The case against re-regulation

At the Freakonomics blog, Justin Wolfers invites Erik Hurst to offer a much-needed counterpoint to calls for re-regulation of the financial sector:

The past decade saw enormous financial innovation and the development of a liquid market to sell mortgage securities for unconventional mortgages (Fannie Mae and Freddie Mac had been securitizing “conventional” mortgages for a long time). Some of these new loans were issued to subprime borrowers: folks with little equity in their homes and lower credit scores.

Yet even as we recognize the costs of the subprime meltdown, we need to recognize the benefits of this innovation.

The homeownership rate in the U.S. increased by 3 percentage points over the past decade — a clear break from the two previous decades of stagnation. Around one-third of these households may ultimately default on their mortgages, but this also means that two-thirds of those who were previously excluded from mortgage markets now own a home.

Access to credit for this historically denied group is a clear benefit of financial innovation. Likewise, even if excessive lending landed us in this mess, the extra investment projects that were funded contributed heavily to economic growth over the past decade and supported the economy during the technology “bust.”

Where to Next?

Knowing what we know now, what is the optimal approach to regulating the subprime sector? Some argue that we should outlaw subprime lending completely. But do we really want to return to the world where the well-off have access to credit, but the historically denied (the poor, the young, African-Americans) can’t access the housing market or other credit markets? Is it really O.K. for only some households to use credit to help them ride out bad times, while others must just do without?

It’s a strange reversal of the usual ideologies, but those of us who care deeply about the poor must care deeply about cultivating a vibrant financial sector to service the subprime market. Otherwise, we truly risk two Americas: the credit-worthy who enjoy the benefits of the capitalist system and a highly developed financial system, and the less credit-worthy, who must live with a level of financial development that we suspect keeps so many third-world nations poor.

I don’t claim to know the best response to the current financial problems, but ten minutes into tonight’s debate it’s clear that we need economists like Hurst keeping regulation in check.