Fighting over Claims

This brief segment from a recent speech by Joe Stiglitz sums up very neatly the nature of our current economic predicament (emphasis added):

We should realize that the resources in our economy... today is the same is at was five years ago. We have the same human capital, the same physical capital, the same natural capital, the same knowledge... the same creativity... we have all these strengths, they haven't disappeared. What has happened is, we're having a fight over claims, claims to resources. We've created more liabilities... but these are just paper. Liabilities are claims on these resources. But the resources are there. And the fight over the claims is interfering with our use of the resources. 

I think this is a very useful way to think about the potential effectiveness under current conditions of various policy proposals, including conventional fiscal and monetary stabilization policies.

Part of the reason for our anemic and fitful recovery is that contested claims, especially in the housing market, continue to be settled in a chaotic and extremely wasteful manner. Recovery from subprime foreclosures is typically a small fraction of outstanding principal, and properly calibrated principal write-downs can often benefit both borrowers and lenders. Modifications that would occur routinely under the traditional bilateral model of lending are much harder to implement when lenders are holders of complex structured claims on the revenues generated by mortgage payments. Direct contact between lenders and borrowers is neither legal nor practicable in this case, and the power to make modifications lies instead with servicers. But servicer incentives are not properly aligned with those of the lenders on whose behalf they collect and process payments. The result is foreclosure even when modification would be much less destructive of resources.

Despite some indications that home values are starting to rise again, the steady flow of defaults and foreclosures shows no sign of abating. Any policy that stands a chance of getting us back to pre-recession levels of resource utilization has to result in the quick and orderly settlement of these claims, with or without modification of the original contractual terms. And it's not clear to me that the blunt instruments of conventional stabilization policy can accomplish this.

Consider monetary policy for instance. The clamor for more aggressive action by the Fed has recently become deafening, with a long and distinguished line of advocates (see, for instance, recent posts by Miles Kimball, Joseph Gagnon, Ryan Avent, Scott Sumner, Paul Krugman, and Tim Duy). While the various proposals differ with respect to details the idea seems to be the following: (i) the Fed has the capacity to increase inflation and nominal GDP should it choose to do so, (ii) this can be accomplished by asset purchases on a large enough scale, and (iii) doing this would increase not only inflation and nominal GDP but also output and employment.

It's the third part of this argument with which I have some difficulty, because I don't see how it would help resolve the fight over claims that is crippling our recovery. Higher inflation can certainly reduce the real value of outstanding debt in an accounting sense, but this doesn't mean that distressed borrowers will be able to meet their obligations at the originally contracted terms. In order for them to do so, it is necessary that their nominal income rises, not just nominal income in the aggregate. And monetary policy via asset purchases would seem to put money disproportionately in the pockets of existing asset holders, who are more likely to be creditors than debtors. Put differently, while the Fed has the capacity to raise nominal income, it does not have much control over the manner in which this increment is distributed across the population. And the distribution matters.

Similar issues arise with inflation. Inflation is just the growth rate of an index number, a weighted average of prices for a broad range of goods and services. The Fed can certainly raise the growth rate of this average, but has virtually no control over its individual components. That is, it cannot increase the inflation rate without simultaneously affecting relative prices. For instance, purchases of assets that drive down long term interest rates will lead to portfolio shifts and an increase in the price of commodities, which are now an actively traded asset class. This in turn will raise input costs for some firms more than others, and these cost increases will affect wages and prices to varying degrees depending on competitive conditions. As Dan Alpert has argued, expansionary monetary policy under these conditions could even "collapse economic activity, as limited per capita wages are shunted to oil and food, rather than to more expansionary forms of consumption."

I don't mean to suggest that more aggressive action by the Fed is unwarranted or would necessarily be counterproductive, just that it needs to be supplemented by policies designed to secure the rapid and efficient settlement of conflicting claims.

