Credit Allocation

Doug Noland

June 6, 2014 

Signs of an upside dislocation

Total (financial and non-financial) Credit jumped $484bn during Q1 to a record $59.399 TN, or 347% of GDP. Although economic growth faltered during the period, Q1 2014 Total Non-Financial Debt (NFD) expanded at a 5.0% rate. Corporate borrowings grew at a robust 9.3% pace, up from Q4’s 7.7% and Q1 2013’s 7.2%. Federal government debt mounted at a 7.1% rate, down from Q4’s 11.6% and Q1 2013’s 10.1%. Consumer Credit accelerated from Q4’s 5.3% rate to 6.6% - the strongest increase in borrowings since Q2 2012. Consumer Credit expanded 4.1% in 2011, 6.2% in 2012 and 5.9% in 2013. If Q1 consumer borrowing is sustained, 2014 will post the strongest consumer (non-mortgage) debt growth since 2001 (8.6%).

The historic increase in federal debt runs unabated. Recall that federal government debt expanded 24.2% in 2008, 22.7% in 2009, 20.2% in 2010, 11.4% in 2011, 10.9% in 2012 and 6.5% in 2013. Federal debt has increased $9.718 TN, or 145%, in 23 quarters. The ongoing expansion of corporate debt is also noteworthy. Corporate debt expanded 8.3% in 2012 and another 8.9% in 2013significantly exceeding the growth in the real economy. We’re in the midst of the strongest corporate debt expansion since the 9.2% in 2006 followed by 13.5% in 2007.

The Household (& Non-profits) Balance Sheet remains key to current Credit Bubble analysis. Household Assets increased $1.506 TN during the quarter to a record $95.549 TN. And with Household Liabilities up only $16.7bn, Household Net Worth jumped another $1.490 TN during the quarter. Over four quarters, Household Assets surged $8.189 TN, or 9.4%, with Liabilities increasing $209bn (1.5%). Household Net Worth surged $7.98 TN, or 10.8%, over the past year.

During the past four years, Household Net Worth has inflated an unprecedented $26.797 TN, or 49%. Over this period, Household holdings of Financial Assets have surged $22.0 TN, or 49%, to a record $67.2 TN. On the back of the QE3 liquidity onslaught, Household Net Worth jumped from 417% of GDP at mid-year 2012 to the recent 478% (and counting!). For comparison, Household Net Worth as a percentage of GDP peaked at 447% during the manic height of the “tech Bubble (Q1 2000).

Analyzing the Fed's most-recent Z.1flow of fundsreport recalls 2007 market exuberance. Looking back at the data, Non-financial Debt (NFD) growth increased to a blistering $2.344 TN in ‘07. Total Mortgage Debt growth, while slowing somewhat from the record 2004-2006 period, was still almost $1.1 TN (vs. 90’s average $268bn). Total Business borrowing rose to a record $1.045 TN. It was easy to ignore some subprime tumult with the economy seemingly firing on all cylinders.

Importantly, near-record 2007 NFD growth was matched by record Financial sector debt expansion. Financial sector borrowings increased an unprecedented $1.944 TN (up from ‘06’s $1.30 TN and ‘05’s $1.08 TN) to $17.103 TN. This pushed six-year growth of Financial sector borrowings to $7.077 TN, or 78%. At the time, I saw the “parabolicfinancial sector ballooning as a major problem. For one, it was indicative of ever heavier financial sector intermediation – the “Wall Street Alchemynecessary to transform progressively risky loans into perceived safe/“money”-like instruments. This unrecognized spike in systemic risk was occurring even in the face of initial cracks in mortgage finance. Actually, subprime stench had the markets salivating over imminent monetary accommodation. The Fed cut the discount rate in an unscheduled meeting on August 17th and pushed rates 100bps lower by year-end. The S&P 500 traded to its then all-time high in October 2007, less than a year away from the abyss.

