Nearly 11 million Americans, or more than a fifth of homeowners, owe more than their properties are worth. And research shows that the deeper in debt people are, the more dramatically they cut back their spending - dragging down the whole economy.
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From left, President Barack Obama and Treasury Secretary Timothy Geithner; a foreclosure sign outside a house. The Obama administration and top economists are at odds over the role of mortgage debt in the recession recovery. The economists say the president could have significantly accelerated the slow economic recovery if he had better addressed the overhang of mortgage debt left burdening Americans when housing prices collapsed. Obama's advisers say that they did all they could on the housing front and that other factors better explain why the recovery has been slow.
Associated Press
By ZACHARY A. GOLDFARB
The Washington Post
WASHINGTON — One year and one month before President Barack Obama won reelection, he invited seven of the world's top economists into a private meeting in the Oval Office for their advice on what do to fix an ailing economy. "I'm not asking you to consider the political feasibility of things," he told them in the previously unreported meeting.
There was a former Federal Reserve vice chairman, a Nobel laureate, one of the world's foremost experts on financial crises and the chief economist of the International Monetary Fund, among others. Nearly to a T, they said Obama should introduce a much bigger plan to forgive part of the mortgage debt owed by millions of homeowners underwater on their properties.
Obama was reserved in response, but Treasury Secretary Timothy Geithner interjected that he didn't think anything of such ambition was possible. "How do we get this done through Congress?" he asked. "What could we actually do that we haven't done?"
The meeting highlighted what today is the biggest disagreement between some of the world's top economists and the Obama administration. The economists say the president could have significantly accelerated the slow economic recovery if he had better addressed the overhang of mortgage debt left burdening Americans when housing prices collapsed. Obama's advisers say that they did all they could on the housing front and that other factors better explain why the recovery has been slow.
The question is relevant because though Obama won a victory earlier this month, the vast majority of voters still say the economy is weak and not getting better. Policymakers in Washington are now focused on another type of debt — the public debt owed by all taxpayers — but the slow economic recovery, which depresses tax revenue, makes that problem harder to solve.
Nearly 11 million Americans, or more than a fifth of homeowners, are buried in debt, owing more than their properties are worth after piling their life savings into their homes — a persistent and largely unaddressed problem that represents the missing link in what many economists consider the administration's overall strong response to the recession.
"Housing was the neglected piece. They have the kind of attitude that they don't believe this is a good value for the money, this is politically unpopular, and there's not much we can do," said Alan Blinder, a former Fed vice chairman consulted frequently by the White House. "There were obvious things to do that academics and others started pointing out back in 2008. That could have shortened the recovery time."
Obama's economic advisers dispute that notion. Geithner said the administration chose the best of the feasible options to deal with the housing crisis.
"We knew the hit to wealth would be damaging. We knew the level of debt had the potential to restrain the strength of recovery," Geithner said in an interview. "The only issue was, what could you do about it? What were the feasible options available?"
Obama's economic advisers believe the ultimate pace of recovery is understandable, if disappointing, given the financial crisis and collapse in housing prices, as well as a number of surprises such as a drought this year, the European debt crisis, rising oil prices and the trade-disrupting Japanese earthquake. They argue that the course they pursued — spending more than a trillion dollars on tax cuts and employment programs — helped all Americans and sped up the recovery, and that alternatives that dealt with housing debt directly were never viable.
Of the original members of Obama's economic crisis team, Geithner, the one still in office, has pressed this point most strongly. Others have said that, if the administration did make a big error in its response to the crisis, it had to do with housing.
Lawrence Summers, formerly Obama's top economic adviser, has said he doesn't think the administration made a major mistake. But this month, he said at a conference in Washington that "if we made a serious mistake, the best arguments would be around questions about housing."
Former budget director Peter Orszag has said "a major policy error" was made. And Christina Romer, formerly Obama's top economist, has said that the driving ideas "may have been too limited" and that there needs to be a bigger focus on reducing mortgage debts — a process known as "principal reduction."
"The new evidence on the importance of household debt has convinced me that we are likely going to need to help homeowners who are underwater," Romer said last month. "Many of these troubled loans will need to be renegotiated and the principal reduced if we are going to truly stabilize house prices and get a robust recovery going."
Some of the most authoritative research on the role of mortgage debt in the recession and recovery — research reviewed personally by Obama — comes in part from an economist from Pakistan who started out studying why poor countries struggle to grow.
Atif Mian, now a Princeton professor, came to focus on how finance can destabilize an economy. He saw how foreign money had flooded Latin America in the 1980s and Southeast Asia in the 1990s, leading to borrowing booms and financial crises.
Not long before the U.S. recession hit, Mian and another young economist, Amir Sufi of the University of Chicago's business school, saw a similar trend here. "The common link to the emerging market crises," Mian said, "is that it all starts with leverage."
