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Easy Credit, Hard Landing

The financial insights of Raghuram Rajan.

Jul 26, 2010, Vol. 15, No. 42 • By CHRISTOPHER CALDWELL
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Under such circumstances, any recession with the slightest perceptible effect on the public will end political careers by the score. And recessions are, alas, inevitable. The result, under both Democratic and Republican leadership, has been reckless government extension of credit. As a remedy for downturns, this has two political advantages. First, it does not bother conservatives as much as handouts do. Second, “easy credit has large, positive, immediate, and widely distributed benefits, whereas the costs all lie in the future. It has a payoff structure that is precisely the one desired by politicians, which is why so many countries have succumbed to its lure.” You might say that the financial crisis reflects the emergence of the off-balance-sheet liabilities—the human costs—of deindustrialization.

This is an account of what ails us that is radically at odds with the familiar tale of greedy bankers in $5,000 suits. “Almost every financial crisis has political roots,” Rajan writes. The credit market—at least as regards housing—was distorted by government policy, not by a sudden and mysterious escalation in “greed.” The trends that shook the world economy came out of Fannie Mae and Freddie Mac, out of the Federal Housing Administration, and out of their “regulator,” the U.S. Department of Housing and Urban Development.

By 2000, HUD required that low-income loans make up 50 percent of Fannie and Freddie’s portfolios. Out of “compassionate conservatism,” perhaps, the Bush administration raised that mandate to 56 percent. Rajan cites Fannie Mae’s former chief credit officer, Edward Pinto, who notes that, by 2008, “the FHA and various other government programs were exposed to about $2.7 trillion in subprime and Alt-A loans, approximately 59 percent of total loans to these categories.” Peter Wallison of the American Enterprise Institute found that government-mandated loans accounted for two-thirds of “junk mortgages.” 

Another way of looking at this problem is provided in a study done by Rajan’s Chicago colleagues Atif Mian and Amir Sufi. They found that, if you look at the period between 2002 and 2005, the number of mortgages obtained in a given ZIP code “is negatively correlated with household income growth.” In other words, lenders preferred un-creditworthy borrowers to creditworthy borrowers. In a market governed by “greed” and undistorted by government pressure, such a result would make no sense.

It is important to note that the “bubble” part of our real-estate crisis was not especially severe. U.S. housing prices, although they rose unduly, were never nearly as out-of-whack as they became in the past decade in Ireland, Spain, or the United Kingdom or as they became in the late 1980s in Japan. The problem was not so much the amount of collateral people got access to through home-equity loans; it was that they were not well-enough vetted for credit-worthiness—at any level of borrowing—to begin with. Almost everyone has rued that sometime in the past generation, the old-fashioned method of checking out mortgage applicants—through face-to-face interviewing and rigorous investigation of applicants’ character and community standing—gave way to an anonymous, bureaucratic, arm’s-length process that could easily be abused. This was damaging in Rajan’s view. “The judgment calls historically made by loan officers were, in fact, extremely important to the overall credit assessment,” he writes. “It really does matter if the borrower is rude, shifty, and slovenly in the loan interview.” 

The change in procedures was not just a matter of bankers’ forgetting or growing sloppy. To inquire too closely into borrowers’ creditworthiness would leave bankers in danger of falling afoul of antidiscrimination laws, particularly after Bill Clinton vowed to crack down on alleged “red-lining” (racial prejudice in mortgage lending) in the 1990s. George W. Bush’s decision to raise the quotas for low-income lending from 50 to 56 percent of loans certainly strikes us today as foolhardy. But can there be any doubt he would have been pilloried as a racist had he sought to lower them? The Indian-born Rajan never enunciates the unavoidable conclusion, but he is constantly walking much closer to it than any American-born academic would dare to: The finance crisis also reflects, in part, the emergence of the off-balance-sheet liabilities of a kind of affirmative action.

The overarching point is that, whereas European countries until about a decade ago addressed sluggish job creation by expanding their welfare states (which made job creation more sluggish still), the United States chose a different path that proved just as counterproductive. It spread a safety net under its less fortunate citizens through wanton credit creation. And the terrible problem of credit is that it resembles alcohol—as the dosage rises, the problems get bigger, but so does the capacity to ignore them.

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