If the Bubble Bursts

Michael Mandel’s piece in Business Week yesterday ended by posing the following question. Suppose the doomsayers are right, and the housing bubble bursts in 2006. Suppose that the fall in real estate prices is large enough and widespread enough to cause significant economic problems for the US. What should Democrats propose that the US government do in response?

The answer depends on what the scenario actually looks like, of course. I would guess that there would be a surge in the number of people defaulting on mortgages, going into personal bankruptcy, and taking large capital losses. This would certainly slow economic growth a bit, and perhaps by a lot. In the worst-case scenario, this could tip the US economy into recession.

A few possible policy prescriptions come to mind. Here’s the start of a list:

• If the number and severity of personal bankruptcy cases rises substantially, one thing to consider is a reevaluation of the recently passed Bankruptcy Reform Act, which significantly increased the repayment burden on individuals for unsecured debts in the case of personal bankruptcy. I would have to defer to the experts on the specifics, but I can imagine changes (perhaps temporary) to bankruptcy laws to make it more lenient on people who have fallen into bankruptcy not because of job loss or large medical bills (two of the largest precipitators of personal bankruptcy), but rather simply because their mortgage payments have risen while the value of their house has fallen.
• Another possibility would be to allow more favorable tax treatment of capital losses for those people who have lost money on their house. For example, one idea might be to increase the maximum amount of a real estate capital loss that one can deduct from one’s income in any particular year.
• More generally, if the economy-wide repercussions of the housing downturn were severe, other types of tax cuts might be an appropriate response. Needless to say, Democrats could and should advocate tax cuts that would look pretty different from those that Bush would probably want: tax cuts that go directly to the middle class, that are limited in duration, and that do not have a major effect on the long-term budgetary health of the US.
• Still more generally, a broad-based economic downturn could bolster calls to strengthen the nation’s social safety net. At a minimum, this could take the form of extending the length of time that individuals can claim unemployment insurance, as was done during the previous recession. In an extreme case, a severe recession (which I’m not predicting, by the way) could help build the case for what is one of my favorite policy topics lately: national single-payer health insurance.
• Finally, it may be appropriate to consider stronger regulation of lending practices. Much of the mortgage activity in recent years has been in “exotic loans”, which may have contributed to the volatility of the real estate market. While some stronger guidance regarding these types of financial products has emerged recently, it may be the case that more is called for.

None of these policy ideas would really prevent a lot of economic hardship from happening in the case of a severe downturn in housing markets. A sharp downturn in housing will hurt, as it must and should. People and firms who have made poor decisions in this housing market will have to live with the consequences, at least to some degree.

But it is also the case that lots of people may suffer from a housing crash through no fault of their own, but simply due to circumstances beyond their control. With them in mind, it is possible to think of ways to cushion the blow, and I agree with Mandel that it’s appropriate to start thinking of ways to do that now.

Kash