For the year 2007, GSE issues (debt & MBS) increased $887.6bn, up from 2006’s $331bn growth. Outstanding ABS increased $350bn. Net Corporate bond issuance was a strong $709bn. A highly unbalanced financial and economic system was becoming only more vulnerable to what I believed was an imminent market tightening of Credit and resulting mortgage downturn. I saw fragility from a highly leveraged system and a heavily imbalanced real economy addicted to enormous amounts of cheap Credit and liquidity

There was acute fragility associated with gigantic speculative leverage in securities and instruments with market prices detached from unfolding fundamental developments. Despite record stock prices and a resilient real economy, the risk of a problematic period of speculative de-leveraging was extreme and growing.

I'll try to explain what I see as current parallels. Federal Reserve Credit has been this cycles’ prevailing source of liquidity, “moneydistorting pricing, risk perceptions and the flow of finance through both the markets and real economy. Importantly, this key source of financial Credit is supposedly ending in a few short months. And like 2007, highly speculative financial Bubble markets choose to disregard fundamental prospects and instead go into destabilizing blow-off mode. Indeed, deteriorating prospectsalong with accompanying shorting and hedging provide market melt-up fuel.

In the 23 quarters Q3 2008 through Q1 2014, Federal Reserve Credit expanded $3.338 TN, or 351%. Over the final parabolicexpansion, Fed Credit/liquidity has surged $1.474 TN, or 52%, in the past 82 weeks. The S&P 500 has increased 50% from June 2012 lows – and is now up 122% from March 2009 lows. Over this period, the small caps have gained 140% and the Morgan Stanley High Tech index has surged 215%.

Similar to 2006/07, a huge expansion in Financial sector Credit stokes an ongoing boom in corporate Credit. A replay of Chuck Prince’sstill dancinglending euphoria ensures a problematic Credit cycle downside. It is these days worth noting that net issuance of Corporate and Foreign Bonds increased $873bn in 2005, $1.242 TN in 2006 and a record $1.251 TN during (an oblivious) 2007. The 2008 Credit dislocation saw Corporate debt contract $215bn – a harsh reminder of how abruptly the Credit cycle can reverse course and bury folks.

It is worth recalling that Non-financial Debt (NFD) growth averaged $720bn annually during the nineties. It jumped to $1.046 TN during bubbling 1999. After a brief slowdown in 2000, aggressive Fed stimulus (and a resulting surge in mortgage borrowings) had NFD growth back in record territory in 2001 at $1.147 TN. NFD growth then jumped to $1.420 TN in 2002 and $1.716 TN by 2003. Fast-forward to 2007 and NFD expansion had jumped to $2.59 TNmore than triple the average from the nineties.

It’s central to my Macro Credit Analytical Framework that prolonged Credit inflations/Bubbles inflate myriad price levels throughout the markets and real economy. After years of Bubble distortions, even the $942bn growth in NFD growth during 2009 was woefully insufficient to sustain real estate, stock and asset prices; as well as incomes, spending and corporate profits in the real economy. Market dislocation abruptly closed the Credit/liquidity spigot for key sectors.

Since the collapse of the mortgage finance Bubble, I have posited that it would require in the neighborhood of $2.0 TN of annual NFD growth to fuel a self-reinforcing recovery in asset prices and economic activity. 
While I expected the federal government to run big deficits, it was not obvious at the time that a rapid doubling of Federal debt would be accommodated at historically low borrowing costs. The key has been a previously unimaginable inflation in Federal Reserve Credit - liquidity that has inundated the securities market and inflated asset prices almost across the board.

