STOCK MARKET WATCH -- Monday, 9 July 2012

[Demeter]

14. The lump of unfairness fallacy (OCTOBER)

http://www.interfluidity.com/v2/2296.html

Ezra Klein is a wonderful writer, but I don’t love his retrospective on the financial crisis. (Kevin Drum and Brad DeLong do.) The account is far too sympathetic. The Obama administration’s response to the crisis was visibly poor in real time. Klein shrugs off the error as though it were inevitable, predestined. It was not. The administration screwed up, and they screwed up in a deeply toxic way. They defined “politically possible” to mean acceptable to powerful incumbents, and then restricted their policy advocacy to the realm of that possible. The administration could have chosen to fight for policies that would have been effective and fair rather than placate groups whose interests were opposed to good policy. They might not have succeeded, but even so, as Mike Koncazal puts it, they would have lost well. We would be better off with good policy options untried but still on the table than where we are now, with policy itself — monetary, fiscal, whatever — discredited as both ineffective and faintly corrupt.

There is a lot in Klein’s piece that I could react to, but I want to highlight one point that is particularly misguided:

But when talking about what might have worked on a massive, economy-wide scale — that is to say, what might have made this time different — you’re talking about something more drastic. You’re talking about getting rid of the debt. To do that, somebody has to pay it, or somebody has to take the loss on it.

The most politically appealing plans are the ones that force the banks to eat the debt, or at least appear to do so. “Cramdown,” in which judges simply reduce the principal owed by underwater homeowners, works this way. But any plan that leads to massive debt forgiveness would blow a massive hole in the banks. The worry would move from “What do we do about all this housing debt?” to “What do we do about all these failing banks?” And we know what we do about failing banks amid a recession: We bail them out to keep the credit markets from freezing up. There was no appetite for a second Lehman Brothers in late 2009.

Which means that the ultimate question was how much housing debt the American taxpayer was willing to shoulder. Whether that debt came in the form of nationalizing the banks and taking the bad assets off their books — a policy the administration estimated could cost taxpayers a trillion dollars — or simply paying off the debt directly was more of a political question than an economic one. And it wasn’t a political question anyone really knew how to answer.

On first blush, there are few groups more sympathetic than underwater homeowners or foreclosed families. They remain so until about two seconds after their neighbors are asked to pay their mortgages. Recall that Rick Santelli’s famous CNBC rant wasn’t about big government or high taxes or creeping socialism. It was about a modest program the White House was proposing to help certain homeowners restructure their mortgages. It had Santelli screaming bloody murder… If you believe Santelli’s rant kicked off the tea party, then that’s what the tea party was originally about: forgiving housing debt.

This all sounds very hard-nosed. There were debts. There were economic losses, such that the debts could not be serviced at initially agreed terms. The consequences of leaving those unserviceable debts in place — frozen household spending, bankruptcy courts and litigation, blown up banks — were intolerable. Therefore, the losses were going to have to be socialized, borne by taxpayers, one way or another. Ultimately, in this view, it is all a matter of dollars and cents. The taxpayer is going to eat the loss, so what’s the best sugar to make the medicine go down? But human affairs are not about dollars and cents. Santelli’s rant and the tea party it kind-of inspired were not borne of a financial calculation — “Oh my God! My tax bill is going to be $600 higher if we refinance underwater mortgages!” Santelli’s rant, quite legitimately, reflected a fairness concern. The core political issue has never been the quantity of debt the government would incur to mitigate the crisis. It was and remains the fairness of the transfers all that debt would finance. A fact of human affairs that proved unfortunately consequential during the crisis is that people perceive injustice more powerfully on a personal scale than at an institutional level. Bailing out the dude next door who cashed out home equity to build a Jacuzzi is a crime. Bailing out the “financial system” is just a statistic. So the anger Santelli channeled led to economically stupid bail-outs of intermediaries rather than end-debtors. Once you understand that the problem is a fairness issue rather than a dollars-and-cents issue, the policy space grows wider. Holding constant the level of expenditure, one can make bail-outs more or less fair by the degree to which you demand sacrifice from the people you are bailing out. TARP was deeply stupid not because it meant socializing risks and costs created by bankers. TARP was terrible public policy because it socialized risks and costs while demanding almost no sacrifice at all from the people most responsible for those risks. The alternative to TARP was never “let the banks fail, and see how the bankruptcy system deals with it.” The alternative would have been to inject public capital (socialize risks and costs!) while also haircutting creditors, writing-off equityholders, firing management, and aggressively investigating past behavior. It was not the money that made TARP unpopular. It was the unfairness. And the unfairness was not at all necessary to resolve the financial problem.

If the Obama administration, or any administration, decided to encourage principal writedowns by having the government simply cover half the loss, that would be unfair. The Rick Santellis of the world might object more than I would, but that would be to my discredit more than theirs. Fairness should never be a policy afterthought. Widely adhered norms of fair play are among the most valuable public goods a society can hold. A large part of why the financial crisis has been so corrosive is that people understand that major financial institutions violated these norms and got away with it, which leaves all of us uncertain about what our own standards of behavior should be and what we can reasonably expect from others. When policy wonks, however well meaning, treat fairness as a public relations matter, they are corroding social infrastructure that is more important than the particular problems they mean to fix.

The good news is that there are lots of ways to craft good economic policy without doing violence to widely shared norms of fairness. See, for example, Ashwin Parameswaran’s “simple policy program“. On a less grand-scale, you’ll find that very few fairness concerns arise if underwater borrowers enjoy principal writedowns in the context of bankruptcy. Such “cramdowns” are consistent with a widely shared social norm, that society will grant (and creditors must fund) some relief from past poor choices to individuals who go through a costly and somewhat shameful legal process. Including mortgages and student loans in that uncontroversial bargain will piss-off bankers who wish to avoid responsibility for bad credit decisions. But it won’t provoke a revolution in Peoria. The Obama administration campaigned on “cramdowns”, but ultimately decided not to push them. I wonder why? Perhaps Ezra Klein will explain how research by Reinhart and Rogoff shows that this too was inevitable.