Correcting Krugman

Paul Krugman and Robin Wells caricature my recent book Fault Lines in an article in The New York Review of Books. The article, and their criticism, however, do have a lot to say about Krugman’s policy views (for simplicity, I will say “Krugman” and “he” instead of “Krugman and Wells” and “they”), which I have disagreed with in the past. Rather than focus on the innuendo about my motives and beliefs in the review, let me focus on differences of substance. I will return to why I believe Krugman writes the way he does only at the end.

First, Krugman starts with a diatribe on why so many economists are “asking how we got into this mess rather than telling us how to get out of it.”? Krugman apparently believes that his standard response of more stimulus applies, regardless of the reasons why we are in the economic downturn. Yet it is precisely because I think that the policy response to the last crisis contributed to getting us into this one that it is worthwhile examining how we got into this mess, and to resist the unreflective policies that Krugman advocates.

My book emphasizes a number of related fault lines that led to our current predicament. Krugman discusses and dismisses two — the political push for easy housing credit in the United States and overly lax monetary policy in the years 2002-2005 — while favoring a third, the global trade imbalances (which he does not acknowledge are a central theme in my book). I will argue shortly, however, that focusing exclusively on the imbalances as Krugman does, while ignoring why the United States became a deficit country, gives us a grossly incomplete understanding of what happened. Finally, Krugman ignores an important factor I emphasize — the incentives of bankers and their willingness to seek out and take the tail risks that brought the system down.

Let me start with the political push to expand housing credit. I argue that in an attempt to offset the consequences of rising income inequality, politicians on both sides of the aisle pushed easy housing credit through government units like the Federal Housing Administration, and by imposing increasingly rigorous mandates on government-sponsored enterprises such as Fannie Mae and Freddie Mac. Interestingly, Krugman neither disputes my characterization of the incentives of politicians, nor the detailed documentation of government initiatives and mandates in this regard. What he disputes vehemently is whether government policy contributed to the housing bubble, and in particular, whether Fannie and Freddie were partly responsible.

In absolving Fannie and Freddie, Krugman has been consistent over time, though his explanations as to why Fannie and Freddie are not partially to blame have morphed as his errors have been pointed out. First, he argued that Fannie and Freddie could not participate in sub-prime financing. Then he argued that their share of financing was falling in the years mortgage loan quality deteriorated the most.? Now he claims that if they indeed did it (and they did not), it was because of the profit motive and not to fulfill a social objective. Let me offer details.

In a July 14, 2008 op-ed in The New York Times, Krugman explained why Fannie and Freddie were blameless thus:

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income. So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works. [emphasis mine]

Critics were quick to point out that Krugman had his facts wrong. As Charles Calomiris, a professor at Columbia University, and Peter Wallison, of the American Enterprise Institute (and member of the Financial Crisis Inquiry Commission), explained, “Here Krugman demonstrates confusion about the law (which did not prohibit subprime lending by the GSEs), misunderstands the regulatory regime under which they operated (which did not have the capacity to control their risk-taking), and mismeasures their actual subprime exposures (which he wrongly states were zero).”

So Krugman shifted his emphasis. In his blog critique of a Financial Times op-ed I wrote in June 2010, Krugman no longer argued that Fannie and Freddie could not buy sub-prime mortgages. Instead, he emphasized the slightly falling share of Fannie and Freddie’s residential mortgage securitizations in the years 2004 to 2006 as the reason they were not responsible. Here again he presents a misleading picture. Not only did Fannie and Freddie purchase whole sub-prime loans that were not securitized (and are thus not counted in its share of securitizations), they also bought substantial amounts of private-label mortgage-backed securities issued by others. When these are taken into account, Fannie and Freddie’s share of the sub-prime market financing did increase even in those years.

“Asset prices and bubbles have momentum. Even if Fannie and Freddie had simply ignited the process, and not fueled it in the go-go years of 2004-2006, they would bear some responsibility.”

Of course, one could question this form of analysis. Asset prices and bubbles have momentum. Even if Fannie and Freddie had simply ignited the process, and not fueled it in the go-go years of 2004-2006, they would bear some responsibility. Krugman never considers this possibility.