The Fed did succeed in rejuvenating strong Credit growth. Q1 2014 NFD was reported at a Seasonally-adjusted and Annualized Rate (SAAR) of $2.113 TN – with NFD growth now above my $2.0 TN bogey for two straight quarters. Considering the degree of Credit expansion, the performance of the economy has been most unimpressive (Q1 GDP up SAAR $11.7bn). I’m further troubled by the composition of the recent Credit expansion. Over the past six months, the $2.0 TN bogey has been achieved with federal debt growth of SAAR $1.1 TN and total Business borrowing at about SAAR $940bn. I would argue that large federal borrowings coupled with corporate debt funding M&A and stock buybacks (“financial engineering”) provide the real economy little bang for the Credit buck. Indeed, the massive inflation of Fed Credit has chiefly fueled dangerous speculation and runaway Bubbles in securities and asset prices. The divergence between inflated asset prices and deflating fundamental prospects now widens by the week.

I have repeatedly drawn parallels between the current extraordinarily protracted Credit Cycle and that from the WWI to 1929 period. Both share similar characteristics of profound technological advancement, “globalization,” financial innovation, experimental activism in monetary management and resulting prolonged Credit, speculative and economic cycles.

Late during the “roaring twentiesBubble period, prices, finance and economic performance all began functioning abnormally. There was confusion. In hindsight, there were obvious warningsYet at the time they were so easily drowned out by a boisterous financial mania. There was the camp that accurately recognized and feared the consequences of historic Credit excess. They argued unsuccessfully for policy-makers to rein in the Bubble to save the financial system and economy from catastrophe (Bernanke’s Bubble poppers”). The Federal Reserve repeatedly acted to reinforce the boomin the end believing downward pressure on prices and associated economic vulnerability dictated ongoing monetary accommodation.

Our central bank at the time was certainly not unaware of the stock market Bubble. The Fed’s focus turned to trying to ensure Credit was allocated to productive endeavors in the real economy rather than to the market exchanges. There were two sides to this debate. The “Bubble poppers” were again correct in stating that it was fallacy to expect that Fed measures could ensure Credit was used productively, not when the pricing and profit backdrop in the real economy was so weak compared to the enormous gains being achieved in the booming securities markets.

The ECB this week introduced targeted long-term refinancing operations” (TLTRO). Despite a historic collapse in sovereign yields and booming stock markets, the Eurozone economy is expected to grow only 1% this year. Many fear that downward pricing pressures are intensifying. In Europe, as around the globe, central bank liquidity has stoked heated financial speculation as economies and prices have continued to cool. The European Central Bank’s plan is to lend to banks specifically to finance loans to business and the real economy. Good luck with that, with feeble return prospects in the real economy paling in comparison to outsized speculative returns so easily achieved in manic securities markets.

The markets foresee only more central bank liquidity making its way to enticing market Bubbles. Italian 10-year sovereign yields sank 20 bps points this week to a record low 2.76%. Imagine a country with complete economic stagnation and debt-to-GDP approaching 130% - and borrowing at yields below 3%. This week saw Spain’s yields sink another 22 bps to a record low 2.63%. Portuguese yields sank 11 bps to a near-record low 3.52%. With mounting debt and deep economic problems, French yields ended the week at 1.70%. A strong case can be made that the European debt Bubble has inflated into one of history’s greatest mispricings of debt securities. European bonds – and global risk markets more generally – are showing signs of upside dislocationlikely spurred by derivatives and speculative trades gone haywire. The “global government finance Bubble thesis finds added confirmation on a weekly basis.

June 6 – Bloomberg: China’s banking regulator vowed to expand loans and cap borrowing costs, seeking to boost the supply of funds to the real economy as growth slows amid a clampdown on shadow financing. Lending to small businesses, major infrastructure projects and first-home buyers will be a priority, the China Banking Regulatory Commission said… To give banks more capacity to lend, the regulator may ease the ratio of loans to deposits by including some stable sources of deposits in the calculation, CBRC Vice Chairman Wang Zhaoxing said… The CBRC will also take measures to rein in bubbles in the nation’s real estate market because reliance of the economy on property and too much credit exposure to the sector could damage the financial system, he said.’”

