The Great Recession's "biggest policy mistake"

Two recent books, Timothy Geithner's "Stress Test: Reflections on Financial Crises" and "House of Debt" by Atif Mian and Amir Sufi, have reignited a discussion over the Obama administration's policies and attitude on mortgage debt relief.

In contrast with the former New York Fed president and later Treasury Secretary's account about the efforts to save the U.S. economy from the collapsing housing market, others say the administration -- more particularly the Geithner-led Treasury -- did not push aggressively for mortgage debt relief .

As a result, very little was done to help households struggling with mortgage debt. Indeed, Mian and Sufi argue that "The fact that Secretary Geithner and the Obama administration did not push for debt write-downs more aggressively remains the biggest policy mistake of the Great Recession."

Who is correct?

It's important to understand that recessions can have many different causes, and the optimal response from policymakers depends critically on the type of recession that occurs. Recessions can be caused by oil price shocks, Fed-induced interest rate spikes, a fall in business and consumer confidence, a drop in productivity, housing bubbles, financial meltdowns and other factors that cause either a reduction in aggregate demand or supply.

And the correct policy response after, say, an oil price shock is very different from the policy needed to respond to fall in business and consumer confidence.

We have just experienced what's known as a "balance-sheet recession" caused by a popped housing bubble and severe problems in the financial sector. In this sort of recession, the balance sheets of households are impaired due to the loss of housing equity and the loss of retirement, education and other savings as stock and other asset values crash. Household balance sheets are also eroded as households that experience job losses dip into their saving to try to make ends meet.

The need for households to rebuild their balance sheets is one of the reasons it takes so long to recover from a balance-sheet recession. When the value of assets like housing equity, stocks and bonds fall while liabilities -- the high debt levels households accumulated prior to the crash -- remain, households begin trying to restore what was lost by reducing consumption and increasing saving.

This process is very slow, taking years for households to pay down debt and rebuild what was lost, and the reduction in the consumption of goods and services as savings rise is a drag on the economy that makes it harder for a recovery to take hold. A "lost decade" like Japan has experienced is more than possible.

The balance sheets of financial institutions were also severely damaged as the assets they held lost value during the crash. Many of these institutions became illiquid and insolvent as a result. The government's response was to institute programs such as TARP that helped to restore the balance sheets of financial institutions, and these programs were very successful. Banks had a tough time to be sure, but the bailout worked, and today the banking sector has largely recovered from its ills.

Unfortunately, households didn't get the same amount of help in large part due to the opposition of Geithner's Treasury. That's why I concur with Mian and Sufi that this is "the biggest policy mistake of the Great Recession." A policy that would have provided households with mortgage debt relief could have made a big difference to those trying to rebuild their balance sheets and eliminate debt.

But households didn't get the kind of attention that big banks got. Instead, Americans were forced to mostly rebuild on their own, and this is a primary cause of the ongoing, slow recovery. It would have still taken time to recover even if households had been helped the way banks were helped. A nation can't quickly dig out of a recession that's so deep -- but it didn't have to take as long as it has.

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