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More on Letting House Prices Fall

Tyler Cowen writes:

Many smart people say we should. It seems increasingly clear that we must. For how long can the government prop them up? Are we never to have a private market in mortgages again?

Yet what happens if we let them fall? Arguably many banks would once again be “under water.” Enthusiasm for another set of bailouts is weak, to say the least. Our government would end up nationalizing these banks and it still would be on the hook for their debts. The blow to confidence would be a major one, especially if along the way we saw a recreation of a Lehman or Bear Stearns or A.I.G. episode.

I increasingly believe there is no easy way out of this dilemma and it is a major reason why the U.S. economy remains stuck. Housing prices must fall, yet…housing prices must not fall.

Here is a very good Dave Leonhardt piece on two different views of housing. It’s where to go, if you are looking for the case for optimism. I am more pessimistic than David because I see the private sector interest in mortgage securities as remaining quite weak, which suggests the market knows which way prices have to move.

To try to answer Tyler’s first question: Years. The Obama administration has written a blank check to Fannie Mae and Freddie Mac, and the Federal Reserve continues to hold trillions in mortgage-backed securities. Reforming housing finance will take years, which means that those supports will remain in place for years.

To try to answer Tyler’s second question: We will. Republicans and Democrats alike want to back the government out of large portions of the mortgage market. A major part of reform will be clarifying, distinguishing and better planning for certain functions — like ensuring banks still offer fixed-rate, 30-year mortgages, or providing low-income housing — and ending other functions.

Either way, the problem militates for slow, moderate changes, rather than the dramatic removal of government supports that might cause prices to fall nationwide — rather than in certain places, like Arizona, Michigan and Nevada — and might tip the country back into a double-dip recession.

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