In the current review piece, Krugman first quotes the book by Nouriel Roubini and Stephen Mihm: “The huge growth in the subprime market was primarily underwritten not by Fannie Mae and Freddie Mac but by private mortgage lenders like Countrywide. Moreover, the Community Reinvestment Act long predates the housing bubble…. Overblown claims that Fannie Mae and Freddie Mac single-handedly caused the subprime crisis are just plain wrong.”

Clearly, Fannie and Freddie did not originate sub-prime mortgages directly — they are not equipped to do so. But they fuelled the boom by buying or guaranteeing them. Indeed, Countrywide was one of their largest originators of sub-prime mortgages, according to work by Ed Pinto, a former chief credit officer of Fannie Mae, and participated from very early on in Fannie Mae’s drive into affordable housing.

For instance, consider this press release from 1992:

Countrywide Funding Corporation and the Federal National Mortgage Association (Fannie Mae) announced today that they have signed a record commitment to finance $8 billion in home mortgages. Fannie Mae said the agreement is the single largest commitment in its history…The $8 billion agreement includes a previously announced $1.25 billion of a variety of Fannie Mae’s affordable home mortgages, including reduced down payment loans…

“We are delighted to participate in this historic event, and we are particularly proud that a substantial portion of the $8 billion commitment will directly benefit lower income Americans,” said Countrywide President Angelo Mozilo…”We look forward to the rapid fulfillment of this commitment so that Countrywide can sign another record-breaking agreement with Fannie Mae,” Mozilo said.

“Countrywide’s commitment will provide home financing for tens of thousands of home buyers, ranging from lower income Americans buying their first home to middle-income homeowners refinancing their mortgage at today’s lower rates,” said John H. Fulford, senior vice president in charge of Fannie Mae’s Western Regional Office located here.

Of course, as Fannie and Freddie bought the garbage loans that lenders like Countrywide originated, they helped fuel the decline in lending standards. Also, while the Community Reinvestment Act was enacted in 1979, it was the more vigorous enforcement of the provisions of the Act in the early 1990s that gave the government a lever to push its low-income lending objectives, a fact the Department of Housing and Urban Development (HUD) was once proud of (see the HUD press releases below).

Perhaps more interesting is that after citing Roubini and Mihm, Krugman repeats his earlier claim: “As others have pointed out, Fannie and Freddie actually accounted for a sharply reduced share of the home lending market as a whole during the peak years of the bubble.” Now he attributes the inaccurate claim that Fannie and Freddie accounted for a sharply reduced share of the home lending market to nameless “others.” But that is just the prelude to changing his story once again: “To the extent that they did purchase dubious home loans, they were in pursuit of profit, not social objectives—in effect, they were trying to catch up with private lenders.”? In other words, if they did do it (and he denies they did), it was because of the profit motive.

Clearly, everything Fannie and Freddie did was because of the profit motive — after all, they were private corporations. But I don’t know how we can tell without more careful examination how much of the lending they did was to meet the government’s affordable housing mandates or to curry favor with Congress in order to preserve their profitable prime mortgage franchise, and how much was to increase the bottom line immediately.? Perhaps Krugman can tell us how he determined their intent?

Interestingly, before the housing market collapsed, HUD proudly accepted its role in pushing low-income lending through the various levers that Krugman now denies were used. For instance, in 2000 when it announced that it was increasing Fannie and Freddie’s affordable housing goals, it concluded:

Lower-income and minority families have made major gains in access to the mortgage market in the 1990s. A variety of reasons have accounted for these gains, including improved housing affordability, enhanced enforcement of the Community Reinvestment Act, more flexible mortgage underwriting, and stepped-up enforcement of the Fair Housing Act. But most industry observers believe that one factor behind these gains has been the improved performance of Fannie Mae and Freddie Mac under HUD’s affordable lending goals. HUD’s recent increases in the goals for 2001-03 will encourage the GSEs to further step up their support for affordable lending.”

