Larry Summers’ Sleepless Nights
July 29, 2014
by Michael Edesess
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Former U.S. Treasury Secretary Lawrence Summers began his review in the June 6 Financial Times of House of Debt, by Atif Mian and Amir Sufi, with high praise: “Atif Mian and Amir Sufi’s House of Debt, despite some tough competition, looks likely to be the most important economics book of 2014; it could be the most important book to come out of the 2008 financial crisis and subsequent Great Recession.”
In a year that saw the publication in English of Thomas Piketty’s Capital in the Twenty-First Century, a book that Summers also praised highly, this is a thundering endorsement. In the case of the Mian and Sufi book, however, what Summers really meant was that the book hit a nerve.
Mian and Sufi, professors at Princeton and the University of Chicago, respectively, have two important messages. The first is that the debt contract is a very poor instrument on which to base a stable economy. “If we are to avoid the painful boom-and-bust episodes that are becoming all too frequent,” say Mian and Sufi, “we must address the key problem: the inflexibility of debt contracts.” They propose an alternative that I will discuss later.
Their second message, occupying most of the book, is that the most commonly accepted explanation of the Great Recession is wrong. They call this explanation the “banking view,” which “holds that the central problem with the economy is a severely weakened financial sector that has stopped the flow of credit.” Mian and Sufi show very persuasively that this view is wrong, and they fault the economics profession for the prevalence of this explanation.
Mian and Sufi believe that because the banking view of the Great Recession is inadequate, the solution of saving the banks was bound to be insufficient to forestall a prolonged economic slowdown. Therefore, they argue that much more effort and resources should have gone into the relief of homeowner debt.
This is where their message hits Summers where it hurts. He does give Mian and Sufi enormous credit for their analysis, but then goes on to criticize them severely for being naive about the realities of policy choices.
I will come back to Larry Summers’s reaction, but first let us look at Mian and Sufi’s arguments. Frequently, evidence in economic analyses is little better than anecdotal. Mian and Sufi’s analysis, however, does live up to the higher standard. It could serve as the paradigm of empirically-based analysis to which all economic studies should aspire.
Unraveling the causes of the Great Recession
Mian and Sufi paint the history of the Great Recession in familiar terms. A pattern of low-quality securitized lending caused a housing bubble: “From 2002 to 2005, credit flooded into low credit-score zip codes. Mortgages originated for home purchase grew 30% per year, compared to only 11% in high credit-score areas.” When the bubble burst it wreaked havoc, engendering a prolonged economic slump.
What is unique about the Mian and Sufi analysis is that they take great pains to construct the sequence of events and establish causation. In particular, they rebut the banking view, which states that it was difficult to get the economy moving again after the crisis because banks were reluctant to lend. The consequent drying-up of credit, according to this view, especially to small businesses, put a damper on economic recovery.
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