Predictably, China is also focused on boosting the “supply of Credit to the real economy.” After allowing their Credit and economic Bubbles to run completely out of control, Chinese officials now confront a monumental task. They must attempt to rein in speculative Credit excess and financial fraud, while ensuring that the “realeconomy receives sufficient Credit to stave off collapse. Acute addiction to copious cheap finance is a fundamental dilemma associated with drawn-out Credit Bubbles. An inevitable tightening of financial conditions (less Credit Availability and associated higher borrowing costs) exposes previous fraud, malfeasance and mal-investment – in the process spurring the self-reinforcing downside to the Credit cycle.

China still retains unusual capacity to sustain lending and Credit growth. Yet, at this point, only a more damagingTerminal Phase” of excess is ensured. From my perspective, it will take an enormous amount of ongoing Credit to hold a nasty Chinese financial and economic downside at bay. This portends serious trouble for the Creditworthiness of the now behemoth Chinese banks as well as the sovereign.

Here in the U.S., with our booming markets dragging the listless economy along, there’s not much talk of Credit allocation. With Bubble excessstocks, bonds, corporate Credit, “tech,” etc. – increasingly hard to ignore, there appears to finally be some concern building at the Fed. The headline from Jon Hilsenrath’s Tuesday WSJ article readFed Officials Growing Wary of Market Complacency.” This was toned down from the original Dow Jones Newswire headline: “Fed Worried Calm Markets Forecast A Storm to Come.” 

Federal Reserve Bank of Kansas City President Esther George was out again this week with her rational raise ratessooner and faster” than the dovish consensus. “My concern is that keeping rates very low into late 2016 will continue to incentivize financial markets and investors to reach for yield in an economy operating at full capacity, posing risks to achieving sustainable growth over the longer run.”

Back in 2007, with cracks forming in mortgage finance, I spent a lot of time pondering how the system could possibly generate sufficient Credit to fuel such an unbalanced and maladjusted economic structure. I have similar concerns today. If Fed Credit growth disappears, I just don’t see how the necessary $2.0 TN of non-financial sector debt growth will be sustained. There is little indication that mortgage Credit expansion will provide much help. Federal deficits are supposed to continue to decline, while state & local government borrowings remain minimal. Corporate Credit growth could continue to boom, although the marketplace appears more late-cycle euphoric to me.

Yet there remains a critical unknown. We are, after all, in the midst of the “Granddaddy of all Bubbles” – and when and how this all concludes nobody knows. It’s an important aspect of Bubble Theory that leverage associated with speculative Bubbles creates its own self-reinforcing liquidity. So I will posit that so long as this Bubble continues to inflate at such a fervent pace, the tapering of Fed Credit has little impact. However, the bigger these Bubbles inflate the greater the risk of a destabilizingrisk offbout of de-risking/de-leveraging. What is a leading catalyst for puncturing a speculative market Bubble? The unsustainability of parabolic blow offspeculative excess.

The next risk offperiod will find participants contemplating a marketplace without constant Federal Reserve liquidity injections. The markets will fret about life without an open-ended Fed QE backstop. Will the Fed be there with its typical timely reinsurance – or might a divided Fed struggle to live up to Dr. Bernanke’s promises? For now, it’s exuberanceemboldened by the notion that persistentdeflationrisks will keep global central bankers in an accommodating and experimental mood.

June 6, 2014 1:14 pm

Lawrence Summers on ‘House of Debt’

Did the response to the financial crisis focus too much on banks while neglecting over-indebted homeowners?

USA. Fort Myers, Fla. October 2008. Foreclosed house.©Bruce Gilden/Magnum Photos
A foreclosed house in Fort Myers, Florida, in October 2008

House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again, by Atif Mian and Amir Sufi, University of Chicago Press, RRP£18/$26, 192 pages

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. Its arguments deserve careful attention, and its publication provides an opportunity to reconsider policy choices made in 2009 and 2010 regarding mortgage debt.