And in 2004, when it announced yet higher goals, it said:

Over the past ten years, there has been a ‘revolution in affordable lending’ that has extended homeownership opportunities to historically underserved households. Fannie Mae and Freddie Mac have been a substantial part of this ‘revolution in affordable lending’. During the mid-to-late 1990s, they added flexibility to their underwriting guidelines, introduced new low-down payment products, and worked to expand the use of automated underwriting in evaluating the creditworthiness of loan applicants. HMDA data suggest that the industry and GSE initiatives are increasing the flow of credit to underserved borrowers. Between 1993 and 2003, conventional loans to low income and minority families increased at much faster rates than loans to upper-income and nonminority families.

IIf the government itself took credit for its then successes in expanding home ownership, why is Krugman not willing to accept its contribution to the subsequent bust as too many lower middle-class families ended up in homes they could not afford? I agree there is room for legitimate differences of opinion on the quality of data, and the extent of government responsibility, but to argue that the government had no role in directing credit, or in the subsequent bust, is simply ideological myopia.

Let me move on to Krugman’s second criticism of my diagnosis of the crisis. He argues that the Fed’s very accommodative monetary policy over the period 2003 to 2005 was also not responsible for the crisis. Here Krugman is characteristically dismissive of alternative views. In his review, he says that there were good reasons for the Fed to keep rates low given the high unemployment rate. Although this may be a justification for the Fed’s policy (as I argue in my book, it was precisely because the Fed was focused on a stubbornly high unemployment rate that it took its eye off the irrational exuberance building in housing markets and the financial sector), it in no way validates the claim that the policy did not contribute to the manic lending or housing bubble.

A second argument that Krugman makes is that Europe too had bubbles and the European Central Bank was less aggressive than the Federal Reserve, so monetary policy could not be responsible. It is true that the European Central Bank was less aggressive, but only slightly so: It brought its key refinancing rate down to only 2 percent, while the Fed brought the Fed Funds rate down to 1 percent. Clearly, both rates were low by historical standards. More important, what Krugman does not point out is that different Euro-area economies had differing inflation rates, so the real monetary policy rate was substantially different across the Euro area despite a common nominal policy rate. Countries that had strongly negative real policy rates — Ireland and Spain are primary exhibits — had a housing boom and bust, while countries like Germany with low inflation, and therefore higher real policy rates, did not. Indeed, a working paper by two ECB economists, Angela Maddaloni and José-Luis Peydró, indicates that the ultra-low rates enforced by both the ECB and the Fed at this time had a strong causal effect in relaxing banks’ commercial, mortgage, and retail lending standards over this period.

I admit that there is much less consensus on whether the Fed helped create the housing bubble and the banking crisis than on whether Fannie and Freddie were involved. Ben Bernanke, a monetary economist of the highest caliber, denies it, while John Taylor, an equally respected monetary economist insists on it. Some Fed studies accept responsibility while others deny it. Krugman, of course, has an interest in defending the Fed and criticizing alternative viewpoints. He himself advocated the policies the Fed followed, and in fact, was critical of the Fed raising rates even when it belatedly did so in 2004. Then, as he does now, Krugman emphasized the dangers from a Japanese-style deflation, as well as the slow progress in bringing back jobs. Then, as he does now, he advocated more stimulus. Then, as he does now, Krugman ignored the longer term adverse consequences of the policies he advocated.

“The United States did not have to run a large trade deficit and absorb the capital inflows – the claim that it had to sounds very much like that of the over-indulgent and over-indebted rake who blames his creditors for being willing to finance him. “

Finally, if he denies a role for government housing policies, or for monetary policy, or even for warped banker incentives, then what does Krugman attribute the crisis to? His answer is over-saving foreigners. Put simply, trade-surplus countries like Germany and China had to reinvest their financial surpluses in the United States, pushing down long-term interest rates in the process, and igniting a housing bubble that eventually burst and led to the financial panic. But this is only a partial explanation, as I argue in my book. The United States did not have to run a large trade deficit and absorb the capital inflows – the claim that it had to sounds very much like that of the over-indulgent and over-indebted rake who blames his creditors for being willing to finance him. The United States’s policies encouraged over-consumption and over-borrowing, and unless we understand where these policies came from, we have no hope of addressing the causes of this crisis.? Unfortunately, these are the policies that Krugman wants to push again. This is precisely why we have to understand the history of how we got here, and why Krugman wants nothing to do with that enterprise.

