on the performance of lending to lower-income borrowers or neighborhoods--populations that are the focus of the CRA.3 These studies found that lending to lower-income individuals and communities has been nearly as profitable and performed similarly to other types of lending done by CRA-covered institutions. Thus, the long-term evidence shows that the CRA has not pushed banks into extending loans that perform out of line with their traditional businesses. Rather, the law has encouraged banks to be aware of lending opportunities in all segments of their local communities as well as to learn how to undertake such lending in a safe and sound manner.
dhlii 04:45 24 Jan 11
If this is what passes for ecomonic thought today we are in deep trouble.
You can eliminate all the grevious mistakes by walls street, and banks and you still eventually end up with a crisis. The elements that you can not eliminate are artificially inflated home prices and increases in unearned credit.
The relevant claim is that government incentives - both directly through regulation like the CRA, and indirectly through artificially low interest rates as well as the GSE's providing a market for bad mortgages, created an artificial boom (strike one) in a long term (strike two) asset (strike three).
It is irrelevant whether the government policies were intended to benefit bankers or the poor.
Government incentives work. Good people, bad people, the rich, the poor - everyone rushes to take advantage.
If your world view requires beleiving that evil bankers manipulated government into allowing them to write bad mortgages and then persuaded government to compell Fannie and Freddie to buy these worthless mortgages, fine. The outcome is still the same.
Most of the rest of this article is just failed 20th century socialist crap.
Whether government attempts to benefit the poor or the ealthy is irrelevant - though in most instances it seeks to be all things to all people. What matters is that when government attempts to manipulate the market - no matter who they wish to favor, someone will figure out how to profit from it, but long run failure is inevitable, and the biggest losers will be the poor.
Regardless of details we are in agreement that government is the cause.
Less government is the solution.
alexferro 09:49 10 Feb 11
There's always been inequality.
Its in the how to get to equality ... without destroying what one has.
HenryH 10:36 05 Apr 11
Republicans and Libertarian also blame the Community Reinvestment Act, which forces banks to give loans in low-income areas. However they conveniently forget that this at was written in response to banks redlining minority and specifically black neighborhoods and banning home loans in those areas. It has also been proven that the CRA did not lead to massive new cash loans. In fact according to most reports I've read (sorry to lazy to find a link, but I'm sure you can google it) the bulk of the underwater loans are not from first time homebuyers buying more house than they could afford, but rather from middle class homeowners refinancing and using their homes like atm's.
Jamake 07:54 20 Apr 11
This is incredibly weak logic in my opinion. Study assumes that Government behavior is the primary cause for every effect in the economy. Study then goes back and looks at long-term income trends and assumes that, because the trends occurred in such and such a way, Government actions both calculated and successful in achieving this outcome. Is this suppose to be a serious attempt to explain who caused the crisis?
Two key issues that are typically missing from the "Predatory Lending" dialogue.
1- the mortgage market was driven by an enormous demand for assets with some "hope" of yielding 6-8% return. Much of this demand came from overseas, recycling of foreign surplus dollars back into the US. However an awful lot of the end buyers were home grown pension plans that NEEDED TO MAKE 7-8% annual returns in order to avoid making annual contributions. Regardless of the where it came from, the demand for high yielding assets as inflation and real yields were falling sent a strong signal to WS to create these assets, essentially creating the supply to fill the demand. This is what WS does. Create and sell assets. (As an aside, this nullifies the Carl Levin line of questioning, "so you (Goldman Sachs) sold crap to your customers?" The customers were demanding these assets, Goldman Sachs and others were simply giving the customer what they were asking for).
2- Home owners took out mortgages and bought property. When the economy turned south, they couldn't afford the payments. Pure and simple. I'm sure some people were taken advantage of with some exorbitant fees and floating rate products, but that cannot be behind millions and millions of foreclosures. I'm not sure how much of the blame should be laid at people who fed the bubble, borrowed too much, thought their job was secure, the market would continue to rise, interest rates would stay low, etc. However, to date, these people have been given a complete and total free ride. In fact they've been given billions of dollars in order to cushion the cost of their mistaken calculations.
