Volume 55, Number 10 · June 12, 2008
Economics: Which Way for Obama?
By John Cassidy
Nudge: Improving Decisions About Health, Wealth, and Happiness
by Richard H. Thaler and Cass R. Sunstein
Yale University Press, 293 pp., $26.00
THE BURSTING OF THE housing bubble and the associated credit crunch has so far wiped out about $3 trillion of wealth—nobody knows the exact amount—caused havoc in the financial markets, and prompted hundreds of thousands of homeowners to default on their monthly mortgage payments. Some experts predict that by the end of 2009, the number of homes entering foreclosure could reach two million. Not surprisingly, the question of what to do about the housing crisis has emerged as a divisive policy issue in the 2008 presidential election, with each of the three leading candidates representing a distinct economic ideology.
John McCain, for all his protestations that economics is not his strong point, has put forward a coherent, if somewhat heartless, case for doing nothing, or very little, anyway. Echoing the arguments that Andrew Mellon, Friedrich Hayek, and other enthusiasts of the free market espoused in the early years of the Great Depression, McCain has said it is no business of the government to bail out people who took out loans they couldn't afford. Evidently such socialistic interventions would only reward reckless behavior, and, in any case, they wouldn't work. The laissez-faire argument says it is better to let the market "correct"—i.e., let the foreclosures mount up—until people learn to live within their means and prices become more affordable, at which point sustainable economic growth will resume.
Hillary Clinton, after initially equivocating, has emerged as the would-be heir to FDR and John Maynard Keynes. In addition to imposing a ninety-day moratorium on foreclosures and a five-year freeze on certain adjustable mortgage rates, she would have the federal government buy up an undetermined number of troubled home loans, enabling lenders to convert them to more affordable deals and putting a floor under the housing market.
Clinton would also allow bankruptcy judges to reduce the value of mortgages, a proposal the banking industry vigorously opposes, and she has criticized McCain as the reincarnation of Herbert Hoover—a comparison that is a bit unfair to the thirty-first president, whose intellectual commitment to voluntarism didn't prevent him from expanding public works programs, raising taxes on the wealthy, and creating two institutions that funneled federal money into the housing market: the Federal Home Loan Bank and the Reconstruction Finance Corporation.
Barack Obama has also criticized McCain for sitting back and watching while so many American families face eviction. Yet his own proposals are more nuanced than Hillary's. They include setting up a $10 billion fund to help prevent foreclosures, cracking down on mortgage fraud, providing tax credits to low- and middle-income homeowners who don't currently itemize their interest payments, and standardizing the terms of mortgages so that potential borrowers can more easily figure out when they are being hoodwinked. Obama has also expressed support for Democratic Senator Chris Dodd's plan to expand the Federal Housing Administration's ability to refinance troubled loans. So far, though, he has been noticeably less enthusiastic than Clinton about a large-scale injection of public funds into the market for mortgages and mortgage securities.
Should Obama win the nomination, political considerations may well force upon him a more interventionist position, but his first inclination is to seek a path between big government and laissez-faire, a trait that reflects his age—he was born in 1961—and the intellectual milieu he emerged from. Before entering the Illinois state Senate, he spent ten years teaching constitutional law at the University of Chicago, where respect for the free market is a cherished tradition. His senior economic adviser, Austan Goolsbee, is a former colleague of his at Chicago and an expert on the economics of high-tech industries. Goolsbee is not a member of the "Chicago School" of Milton Friedman and Gary Becker, but he is not well known as a critic of American capitalism either. As recently as March 2007, he published an article in The New York Times pointing out the virtues of subprime mortgages. "The three decades from 1970 to 2000 witnessed an incredible flowering of new types of home loans," Goolsbee wrote. "These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital."
When I spoke to Goolsbee earlier this year, he said that one of the things that distinguished Obama from Clinton was his skepticism about standard Keynesian prescriptions, such as relying on tax policy to stimulate investment and saving. In a recent posting on HuffingtonPost.com, Cass Sunstein, who for ten years was a colleague of Obama's at the University of Chicago Law School—and has said he is "an informal, occasional adviser to him"—made a similar point regarding government oversight of the financial markets: "With respect to the mortgage crisis, credit cards and the broader debate over credit markets," Sunstein wrote, "Obama rejects heavy-handed regulation and insists above all on disclosure, so that consumers will know exactly what they are getting."
