America's Problems Run Deeper than Wall Street
by Martin Feldstein
CAMBRIDGE-With less than two months remaining before America's
presidential election, much attention is focused on the state of the
American economy and the challenges that it will present to the next
We are in the midst of a financial crisis caused by the serious
mispricing of all kinds of risks and by the collapse of the housing
bubble that developed in the first half of this decade. What started
as a problem with sub-prime mortgages has now spread to houses more
generally, as well as to other asset classes. The housing problem is
contributing to the financial crisis, which in turn is reducing the
supply of credit needed to sustain economic activity.
Indeed, the financial crisis has worsened in recent weeks, reflected
in the US Federal Reserve's takeover of quasi-government mortgage
lenders Fannie Mae and Freddie Mac-which may cost American taxpayers
hundreds of billions of dollars-as well as the bankruptcy of Lehman
Brothers and the sale of Merrill Lynch. Ultimately, these financial
failures reflect the downward spiral of house prices and the
increasing number of homes with negative equity, i.e., with
substantial mortgage debt in excess of market values.
Negative equity is significant because mortgages in the United States
are generally "no recourse" loans. If a homeowner defaults, creditors
can take the house, but they cannot take other property or income to
make up any unpaid balance. Even in those states where mortgages are
not "no recourse" loans, creditors generally do not pursue the assets
or income of individuals who default.
We cannot be sure about how much further house prices will fall.
Experts say another 15% decline is required just to return to the
pre-bubble price path. But there is nothing to stop the decline from
continuing once it reaches that point. The growing gap between
mortgage debts and house prices will continue to increase the rate of
defaults. Many homeowners who can afford to make their mortgage
payments will choose to default, move to rental housing, and wait to
purchase until house prices have declined further.
As homeowners with large negative equity default, the foreclosed homes
contribute to the excess supply that drives prices down further. And
the lower prices lead to more negative equity and therefore to more
defaults and foreclosures. It is not clear what will stop this
Declining house prices are key to the financial crisis and the outlook
for the economy, because mortgage-backed securities, and the
derivatives based on them, are the primary assets that are weakening
financial institutions. Until house prices stabilize, these securities
cannot be valued with any confidence. And that means that the
financial institutions that own them cannot have confidence in the
liquidity or solvency of potential counterparties-or even in the
value of their own capital. Without this confidence, credit will not
flow and economic activity will be constrained.
Moreover, because financial institutions' assets were bought mainly
with borrowed money, the shortage of credit is exacerbated by their
need to deleverage. Since raising capital is difficult and costly,
they deleverage by lending less.
But the macroeconomic weakness in the US now goes beyond the decreased
supply of credit. Falling house prices reduce household wealth and
therefore consumer spending. Falling employment lowers wage and salary
incomes. The higher prices of food and energy depress real incomes
further. And declining economic activity in the rest of the world is
lowering demand for US exports.
The US Federal Reserve has, in my judgment, responded appropriately by
reducing the federal funds interest rate sharply and creating a
variety of new credit facilities. The low interest rate helped by
making the dollar more competitive, but otherwise monetary policy
appears to have lost traction because of the condition of the housing
sector and the dysfunctional state of the credit markets.
The US Congress and the Bush administration enacted a $100 billion tax
rebate in an attempt to stimulate consumer spending. Those of us who
supported this policy generally knew that history and economic theory
implied that such one-time fiscal transfers have little effect, but we
thought that this time might be different. Our support was, in the
words of Samuel Johnson, a triumph of hope over experience.
In the end, our hopes were frustrated. The official national income
accounting data for the second quarter are now available, and they
show that the rebates did very little to stimulate spending. More than
80% of the rebate dollars were saved or used to pay down debt. Very
little was added to current spending.
So that is where the US is now: in the middle of a financial crisis,
with the economy sliding into recession, monetary policy already at
maximum easing, and fiscal transfers impotent. That is an unenviable
situation, to say the least, for any incoming president.
Martin Feldstein, a professor of economics at Harvard, was formerly
Chairman of President Ronald Reagan's Council of Economic Advisors and
President of the National Bureau for Economic Research.
Copyright: Project Syndicate, 2008.