One of the most interesting proposals of this kind was floated back in October 2008 by John Geanakoplos and Susan Koniak, and a second article a few months later expanded on the original. It's worth examining the idea in detail. First, deadweight losses arising from foreclosure are substantial:

For subprime and other non-prime loans, which account for more than half of all foreclosures, the best thing to do for the homeowners and for the bondholders is to write down principal far enough so that each homeowner will have equity in his house and thus an incentive to pay and not default again down the line... there is room to make generous principal reductions, without hurting bondholders and without spending a dime of taxpayer money, because the bond markets expect so little out of foreclosures. Typically, a homeowner fights off eviction for 18 months, making no mortgage or tax payments and no repairs. Abandoned homes are often stripped and vandalized. Foreclosure and reselling expenses are so high the subprime bond market trades now as if it expects only 25 percent back on a loan when there is a foreclosure.

Second, securitization precludes direct contact between borrowers and lenders:

In the old days, a mortgage loan involved only two parties, a borrower and a bank. If the borrower ran into difficulty, it was in the bank’s interest to ease the homeowner’s burden and adjust the terms of the loan. When housing prices fell drastically, bankers renegotiated, helping to stabilize the market. 

The world of securitization changed that, especially for subprime mortgages. There is no longer any equivalent of “the bank” that has an incentive to rework failing loans. The loans are pooled together, and the pooled mortgage payments are divided up among many securities according to complicated rules. A party called a “master servicer” manages the pools of loans. The security holders are effectively the lenders, but legally they are prohibited from contacting the homeowners.

Third, the incentives of servicers are not aligned with those of lenders:

Why are the master servicers not doing what an old-fashioned banker would do? Because a servicer has very different incentives. Most anything a master servicer does to rework a loan will create big winners but also some big losers among the security holders to whom the servicer holds equal duties... By allowing foreclosures to proceed without much intervention, they avoid potentially huge lawsuits by injured security holders. 

On top of the legal risks, reworking loans can be costly for master servicers. They need to document what new monthly payment a homeowner can afford and assess fluctuating property values to determine whether foreclosing would yield more or less than reworking. It’s costly just to track down the distressed homeowners, who are understandably inclined to ignore calls from master servicers that they sense may be all too eager to foreclose.

And finally, the proposed solution:

To solve this problem, we propose legislation that moves the reworking function from the paralyzed master servicers and transfers it to community-based, government-appointed trustees. These trustees would be given no information about which securities are derived from which mortgages, or how those securities would be affected by the reworking and foreclosure decisions they make. 

Instead of worrying about which securities might be harmed, the blind trustees would consider, loan by loan, whether a reworking would bring in more money than a foreclosure... The trustees would be hired from the ranks of community bankers, and thus have the expertise the judiciary lacks...  

Our plan does not require that the loans be reassembled from the securities in which they are now divided, nor does it require the buying up of any loans or securities. It does require the transfer of the servicers’ duty to rework loans to government trustees. It requires that restrictions in some servicing contracts, like those on how many loans can be reworked in each pool, be eliminated when the duty to rework is transferred to the trustees... Once the trustees have examined the loans — leaving some unchanged, reworking others and recommending foreclosure on the rest — they would pass those decisions to the government clearing house for transmittal back to the appropriate servicers... 

Our plan would keep many more Americans in their homes, and put government money into local communities where it would make a difference. By clarifying the true value of each loan, it would also help clarify the value of securities associated with those mortgages, enabling investors to trade them again. Most important, our plan would help stabilize housing prices.

As with any proposal dealing with a problem of such magnitude and complexity, there are downsides to this. Anticipation of modification could induce borrowers who are underwater but current with their payments to default strategically in order to secure reductions in principal. Such policy-induced default could be mitigated by ensuring that only truly distressed households qualify. But since current financial distress is in part a reflection of past decisions regarding consumption and saving, some are sure to find the distributional effects of the policy galling. Nevertheless, it seems that something along these lines needs to be attempted if we are to get back to pre-recession levels of resource utilization anytime soon. And the urgency of action does seem to be getting renewed attention.

The bottom line, I think, is this: too much faith in the traditional tools of macroeconomic stabilization under current conditions is misplaced. One can conceive of dramatically different approaches to monetary policy, such as direct transfers to households, but these would surely face insurmountable legal and political obstacles. It is essential, therefore, that macroeconomic stabilization be supplemented by policies that are microeconomically detailed, fine grained, and directly confront the problem of balance sheet repair. Otherwise this enormously costly fight over claims will continue to impede the use of our resources for many more years to come.