There is also a matter of detail suggesting why we cannot only blame the foreigners. The housing bubble, as Monika Piazzesi and Martin Schneider of Stanford University have argued, was focused in the lower income segments of the market, unlike in the typical U.S. housing boom. Why did foreign money gravitate to the low income segment of the housing market? Why did past episodes when the U.S. ran large current account deficits not result in similar housing booms and busts?? Could the explanation lie in U.S. policies?

My book suggests that many — bankers, regulators, governments, households, and economists among others — share the blame for the crisis. Because there are so many, the blame game is not useful. Let us try and understand what happened in order to avoid repeating it. I detail the hard choices we face in the book. While it is important to alleviate the miserable conditions of the long-term unemployed today, we also need to offer them incentives and a pathway to building the skills that are required by the jobs that are being created. Simplistic mantras like “more stimulus” are the surest way to distract us from policies that generate sustainable growth.

Finally, a note on method. Perhaps Krugman believes that by labeling other economists as politically extreme, he can undercut their credibility. In criticizing my argument that politicians pushed easy housing credit in the years leading up to the crisis, he writes,? “Although Rajan is careful not to name names and attributes the blame to generic ‘politicians,’ it is clear that Democrats are largely to blame in his worldview.” Yet if he read the book carefully, he would have seen that I do name names, arguing both President Clinton with his “Affordable Housing Mandate” (see Fault Lines, page 35), as well as President Bush with his attempt to foster an “Ownership Society” (see Fault Lines, page 37) pushed very hard to expand housing credit to the less well-off. Indeed, I do not fault the intent of that policy, only the unintended consequences of its execution. My criticism is bipartisan throughout the book, including of the fiscal policies followed by successive administrations. Errors of this kind by an economist of Krugman’s stature are disappointing.


It is not stimulus--and lot's of it--that is the problem. It was the directing of stimulus money in the wrong direction, I believe. Consider the following....

Instead of giving money to banks--which, in turn, DID NOT provide any significant breaks to mortgage holders--we should have provided the money to the mortgage holders, in my opinion, on the condition that they use it to pay their mortgage payments. That would filter the money to the banks while at the same time providing some cushion for the homeowners.

We should have foreseen that in tight economic conditions, companies are going to play safer by not hiring or expanding (at least as rapidly). At such times, the GOV'T, almost of necessity, has to do the hiring. It might be a CCC-like program that puts people to work in jobs that benefit the infrastructure, national parks, etc., but sometimes the gov't--the least efficient one among us--has to do more than throw money at corporations.

In addition, if the gov't wants the wealthy to start businesses, etc., how about providing carrots and sticks? That is, TAX the wealthy more if they don't use their money to start jobs in the U.S. And if they do, reward them.

Lastly, I am of the opinion that IF IF IF we could have found "the hinge," we could have put much less stimulus money to that end, thereby positively affecting the entire economy. But there did not seem to be any real search for "the hinge," rather a desperate throwing of money in the direction of the very ones who brought about the crisis.

One more thing--destroy Goldman Sachs and the world will soon be a better place. I'm convinced that they play far too large a role in our nation's policy, using their cachet to gain entrance to the highest levels of power...and take care of themselves first. I would bet an ice-cold Coca-Cola that the fingerprints of Goldman Sachs are all over this financial crisis to a greater degree than almost anyone else.



Mr. Krugman is a humorless, unhappy, man. His considerable intellect is dwarfed by his ego. Once a person understands this, everything he says makes sense.

This equally intelligent author stands in a long line of economists who have tried to debate Mr. Krugman using facts and reason. There are no logical arguements that can penetrate that ego. C'est la vie.


Nonetheless, it remains a fact that very few economists predicted this, in fact, about the number that would be expected through random chance. Were I an economist, I'd be questioning the theories that drive my "science", not pointing fingers at each other.


This is a good counterattack on Krugman and a terrible defense of positions held against Krugman's attack. As a result, you both look weak. Maybe that's as it should be.