The two economists compared what happened in U.S. counties where people had racked up huge debts with those where people had borrowed little. It had long been thought that when people's homes declined in value, they'd spend less because they'd feel less wealthy.
But Mian and Sufi's research showed something more specific and powerful at work: People who owed huge debts when their homes declined in value cut back dramatically on buying cars, appliances, furniture and groceries. The more they owed, the more they cut back. People with little debt hardly slowed spending at all.
This was important because consumer spending makes up the lion's share of economic activity, and even a small increase or decrease can have a big impact on growth and affect millions of jobs.
From 2006 through 2009, overall consumer spending was flat, according to calculations Sufi completed for The Washington Post. But among the quarter of U.S. counties with the highest debt, it fell 5.5 percent. Without that hit, spending nationwide would have increased by 2.4 percent.
In other words, indebted Americans had an outsize effect, pulling down the rest of the nation's economy.
Some people reduced spending because they had lost their homes to foreclosure, damaging their ability to borrow. Others no longer could tap home-equity lines. Still others, facing high monthly payments each month, used every extra penny to pay off debt.
When the Federal Reserve aggressively lowered interest rates, it helped many borrowers but not those underwater, because banks wouldn't refinance them. Fed data show that among most Americans, the number of people paying more than 40 percent of their income toward debt — a high threshold — declined from 2007 and 2010. But among people who had seen their wealth disappear, it surged.
Historically, Sufi said, "places that have bigger recessions usually have stronger comebacks." But his calculations showed that since the end of the recession, places with high levels of debt have not had robust recoveries.
Other economists — from both parties — were making the same point around the time Obama came to office. Blinder, a former Clinton administration official, and Martin Feldstein, a former Reagan administration official, developed plans calling on the government to commit hundreds of billions of dollars to restructure millions of mortgages with lower interest rates and principal balances.
"I think the missed opportunity to forgive principal at the end of 2008 and beginning of the 2009 was the biggest mistake the administration made in trying to deal with the crisis," said John Geanakoplos, a Yale economist who proposed a plan to reduce principal.
The architects of the Obama administration's response to the recession — Summers, the economic adviser, and Geithner — knew all too well the problems of a debt overhang.
The two had begun their public service careers — Geithner at Treasury, Summers at the World Bank — in the shadow of the Latin American debt crisis. A tough-minded rescue plan by Treasury Secretary James Baker had failed and been replaced by a more generous one by Baker's successor, Nicholas Brady, that finally helped Latin America shed its debts.
As Obama took office, Summers would note how the Brady plan had succeeded where the Baker plan failed. But although the new Obama administration had hundreds of billions of dollars in unspent financial bailout funds available to use, it decided against any significant program to reduce the debts of underwater homeowners.
"No one was in doubt that debt overhangs were an important problem," Summers said recently at a conference. But despite exploring many proposals, the administration did not see a plan that did not have the potential to cause "effects worse than the cure," he said, such as cratering the financial system by forcing banks to absorb huge losses.
At a more basic level, officials simply did not believe a big program of debt forgiveness was a smart investment, costing hundreds of billions of dollars — money that it preferred to spend on a massive economic stimulus that could much more quickly lift the economy. The administration also unveiled a more modest program designed to avert foreclosures by reducing monthly mortgage payments but not the total debt balance.
In late 2009, the economy started to grow at a pace of 4 percent per year — fast enough that employment would have gotten back to normal by just about now. But in 2010, growth sputtered to 2 percent. The administration responded with more stimulus. But the pattern repeated itself in 2011 and this year.
Today, administration officials say they do not see the mortgage debt overhang primarily at work. Rather, they say, foreign shocks, cuts in local and state spending, and other factors dragged down the economy.
Still, in the past year, Obama has expanded programs to try to better tackle mortgage debt, announcing more federal funding to write down loans and an expanded program to allow underwater homeowners to refinance.
The efforts seem to have had positive effects. A greater number of underwater borrowers have reduced their principle balances and been able to refinance, and the housing market has enjoyed a modest recovery.
Not everyone is impressed, though. "I don't see the kind of aggressive approach that could make a big difference," Romer said in September at Hofstra University.
Many Americans still have a long way to return to normal, pre-boom levels of debt. Although Americans racked up $5 trillion in new mortgage debt before the crisis, they have only erased about $1 trillion of that burden, according to the Fed. Research by Karen Dynan of the Brookings Institution shows more than 10 percent of families would have to save all of their income for six months to pay down the debt they accumulated in the boom years.
"The housing sector is far from being out of the woods," Federal Reserve Chairman Ben Bernanke said last week. "We should not be satisfied with the progress we have seen so far."
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