Reciprocal Fear and the Castle Doctrine Laws

In his timeless classic The Strategy of Conflict, Thomas Schelling began a chapter on the "reciprocal fear of surprise attack" as follows:

If I go downstairs to investigate a noise at night, with a gun in my hand, and find myself face to face with a burglar who has a gun in his hand, there is a danger of an outcome that neither of us desires. Even if he prefers to just leave quietly, and I wish him to, there is danger that he may think I want to shoot, and shoot first. Worse, there is danger that he may think that I think he wants to shoot. Or he may think that I think he thinks I want to shoot. And so on. "Self-Defense" is ambiguous, when one is only trying to preclude being shot in self-defense.

This effect is empirically important, and is part of the reason why homicide rates vary so greatly across otherwise similar locations, and can change so sharply over time at a given location. In our attempt to understand why the Newark homicide rate doubled in just six years from 2000-2006 while the national rate remained essentially constant, Dan O'Flaherty and I found a substantial number of homicides to be the outcome of escalating disputes between strangers or acquaintances often over seemingly trivial matters. High rates of homicide make for a tense and fearful environment within which the preemptive motive for killing starts to loom large, and this itself reinforces the cycle of tension, fear, and continued killing. Incremental reductions in homicide under such circumstances are unlikely to be feasible, but sudden large scale reductions that transform the environment and break the cycle can sometimes be attained. Similar effects arise with international arms races.

In the jargon of economics, homicide is characterized by strategic complementarity: any increase in the willingness of one set of individuals to kill will be amplified by increases in the willingness of others to kill preemptively, and so on, in an expectations driven cascade. Any change in fundamentals can set this process off, such as a breakdown in law enforcement, easier availability of firearms, or increases in the value of a contested resource.

The logic of strategic complementarity implies that a broadening of the notion of justifiable homicide, in an attempt to benefit potential victims of crime, can have tragic and entirely counterproductive effects. Florida's 2005 stand-your-ground law is an example of this, and more than twenty other states have adopted similar legislation in its wake. These are sometimes called castle doctrine laws, since they extend to other locations the principle that one does not have a duty to retreat in one's own home (or "castle").

Enough time has elapsed since the passage of these laws for an empirical analysis of their effects to be be conducted, and a recent paper by Cheng and Hoekstra does exactly this. Determining the causal effects of any change in the legal environment is always a tricky business. The authors tackle the problem by grouping states into those that adopted such laws and those that did not, and comparing within-state changes in outcomes across the two groups of states (the so-called difference in differences identification strategy). Their findings are striking:

Results indicate that the prospect of facing additional self-defense does not deter crime. Specifically, we find no evidence of deterrence effects on burglary, robbery, or aggravated assault. Moreover, our estimates are sufficiently precise as to rule out meaningful deterrence effects. 

In contrast, we find significant evidence that the laws increase homicides... the laws increase murder and manslaughter by a statistically significant 7 to 9 percent, which translates into an additional 500 to 700 homicides per year nationally across the states that adopted castle doctrine. Thus, by lowering the expected costs associated with using lethal force, castle doctrine laws induce more of it... murder alone is increased by a statistically significant 6 to 11 percent. This is important because murder excludes non-negligent manslaughter classifications that one might think are used more frequently in self-defense cases. But regardless of how one interprets increases from various classifications, it is clear that the primary effect of strengthening self-defense law is to increase homicide.

These are statistical findings and refer to aggregate effects; no individual homicide can be attributed with certainty to a change in the legal environment, not even the one killing that has brought castle doctrine laws into national focus. Nevertheless, we now have compelling evidence that the adoption of such laws has led directly to several hundred deaths annually nationwide, with negligible deterrence effects on other crimes. While the latter finding may be surprising, the former should have been entirely predictable.

Elinor Ostrom, 1933-2012

The political scientist Elinor Ostrom, co-recipient of the 2009 Nobel Prize in Economics, died this morning at the age of 78. I met her just once, after a talk she gave at Columbia sometime in the 1990s. It was in a very interesting seminar series organized by Dick Nelson if I recall correctly.