House of Debt is important because it persuasively demonstrates that the conventional meta-narrative of the crisis and its aftermath, which emphasises the breakdown of financial intermediation, is inadequate. It then goes on to provide a supplementary and in some ways alternative explanation focusing on the deterioration of household balance sheets, an analysis that has profound implications for policy directed both at preventing crises and responding to them when prevention fails.

The book is largely free of equations, jargon, econometrics or data tables. However, no reader should be deceived. It is a summary of a highly serious programme of economic researchone that is in many ways a model for what economists should do

Mian and Sufi, professors at Princeton and the University of Chicago respectively, have examined a profoundly important question: what causes protracted downturns in economic activity? They have marshalled new data – for example, on spending by zip code – to test their hypotheses, assembling such a range of evidence from so many different sources that their conclusions are not susceptible to challenge by those looking to point out statistical errors.

Most in the financial community, the policy community and the commentariat see a breakdown in financial intermediation as the root cause of the financial crisis and Great Recession. The failure to bail out Lehman Brothers is usually viewed as the prelude to crisis intensification. Published accounts by leading actors such as Henry Paulson, Sheila Bair and Timothy Geithner provide a narrative of bailout decisions made with respect to Bear Stearns, Lehman, Fannie Mae and Freddie Mac, Wachovia, Washington Mutual, Bank of America and Citi that brings to mind generals’ war memoirs as they describe the various battles they fought to keep financial institutions, or at least their lending, alive. And the debates about crisis prevention, as illustrated most vividly in the context of the Dodd-Frank regulatory legislation, centre around policies towards banks and the shadow banking system.

Mian and Sufi point out a variety of problems with this approach. First, they note that data on credit spreads suggest that the financial system was fully repaired by late 2009, and that even though the economy at that point was very depressed, growth has been anaemic since. Second, they observe that spending on housing and durable goods such as furniture and cars decreased sharply in 2006 and 2007, well before any financial institution became vulnerable. Likewise, they note that the initial impetus behind recession in the US appears to have been a decline in consumer spending. Additionally, the authors observe that when asked why they were not borrowing more, even small businesses, the sector most dependent on banks, more often than not blamed a lack of customers rather than banks’ unwillingness to lend.

None of this sits easily with what Mian and Sufi call the banking view of the Great Recession. They argue that, rather than failing banks, the key culprits in the financial crisis were overly indebted households

Resurrecting arguments that go back at least to Irving Fisher and that were emphasised by Richard Koo in considering Japan’s stagnation, Mian and Sufi highlight how harsh leverage and debt can be – for example, when the price of a house purchased with a 10 per cent downpayment goes down by 10 per cent, all of the owner’s equity is lost. They demonstrate powerfully that spending fell much more in parts of the country where house prices fell fastest and where the most mortgage debt was attached to homes. So their story of the crisis blames excessive mortgage lending, which first inflated bubbles in the housing market and then left households with unmanageable debt burdens. These burdens in turn led to spending reductions and created an adverse economic and financial spiral that ultimately led financial institutions to the brink.

This interpretation resolves the anomalies that Mian and Sufi highlight. Households do not spend while they are still overly indebted, which precipitates slow growth even after banking is restored to health. Spending slowdowns are caused by household over-indebtedness, so of course they precede problems in the banking system. And, when consumers do not spend, businesses have less need to borrow to finance investment, inventories or receivables.

Their analysis, presented with far more depth and subtlety than I have been able to reflect here, is a major contribution that furthers our understanding of the crisis. It certainly affects what I will examine in trying to predict and forestall future crises. And it should influence policies aimed at crisis prevention by demonstrating the insufficiency of keeping financial institutions healthy and by making a case for macroprudential measures directed at preventing runaway growth in household debt.

When one has a persuasive and novel idea, there is an inevitable temptation to push it a bit too far and to weight it excessively relative to less novel truths. Mian and Sufi succumb to this temptation in the last third of their book, where they discuss the policy responses to the crisis. Like the 2005 homeowners used to capital gains, they are unable to resist doubling down by levering up.