On balance, I remain entirely unconvinced that the bubble was the result of policies to encourage purchases of low-priced homes by low-income renters. If you wish to argue that these policies had unintended impacts on other, higher-income homeowners, I'm listening. I watched mortgage companies' aggressive marketing of no- and low-down-payment loans at--initially--very low interest rates for moderate- and high-priced homes, along with similar marketing of refinancing and second mortgages for these homes, with little or no regard for these customers' abilities to pay beyond the first months. That's where the money was, and I strongly suspect that's the primary source steeply rising home prices (the bubble). I have seen hints that Fannie/Freddie were not big players in this nefarious marketing effort targeting middle- and higher-income homeowners. But perhaps somewhere out there is a truly solid analysis on the question.



The fault lies not with government, but wit the system--democracy. Churchill (I think) said democracy is the worst form of government except for all the others. I think the worst thing to be said about democracy is that it works.



"no one held fire to banker's feet forcing them to make loans they KNEW could never be repaid"

You couldn't be more wrong. Read _Architects of Ruin_ for a description of how the government (mostly left wing politicians) used the CRA to do exactly that.


To meet the deadline for his column, Krugman merely rewrites the latest memo he's received from the White House. Unfortunately, he's abdicated his Nobel for thinking in order to become a liberal fish wife.


When trying to blame the government for the crash of 2008, why does Raghuram G. Rajan not mention the fraud committed by numerous Goldman Sachs, and possibly other investment banking institutions. They created toxic assets, sold them as AAA to their clients, and then shorted the assets.


And where is the "Freakonomics" connection?

Dismal offerings from the dismal science, eh?

From the disgraceful response to his Nobel prize to this, you folks are compromising your integrity. At the very least, his blog title is honest about what to expect from it.

And if the mission of this blog has morphed into somehow promoting education and integrity on economic affairs, why not hack down Mankiw's reposting of the Viard piece which deliberately misrepresents our tax system to argue for extending the Bush tax cuts(his own textbook describes the difference between effective and marginal rates!).

Even if Ragu is 100% right, letting this blog devolve into periodic rants and jabs against Paul will only turn off your fan base of economic professionals... further compromising any perception of integrity this blog has.


Robert Evans- "At the beginning and at the end of the article we are told to avoid unreflective policeis of simple stimulus. Yet no alternative policices were suggested. One wonders why."

Here is a clue: The govt created the problem. What we do not need is more action by the government. The correct policy is for the government to do nothing and get out of the private sector's way. I know, fat chance of that happening with that socialist in the WH.


@Random- "When trying to blame the government for the crash of 2008, why does Raghuram G. Rajan not mention the fraud committed by numerous Goldman Sachs, and possibly other investment banking institutions. They created toxic assets, sold them as AAA to their clients, and then shorted the assets."

Umm, they were rated as AAA because they had the full backing of the US government, via FF.. You do know that Sachs or any bank for that matter dont assign credit ratings?


Agreed with Michael, #26.

Krugman uses data to back up many of his arguments. That sets him above many others in the debate.

Show me data, Mr. Rajan. Real-world, accountable, observational data.

pk de cville

My Bottom Line:

Are you pro intermediate stimulus to hire back the unemployed or are you pro austerity?

If you're pro austerity, what will you say to the unemployed over 45?

How long will it take for our poverty and homeless levels to double and quadruple at these 'recovery' rates?

How long will it take before U of C begins reducing it's staff positions?


"for simplicity, I will say "Krugman" and "he" instead of "Krugman and Wells" and "they"),"

Let me correct that for you:
"For sexism's sake, I will say ..."


MjB, so let me distill this down. Irresponsible lending by the banks was the result of deregulation by the government hoping the banks would lend more for the social good. Since no one was holding their feet to the fire to have responsible business practices, they did not. Ummmm. Okay. Let me correct that a little for you.

After years of political capture and massive lobbying, the financial industry was stripped of all regulatory oversight. Accounting rules were so negated that even the shakiest banks could hide their conditions. The political cover for some of this was encouraging the economy and for others it was helping those who needed it most.