I was a great admirer of Ostrom's research on common pool resources, and tried to interpret some of her insights from an evolutionary perspective in some joint work with E. Somanathan a while ago. I've written about her here on a couple of occasions, and once reviewed a book that was largely a celebration of her vision (she had a hand in no less than six chapters).

Here are some extracts from a post written soon after the Nobel announcement:

Ostrom’s extensive research on local governance has shattered the myth of inevitability surrounding the “tragedy of the commons” and curtailed the uncritical application of the free-rider hypothesis to collective action problems. Prior to her work it was widely believed that scarce natural resources such as forests and fisheries would be wastefully used and degraded or exhausted under common ownership, and therefore had to be either state owned or held as private property in order to be efficiently managed. Ostrom demonstrated that self-governance was possible when a group of users had collective rights to the resource, including the right to exclude outsiders, and the capacity to enforce rules and norms through a system of decentralized monitoring and sanctions. This is clearly a finding of considerable practical significance. 

As importantly, the award recognized an approach to research that is practically extinct in contemporary economics. Ostrom developed her ideas by reading and generalizing from a vast number of case studies of forests, fisheries, groundwater basins, irrigation systems, and pastures. Her work is rich in institutional detail and interdisciplinary to the core. She used game theoretic models and laboratory experiments to refine her ideas, but historical and institutional analysis was central to this effort. She deviated from standard economic assumptions about rationality and self-interest when she felt that such assumptions were at variance with observed behavior, and did so long before behavioral economics was in fashion... 

There is no doubt that her research has dramatically transformed our thinking about the feasibility and efficiency of common property regimes. In addition, it serves as a reminder that her eclectic and interdisciplinary approach to social science can be enormously fruitful. In making this selection at this time, it is conceivable that the Nobel Committee is sending a message that methodological pluralism is something our discipline would do well to restore, preserve and foster.

And from the book review:

Although several distinguished scholars have been affiliated with the workshop over the years, Ostrom remains its leading light and creative force. It is fitting, therefore, that the book concludes with her 1988 Presidential Address to the American Political Science Association. In this chapter, she identifies serious shortcomings in prevailing theories of collective action. Approaches based on the hypothesis of unbounded rationality and material self-interest often predict a “tragedy of the commons” and prescribe either privatization of common property or its appropriation by the state. Policies based on such theories, in her view, “have been subject to major failure and have exacerbated the very problems they were intended to ameliorate”. What is required, instead, is an approach to collective action that places reciprocity, reputation and trust at its core. Any such theory must take into account our evolved capacity to learn norms of reciprocity, and must incorporate a theory of boundedly rational and moral behavior. It is only in such terms that the effects of communication on behavior can be understood. Communication is effective in fostering cooperation, in Ostrom’s view, because it allows subjects to build trust, form group identities, reinforce reciprocity norms, and establish mutual commitment. The daunting task of building rigorous models of economic and political choice in which reciprocity and trust play a meaningful role is only just beginning... 

The key conclusions drawn by the contributors are nuanced and carefully qualified, but certain policy implications do emerge from the analysis. The most important of these is that local communities can often find autonomous and effective solutions to collective-action problems when markets and states fail to do so. Such institutions of self-governance are fragile: large-scale interventions, even when well-intentioned, can disrupt and damage local governance structures, often resulting in unanticipated welfare losses. When a history of successful community resource management is in evidence, significant interventions should be made with caution. Once destroyed, evolved institutions are every bit as difficult to reconstruct as natural ecosystems, and a strong case can be made for conserving those that achieve acceptable levels of efficiency and equity. By ignoring the possibility of self-governance, one puts too much faith in the benevolence of a national government that is too large for local problems and too small for global ones. Moreover, as Ostrom points out in the concluding chapter, by teaching successive generations that the solution to collective-action problems lie either in the market or in the state, “we may be creating the very conditions that undermine our democratic way of life”. The stakes could not be higher.

Earlier tributes to Ostrom from Vernon Smith and Paul Romer are well worth revisiting.