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What do the recent housing bubble and the Titanic have in common? Conventional wisdom at the time said both were indestructible and neither provided enough support for its patrons.
This was the recurring analogy at the “Understanding the Housing Crisis” conference held at the Boston Federal reserve Wednesday (May 5) — an event co-sponsored by the Rappaport Institute for Greater Boston and the Taubman Center for State and Local Government. The Titanic analogy was presented by Paul Willen, senior economist and policy advisor at the Boston Federal Reserve, and other panelists expanded on that thought.
Edward Glaeser, director of the Rappaport Institute and the Taubman Center, presented new research from a policy brief titled, “Did Credit Market Policies Cause the Housing Bubble?” In his presentation, he compared the home mortgage interest deduction — a subsidy for potential homebuyers — to a subsidy for tickets to the Titanic. He said though the subsidy was not the only factor that led to homeowners borrowing more than they could afford — an approach he called irrational and unsustainable — it certainly did not help the situation.
“It’s just madness to encourage people to leverage themselves to the gill to bet on the vicissitudes of housing,” said Glaeser. “It just makes very, very little sense. It’s not a recipe toward encouraging asset accumulation – it’s a recipe for encouraging people to take on large amounts of risk.”
Eventually, by encouraging homeowners to over borrow, the subsidy contributed — along with many other factors — to a housing bubble. This bubble was caused by irrational expectations, but no one could describe where those expectations came from. There was consensus among the panelists that it is impossible to understand what causes these bubbles, but the government must work towards a solution to prepare for them in the future.
“These bubbles will continue,” said Glaeser. “We don’t understand them. It will take decades before we’re actually able to make sense of them and to figure out what policy cocktail will reduce the probability of these bubbles occurring.”
Harvard Kennedy School Dean David T. Ellwood, who moderated the event, echoed the difficulty in crafting public policy to prevent bubbles. But Ellwood pushed the panelists to dig for what exactly caused the bubble and provide some prescription of policy that could help.
“You left us with a lovely analogy that we didn’t have enough lifeboats and the Titanic,” said Ellwood to Willen. “But you didn’t tell us, however, what was the equivalent of requiring more lifeboats. Are we talking about reducing leverage? Tell us about what we should do.”
Willen responded with two policy recommendations: Limit the amount that people can borrow (based on their income) and insure owners from a precipitous drop in the value of their home.
“Certainly one of the things we can do is either to reduce the amount of leverage that people take so they have a bigger cushion when they buy the house,” said Willen. “And the other thing is a fixed-rate mortgage insures the borrower against interest rate risk, and I think there are probably financial innovations we need to work on that will insure people against house-price risk.”
In the end, the panelists agreed that reforming housing policy was necessary, despite the lack of simple, straightforward answers. Ellwood warned against rushing reform amidst anger and a desire for answers, and urged getting the policy done correctly instead of quickly.
“Everything is not as it seems,” he said. “And in times of great crisis people look for simple magic bullets, simple answers, simple explanations and so forth. And so one of the lessons here is: Stop and think. Don’t just instantly react. It’s very easy to make the medicine worse than the disease.”