They are sharply critical of what they see as the dominance of the banking view over their preferred levered losses view. At points they are not completely clear but Mian and Sufi mostly, if reluctantly, accept the necessity of action to support the financial system once the fires were burning. It is difficult to see how any prudent policy maker, after witnessing the Armageddon that followed the collapse of Lehman, could have failed to take steps to prevent further collapses. Certainly, plenty of tactical questions can be raised about the steps that were taken

With hindsight some argue that more pain should have been imposed on the financial sector. In the moment, though, the overwhelming imperative was restoring confidence at a time when complete breakdown looked like a real possibility. The government got back substantially more money than it invested. All of the senior executives who created these big messes were out of their jobs within a year. And stockholders lost 90 per cent or more of their investments in all the institutions that required special treatment by the government.

Aside from a few undeveloped questions about whether less could have been done to bail out bondholders while saving the financial system, Mian and Sufi do not really challenge any of this. Instead, they train their fire on policy makers’ failure to take proper account of the levered losses view by providing far more sweeping mortgage relief. They argue that if policy makers had better appreciated their arguments about household balance sheets and been less cognitively captured by banking system concerns, the outcome could have been much better.

Obviously, as the director of President Barack Obama’s National Economic Council in 2009 and 2010, I am an interested party here. It seems to me that Mian and Sufi are naive on policy and contribute much less to the debate on this than they suppose. Their indignation seems to get the better of them as they move from citing the Quarterly Journal of Economics to the National Journal, and from Irving Fisher to Bloomberg News; and, for all their commitment to careful scholarship, they seem not to have spoken to those involved in making policy towards housing during the crisis.

We all believed in 2009 what Mian and Sufi have now conclusively demonstrated – that reducing mortgage debt would spur consumer spending. And there was intense frustration with how few homeowners our programmes were reaching, to the point where I convened all the relevant officials from the Treasury, the Housing and Urban Development department and other agencies every month for two years to challenge them to find ways to accelerate the process and to make sure that they were considering all the various schemes academics and others were suggesting. So Mian and Sufi are not wrong in their dissatisfaction.

Where they do, in my view, go badly wrong is in suggesting that the failure to do more for underwater homeowners reflected a blinkered attachment to an at best incomplete, and at worst harmful, banking-based view of what was happening. Mian and Sufi’s error is a common one among academic economists, many of whom are unwilling to try to understand policy choices that arise from considerations outside simple models.

Start where Mian and Sufi start, with the idea of “cram-down”: the notion that bankruptcy judges should be allowed to write down mortgage debt, and that permitting them to do so would increase the bargaining power of homeowners seeking relief. Although it is more complex than Mian and Sufi suggest, I believe on balance this would have been better public policy, and so argued vigorously in these pages in February 2008.

Why didn’t the administration push for such legislation? Simple. The judgment of the president and his advisers was that there was essentially no chance of it getting the requisite 60 votes in the Senate, where we were not even able to muster a simple majority. Should a more Herculean effort have been made? Perhaps

But the president and his team felt that in a world where many legislative battles lay ahead, a failure on cram-down would be costly in time and political capital. Critics who disagree at this late date are obliged to provide an alternative analysis of the political calculus, not a mere recitation of the arguments for cram-down.

What about the various ideas put forward for bringing about mortgage relief through either coercion or financial inducement? Mian and Sufi’s impressive empirical work demonstrates that households have a propensity to spend perhaps 15 per cent of any debt reduction they receive. So if on very generous assumptions $3tn of mortgage debt was written down by a third, thus reducing $1tn in mortgage debt, this would have added $150bn or 1 per cent of gross domestic product to spending at time when the output gap was close to 10 per cent of GDP. In assessing this benefit, we were very mindful of the Hippocratic Oath’s admonition – “first, do no harm” – and took into account a variety of considerations that Mian and Sufi do not seriously discuss.