If Obama isn't an old-school Keynesian, what is he? One answer is that he is a behavioralist—the term economists use to describe those who subscribe to the tenets of behavioral economics, an increasingly popular discipline that seeks to marry the insights of psychology to the rigor of economics. Although its intellectual roots go back more than thirty years, to the pioneering work of two Israeli psychologists, Amos Tversky and Daniel Kahneman, behavioral economics took off only about ten years ago, and many of its leading lights, among them David Laibson and Andrei Shleifer, of Harvard; Matt Rabin, of Berkeley; and Colin Camerer, of Caltech, are still in their thirties or forties. One of the reasons this approach has proved so popular is that it appears to provide a center ground between the Friedmanites and the Keynesians, whose intellectual jousting dominated economics for most of the twentieth century.
The central tenet of the Chicago School is that markets, once established and left alone, will resolve most of society's economic problems, including, presumably, the mortgage crisis. Keynesians—old-school Keynesians, anyway—take the view that markets, financial markets especially, often fail to work as advertised, and that this failure can be self-reinforcing rather than self-correcting. In some ways, the behavioralists stand with the Keynes-ians. Markets sometimes go badly awry, they agree, especially when people have to make complicated choices, such as what type of mortgage to take out. But whereas the Keynesians argue that vigorous regulation and the prohibition of certain activities such as excessive borrowing are often necessary, behavioralists tend to be more hopeful about redeeming free enterprise. With a gentle nudge, they argue, even some very poorly performing markets—and the people who inhabit them—can be made to work pretty well....
As it happens, there is a coherent and well-developed economic philosophy that was explicitly designed to deal with the law of unintended consequences, and it is regulatory Keynesianism of the sort practiced in the United States and Britain from the end of World War II until the 1980s, a period, not coincidentally, in which working people saw their living standard improve at an unprecedented clip. With respect to the national economy, Keynesians worry that unfettered capitalism is subject to ruinous boom-bust cycles, so they advocate management of demand through interest rates or government programs that create jobs. On the micro-level, they believe that some economic activities have harmful effects that the price mechanism fails to capture, so they support taxation and regulation. Behavioral economics, by demonstrating how people often fall victim to confusion, myopia, and trend following, provides another convincing ratio-nale for Keynesian policies, but you wouldn't realize that from reading Thaler and Sunstein.
Obama, as far as I know, doesn't refer to himself as a libertarian, but on occasion he appears to be unduly influenced by the need to preserve choice. Rather than mandating universal health coverage, for example, he has promised to set up a new, subsidized, government-operated insurance plan for people who aren't covered by their employers and who don't qualify for Medicare. But if a young and healthy person, for whatever reason, didn't want to buy health coverage, an Obama administration wouldn't compel that person to do so, despite the strong financial and moral arguments for expanding the risk pool. Just how to compel healthy young people to buy health insurance remains a large question; but it is one that should be addressed.
On other issues, such as trade policy and regulation of the financial industry, Obama has recently adopted a more dirigiste tone than Thaler and Sunstein would care for. More generally, he has talked about confronting entrenched interests and giving a voice to the excluded. Doubtless, he means what he says, and his ability to attract new voters, especially young ones, suggests he could have more success in overcoming the forces of inertia and reaction than the Clintons did in 1993–1994.
But for what policy purposes are the masses to be mobilized? According to Obama's program, the answers include another middle-class tax cut; more tax credits for education and fuel-efficient cars; a bigger budget for the National Science Foundation; and the establishment of a National Infrastructure Reinvestment Bank, with an annual budget of $6 billion. At best, these proposals would represent a useful start in redressing the inequities and shortcomings produced by twenty-five years of Republican domination. If the next Democratic president wants to leave a truly lasting legacy, he or she will have to do more than nudge the country in a different direction.