In reality this let the financial industry play massive games with financial 'instruments' and 'securitization'. To protect these games the federal government even used the OCC against state regulatory agencies. All along the financial spectrum people took their cut, making it individually profitable to those who might make noise. For those at the top it was rolling in cash time. And the housing bubble needed to continue because those at the top needed product to slice and dice and sell to continue rolling in it. So new and exotic mortgages were created - all unstable. Standards were relaxed or ignored.

None of this was for the public good. Phil Gramm and Richard Rubin didn't design this for the public good. It was all done for greed. And the political and regulatory capture was so complete that when it all burst, the people at the very top of the food chain were saved by the American tax payer. And only the 95% at the bottom chain were held responsible - through taxes and falling home prices and lost jobs and lost homes.

There is one answer to all this - Cheap labor conservative economic policies of the last thirty years. The boondoggle of supply side economics coupled with the I owe nothing to my workers, my community, or my country only to my own profits deregulation push have brought us to this point where the ONLY thing keeping the US economy afloat was the housing bubble. We moved out the jobs, sold the ideas, and regressively taxed working Americans out of all progress for three decades. Until there was practically nothing left.

Greed is good. Only when it isn't. And now we aren't even supposed to recognize that those who have been the greediest are at fault. The government was for not making them be responsible to their business, their workers, their community and their customers.



Government policy undoubtedly played a role (perhaps major role) in the housing bubble. Indeed, the single biggest factor may have been the lenders' ability to re-sell mortgages after taking a handsome profit for originating and packaging them as securities--virtually decoupling the risk of and reward from the mortgage lending. All of this "free market" speculation was probably faciliated by a loose monetary policy. But that does not tell us how to restore the US economy.

The harsh reality is that aggregate demand is way down. Businesses are not hiring or investing and will not hire or invest until their customers buy enough goods and services to justify hiring additional workers and increasing capacity. The inflation feared from additional simulus was already realized during the housing bubble years. Now that the bubble has burst, the US economy is experiencing no inflation whatsoever and is in danger of entering a deflationary spiral. This defationary threat is very similar to the deflation of the Great Depression, except that this time the federal government has taken aggressive action to salvage the banking system and also adopted the $800 billion stimulus package. As a result, unemployment hovers at 10% instead of 25%. Thus, without an increase in aggregate demand, there will not be a meaningful recovery.

Now, we can argue about exactly how to simulate demand (e.g., infrastructure, social, or defense spending), but it cannot be reasonably argued that aggregate demand is adequate or should not be stimulated. Ignoring the harsh reality facing businesses everywhere (even the major oil companies' revenues are down due to lower prices and demand) will not make that reality disappear. Until the hoarding of liquiidity is stopped by a return of normal demand, the economy will not fully recover.



"When these are taken into account, Fannie and Freddie's share of the sub-prime market financing did increase even in those years"

Um, no. Sorry, but the link you provided to support this point directly refutes it. Chart 49 (page 142 of the pdf) shows that even with all of the AEI reports suggested adjustments, GSE overall market share fell from 2004-2006. And chart 51 (page 147) specifically shows Fannie and Freddie's sharply declining share of sub-prim lending in those years.

Let's note first that Krugman is accurately citing government figures from the bipartisan FCIC.

What you are citing as a rebuttal is a report from the highly partisan and not very respected American Enterprise Institute. And yet, that report still supports Krugman more than you.

Debbie R.

Hasn't the role of Fannie and Freddie has always been to encourage and facilitate mortgage lending? They have always been adding "fuel" to the fire, that was why they were created. They were not the originators of these dubious loans, nor were they the ones who came up with the financial instruments which allowed investment firms to make billions of dollars selling loans of dubious value as AAA rated investments.


Below from Krugman, Vintage 2002. He certainly did not ignore the possibility of a housing bubble - he actually called on the Fed to deliberately create one:

Dubya's Double Dip?
Published: August 2, 2002

"The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."


I agree with several other commenters here - such ad hominem attacks against Krugman really compromise whatever integrity or impartiality this blog claims to have.

I even took the time to read the Krugman and Wells article that Rajan is responding to, and this post seems like a total overreaction.