You can say what you want about the buyers of assets, those end-users who effectively made the bad loans. But at least they paid for their mistakes in that their assets went down in value. I know people lost "their homes" and their lives have been turned upside down. Bad things happen to you in life when you make poor decisions. I think we need to ask ourselves what would have happened if people hadn't borrowed more than they could repay? If people hadn't defaulted on their loans? If they hadn't driven up the price of homes to silly levels? Would the crisis have still occurred?
melee 10:59 01 May 11
Thank you, Simon Johnson and Daron Acemoglu, "increasing homeownership among relatively poor people, pushed too many into taking out subprime mortgages that they could not afford" is the most misleading statement made on the "subprime mortgage mess". Classic "blame the victim."
The rapacious practices of the companies doing the lending, with escalating interest and other loan servicing costs, meant that many not only lost their homes, but what little savings they had, as well.
VarunNagaich02 01:03 19 Jun 11
Watch Inside Job the documentary...
llisa2u2 04:48 29 Jun 11
It is so convenient to use the common words of "government", or any other anonymous generalized entity to become the "BLAME LABEL" for the results of numerous specific human beings. There needs to be more identification and commentary on the decision making processes chosen and made by specific human beings, their positions, and their salaries.
Ideological, and political discussion has its limits in the real world. Unless real people are identified as who and what they are, and the effects of their decisions, everybody is existing in a house of cards bombarded by the can kicked down the road. And I sure don't mean the yellow brick road. It's turning pretty yucky and brown all over!
slurpy 05:38 08 Jul 11
I take issue with the sensationalist title of this article - I don't think anyone is blaming "the poor" for causing the crisis - the argument is, as Mr. Johnson himself states, that Government policies were at the center of the crisis i.e. easy credit extended to low income households through unreasonably low interest rates after the dot com bubble for an unreasonably long time in addition to Fannie Mae and Freddie Mac etc - "the poor" themselves have nothing to do with the argument, they were tricked, fooled and forced into mortgages they couldn't handle and might not have fully understood.
Saying that proponents of an argument placing government at the center of the crisis are "blaming the poor" is completely of the mark. I think Mr. Johnson thinks it is a good way of discrediting this particular point of view and you know it, a good way of getting people to read this article even though the title has nothing to do with what you are presenting.
I personally do not think government was at the center of the crisis but I think differing points of view should be presented fairly and catchy sensationalism should be avoided.
The crisis was highly complex and at some point people have to stop pointing fingers at the left or right and agree that there are players and policies in both government and private finance that are guilty of severe misconduct and lack of foresight.
abrown 06:07 07 Nov 11
I think its unfair to say that the poor caused the crisis. Preciscely, the cause was bad politics.
Polititians wanted to boast of increased access to housing. Despite public statements by the then president Bush in the 2000's Bush failed to make the statement clear by explicitly withdrawing the state guarantees for subprime mortgages such a move would have adverse political implications.
I still believe that there was no crisis, the state guaranteed housing for the poor and honoured the obligations by bailing out the banks that held these assets. The slow down in compensating for an overdrive that came as a result of the excessibe high spped of growth.
21tiger 03:40 14 Nov 11
I find it hilarious that we have to reveal our Education level just to get a free account on this site, and this is the kind of blather that actually gets published. Parroting, what, FOX News talking points? Ouch. Yes, the people in this country with the least amount of power, who took no risks, have driven the economy over a cliff. Brilliant.
lukehlee 08:15 19 Jan 11
What of course precipitated the financial crisis – i.e. the immediate cause -- was that we did not effectively regulate the creation of sub-prime financial products. Despite the potential risks of those products, financial institutions went ahead, as it was felt they contributed to increasing the level of consumer spending. We now know we were wrong. So, to our peril, we did not put a stop to what we now recognize as a dubious policy that exacerbated the situation. Finally, from the housing market bubble burst to the financial meltdown, the economy has now plummeted to a perilously catastrophic level.
What, then, is the real cause of the current economic and social crisis? The conventional answer is that it is the housing market bubble burst or the sub-prime mortgage system failures. That’s the simple answer. But what underlies those?
I believe we have made a serious mistake in the market or economy over the last 20 to 30 years, but we have not considered this at all in our ruminations about the economy. If we do not fix this mistake, I strongly believe that we cannot create enough jobs and also make sustainable economic growth. That is, this economic and social tailspin cannot be stopped. It could even develop into a far worse crisis.
I would strongly suggest you see this article about the mistake: "Breaking Down the Economic Death Spiral – and Saving the World Economy" http://t.co/8pMwQh7