In “The Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do about It,” a book out this month, noted economist Robert Shiller dissects the current housing-market collapse and offers suggestions for a broader recovery. He recently took time to speak with Alison Gregor for The Real Deal.
The Real Deal: In what ways is this particular housing crisis similar to or different from past housing crises?
Robert Shiller: It differs in a very important way, and that is that … it’s much more general than we’ve ever seen. There were bubbles or booms in homes that were much talked about in the past … but now we’re seeing [that happening] in many, many places. And I think this reflected a change in thinking.
TRD: So what ultimately caused the subprime mortgage crisis?
RS: What I argued in my book was that the ultimate cause of the subprime crisis was the perception that home prices can never fall. I tell a story of when I was debating Frank Nothaft, who is chief economist of Freddie Mac, and I asked him about the stress-testing for the Freddie Mac portfolio that had been done. And I asked him, ‘Have you considered the possibility of a major decline in home prices?’ And he said, ‘Yes, we have.’ I said, ‘What’s the biggest decline you’ve considered?’ And he said, ‘We’ve actually considered a decline of 13.5 percent.’ And then I said, ‘Well, what if it’s a bigger decline than that?’ And he said, ‘We’ve never had, not since the Depression, a bigger decline than that.’ And so he was just considering it impossible. Well, it’s happened. So I think they were just thinking it was impossible that home prices would ever fall. And I think that was the error in thinking.
TRD: Was this crisis also different from those past because it has become a global crisis?
RS: There’s immediate contagions through the subprime securities, which are held in other countries — [investment banks in Europe] failed because they were investing in subprime securities, so that was one kind of contagion that went from the U.S. to other countries. But I think there was a more general contagion that worked through markets. Home prices have been strong in a lot of countries until recently; I think that reflects similar patterns of thinking around the world.
TRD: Let’s talk about prospective solutions.
RS: The government is not really able to completely insulate everyone from mispricing that occurred, and people took positions based on assumptions that were wrong, and part of living in a capitalist world is we can’t protect everyone completely. So the Housing and Economic Recovery Act that was passed last month was an important step; unfortunately, I think it wasn’t big enough.
We’re seeing a national catastrophe unfolding, and it’s likely we will have over
5 million homeowners in default by the end of next year, and I think these people need to be treated fairly. So the Housing and Economic Recovery Act does have a provision for rescuing as many as 400,000 homeowners … but it’s not going to rescue the bulk of them, so we are still facing a national tragedy. There was a lot of opposition to that act, so this is what we’ve got.
In my book, I advocated a bigger plan … we also need more economic stimulus. I think the economy is likely to be weak for some time. It’s just that the crisis is bigger than the solution that’s been offered so far.
TRD: Besides government action, are there any other fixes to this crisis?
RS: I say we should take this as an opportunity to rethink our financial markets and how they serve our people. We should always take a crisis as a time when people are ready for change … We should use this as an occasion to further “democratize” finance; that is, to bring enlightened risk management more to the people. One thing I recommend in the book is the government ought to subsidize financial advice. This is a very unusual proposal; I don’t know if it’s been proposed before.
The way I think of it is, most people who are wealthy spend a good deal of money both on medical advice and on financial advice. Our government sees it is important that we subsidize medical advice for low-income people, but we don’t subsidize their financial advice at all. But they’re both important … Lots of people weren’t getting disinterested advice; there were mortgage brokers who were trying to sell them a mortgage, and that wasn’t the same as giving them honest advice.
TRD: Should there be some form of regulation of mortgage brokers?
RS: I think we would ideally have a consumer-oriented regulator. Right now … people in Congress like to operate within existing agencies, so we have the FHA, for example, involved in helping with the foreclosure crisis. But the idea of creating a new consumer protection agency is not prominent.
[U.S. Treasury] Secretary Henry Paulson issued earlier this year what was called a blueprint for financial regulation, and in that document he and his two co-authors advocated what they called a Business Conduct Agency within the government … But Paulson’s blueprint has not, as far as I know, received as of this date a favorable reception in Congress. [Home equity insurance policies are] something I’ve been advocating for years without success. This is the time to start it. On top of that, one thing I’ve been doing to try to facilitate home equity insurance is launching a futures market for single-family homes. So we tried to create a futures market and we have it going in Chicago now, but unfortunately it’s not very big yet, so we still don’t have the hedging market. I think it will take years to develop … You can see it: housing.cme.com.
TRD: How long will it take for this mortgage and credit crisis to play out at this point?
RS: I can’t give forecasts for home prices because I’m involved with production of indexes … The government has taken some steps. I’ve also mentioned that the Federal Reserve has done some rather aggressive things. For instance, it bailed out Bear
Stearns, and Bear Stearns is not a bank, it’s a brokerage firm. So the Fed was extending its mission. Ben Bernanke is … in a difficult situation now. Because of oil price increases, we’ve seen a resurgence of inflation. So at the same time the markets are going through a difficult period, and he might like to cut interest rates more, [but] there’s this inflation building up, so it’s hard for him to deal with this crisis.
TRD: Ultimately, what do you think he
should do?
RS: I think he has to stand ready to extend credit to troubled financial institutions … This goes again to bailing out Fannie and Freddie. Congress approved that with this bill passed last month, and I think that was a good thing to do, even though it’s going to generate criticism.
We can’t let the financial system collapse; there’s a possibility of a crisis in confidence if we let that happen. So the Fed is an important line of defense for this crisis … The Fed is a little bit hamstrung, so it’s possible that the credit crisis will continue for some time, but I’m hopeful that we as a nation will pull through and respond in creative ways to this crisis. That’s why I wrote the book; I wanted to encourage that.
TRD: I know the media coined the name ‘Dr. Doom’ for you; I was thinking you might prefer the name ‘Dr. Dose of Reality?’
RS: Or ‘Dr. Fix-it.’