Since my last post, venting over those who blame the financial crisis on the government policies to help low-income people, Raghuram Rajan has fired back at Paul Krugman over how much blame should go to Fannie Mae (FNM) and Freddie Mac (FRE).
Since I mentioned Krugman’s criticism of Raghu, I want to clarify a couple of points. For starters, I think Krugman was over-the-top toward him. Rajan is most definitely not a member of the right-wing fantasy history campaign. He may be at the University of Chicago, but he is not an ideologue and he is an outstanding scholar.
As many people know, Rajan gave a courageous paper at the Fed’s Jackson Hole conference in 2005, in which he argued that short-term incentives on Wall Street were corrupting the financial system and posing potential big risks to the world. This was two years before the crisis got underway, and the main theme of that particular retreat was to celebrate the legacy of Alan Greenspan (prematurely, it turned out). I was there, and I can confirm that Raghu was greeted almost with scorn. As Justin Lahart later remarked in the WS Journal, people reacted as if he were some kind of a Luddite. But Raghu was right, and many of his criticisms are now conventional wisdom.
Second, Rajan’s views are moderate and thoughtful compared to those of the true wingnuts. In his recent FT commentary, Rajan glancingly referred to the vast sums of money that Congress steered toward low-income homeowners as part of how government policy “distorted” the market.
Irrational exuberance played a part, but perhaps more important were the political forces distorting the markets. The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans.
Compared to the truly awful World Bank paper I described last week, not to mention the right-wing talk-show hosts, this was pretty tame. Rajan didn’t even mention the Community Reinvestment Act in his FT commentary, which the talk-show types claim “forced” the banks to make dangerous loans to irresponsible poor people. In his response to Krugman, Rajan completely disavows that whole argument. Thank God.
On Fannie and Freddie, he argues that two institutions contributed to the mess by buying a lot of subprime-backed paper — as much as $434 billion worth during the housing bubble. That’s probably less a quarter of all the subprime and Alt-A securities that were sold in that period, but it’s not nothing. Rajan says that has to have played a role in the madness:
The key question the “Fannie and Freddie did not contribute to the crisis” battalion leaves unanswered is why the “greedy” bankers turned to lending to the poor….the housing boom and the bust were most pronounced amongst the lower end of the housing market, unlike previous housing booms …. I argue that the government and its support to low-income housing made this segment of the market attractive. The government and politicians may have gone in with noble intent (as is usually the case), but with devastating and unintended consequences.
I strongly disagree several of Raghu’s points here. For one thing, the government didn’t need to prod the mortgage lenders into seeking out lower-income borrowers. By 2004, and certainly by 2006, the higher end of the mortgage market was so picked-over and saturated that lenders were desperate for new territory. They had no place to go but down.
Second, the big question isn’t whether Fannie and Freddie made things worse. I agree; they did. But the really key question for future policy purposes is this: who was driving whom? For that, you should look at who was firstest with the mostest in the subprime/no-doc/option-arm arena. The answer on both counts, by a wide margin: private label securitizers. Yes, Fannie and Freddie contributed to the bubble and the bad lending. But it wasn’t because they were trying to help the poor, and they certainly weren’t the driving force. They were just trying to keep up with their private-sector rivals.
That’s a big distinction. The big lesson here was not about government distortions to the market (except perhaps the Fed’s low interest rates). The big lesson here was that unrestrained, unregulated lending practices by the private sector can be dangerous for consumers and for the financial system as a whole. To the extent that “government policy” contributed to the crisis, the first failure was in not stopping the reckless private-sector lending and the second failure was in not stopping Fannie and Freddie from following suit.