First, there was the risk of bringing down the system in an effort to save it. Banks had substantial mortgage holdings and especially large quantities of subordinated second mortgages and home equity lines of credit, which would have been wiped out if mortgage principal had been reduced in a way that respected the seniority of first mortgages. 

We recognised that large-scale principal reduction would draw in a large number of mortgages that were not delinquent and would otherwise be paid in full. As a consequence, there was the risk of sucking hundreds of billions of dollars out of the banking system. Given that government funds for capital infusions were scarce and that each dollar of bank capital supports $12 of lending, we worried that the spending gains from reducing mortgage debt might well be exceeded by the spending losses from reducing the flow of capital. This fear may have been exaggerated. If they think so, Mian and Sufi owe an explanation as to why.

Second, there was the issue of chilling future lending. Like the Brady plan for Latin America, most debt reduction schemes are voluntary, at least on their face. This is because of a fear that if the government simply starts requiring creditors to write down debts, especially debts that are being serviced, or rearranging creditor priority, the flow of future credit will be inhibited. 

It did not seem unreasonable to worry at the time that if government forced the write-off of a trillion dollars of mortgage debt, flows of not only mortgage debt but also car loans and credit card debt to consumers would be inhibited as well. This was not a small concern, as the automobile industry was in freefall and consumer confidence was deteriorating very rapidly.

Third, there was the danger of prolonging the housing market’s problems. Even the relatively limited programmes in place have spent as much as a third of their money delaying, rather than avoiding, foreclosures. All that we heard at the time suggested that a significant part of the reason why the housing market was dead was that no one wanted to buy because of a fear that it had further to fall. Delaying inevitable foreclosures with relief risked exacerbating this problem and risked larger foreclosure discounts when houses were ultimately sold.

Fourth, there were regulatory issues. For example, we spent a great deal of time looking at ideas that involved the government buying underwater mortgages from banks on the general model of the Home Owners’ Loan Corporation scheme pursued during the Great Depression. The problem was that in many cases mortgage assets were carried on banks’ books at valuations far above what appeared to be current market value. Buying them at such valuations would have been a massive backdoor subsidy to banks of the kind we would not accept. Forcing writedowns was precluded for regulators who feared what it would do to banks’ capital positions.

Fifth, anyone who has worked in government knows that it is much easier to design policy than to implement it. We were, for example, very aware of the traditional idea that at moments of financial distress it is necessary to convert fixed debt claims into equity and explored all sorts of ideas for writing down mortgages and giving creditors claims on subsequent home price appreciation that would liquefy when the home was sold. Our conclusion was that the administrative capacity to negotiate such arrangements and then to track them through time and collect when homes were sold could not be brought into existence in a reasonable time.

Looking back, there are things I wish had been done differently, such as putting in place more satisfactory leadership at the Federal Housing Finance Agency and more effectively mobilising Fannie Mae and Freddie Mac to help bolster the housing market. The various liberalisations of the Home Affordable Modification Program and the Home Affordable Refinance Program that were put into place over time should, with the benefit of hindsight, have been introduced at the beginning

We may well have misjudged some risks or missed important opportunities to carry out effective policy. Certainly, I have stayed up at night while in government and afterwards worrying over these possibilities. But seriousness requires grappling with the challenges that policy makers perceived, not merely pointing out the importance of debt and citing various plans that were put forward in op-eds. Perhaps this can be the authors’ next project.

The reality that the post-crisis policy challenges were more complex than they recognise detracts only slightly from Mian and Sufi’s accomplishment in House of Debt. All future work on financial crises will have to reckon with the household balance sheet effects they stress. After their work, we can still believe in the necessity of financial rescues; however, we can no longer believe in their sufficiency. And after their work, we have an important new agenda of reforms to consider if future crises are to be prevented.

Lawrence Summers is Charles W Eliot University Professor at Harvard and a former US Treasury secretary