Foreclosure Crisis

by Luke Paulsen
Princeton University

Semifinalist

My proposed solution to the foreclosure crisis is a government program that focuses on voluntary re-negotiation mortgages and on moral encouragement for banks and homeowners.

When I first thought about solving the foreclosure problem, I tried to approach it from an economic point of view. Where would the money go? What were the correct incentives? How could an effective aid program be managed? There were endless possibilities for what strategy to choose. I felt sure that I could work out a nice, tidy solution somehow.

It didn't work at all. The more I thought about it, the more I realized that a purely economic approach to this question was doomed to failure — because in the strictest sense, the foreclosure crisis is not an "economic" problem! From a classical economic point of view, the "foreclosure crisis" is a necessary (if painful) economic correction. Many people, and many banks, effectively made bets on the reliability of "bad" mortgages — and, because they made poor bets, they lost a large amount of money. Yet the possibility of losing is an essential part of any gamble; to insure against that possibility, or to support only those who lose their bets, is to destroy the premise of the whole system. In such a "gambling" scenario it is expected — essential, even — that there is a chance of losing. From the economist's view, there is nothing "wrong" with this situation; economists are concerned with things as they are, not things as they should be ...

An analysis with classical economics leaves us without a problem to solve — let alone a solution — so the logical next place to turn is economic policy. Having agreed that allowing thousands of homes to foreclose is not acceptable from a policy point of view, can we find any economic tools that might yet be helpful in fighting foreclosure? Yes, we can find such tools — that's the good news  — but the bad news is that those tools are not long-term solutions. For example, the government could offer aid to help struggling homeowners with their mortgage payments, but in the long run, such a policy will only encourage more unsustainable mortgage bets. An even more aggressive policy might demand that all banks reduce interest rates on certain types of loans — but this would likely destroy confidence in the system, in addition to encouraging irresponsible borrowers. The bottom line is that any action to shield homeowners from the consequences of foreclosure will have this same effect of worsening the original problem. The cause (unwise borrowing) cannot be separated from its natural effect (foreclosure) without destroying the entire system.

This economic analysis of the foreclosure crisis seems to leave us with an insoluble problem. The only sustainable way to solve the problem of irresponsible borrowing is to allow the market to return to equilibrium — that is, to allow the complete consequences of missed payments and foreclosures to take effect, and perhaps even to increase those consequences in order to deter other prospective borrowers. Yet this is precisely the consequence that is unacceptable from a short-run standpoint. Of course, the best way to deal with such crisis is to prevent them from happening at all — but absent such impossibilities as the sudden invention of a time machine, we are stuck in our current dilemma, with no apparent way out except to suffer seemingly unacceptable consequences.

This, at any rate, is what economics tells us. But rather than looking for a clever way out of this economic trap, what if we embraced the force of our dilemma and simply abandoned the entire paradigm? Economics has conclusively shown that it cannot help us. This is not a promising result, to be sure, but we can learn something from it: namely, that we must look outside the realm of economics to find a solution.

One of the greatest ironies of the recent economic crisis is that economic responses are the only ones being seriously considered. Many policy-makers have found it convenient to blame the recession on economists and their ideas about the market system, yet their own policies reveal an increased rather than decreased faith in the usefulness of standard economic tools — stimulus, taxes, monetary policy, and so on. The apparent assumption is that if we use a different kind of economics to run our system, then everything will become better. There is, however, an alternative explanation well worth considering. Perhaps the real source of the problem is not the wrongness of certain economic ideas, but our dependence on economics to do what it was never designed to do in the first place! Maybe no pure economic theory holds the solution to the problems of our national economy. In other words, maybe economics is not the tool we should be using!

The obvious objection is that economics is, by definition, the study of the economy, and therefore the best positioned to effect an economic recovery. But while this is partly true, it is important to remember that the "economy" is not just some isolated idea. It involves — indeed, one could argue it is the sum of — every individual's ideas, preferences, and attitudes regarding his or her wants and needs. That is the economy's bottom line — a bottom line that most economists, quite naturally, take for granted. In fact, it is essential to economics that this baseline be ignored: economics is designed to give us the big picture, typically at the expense of individual data points. This perspective is what makes economics such a powerful tool; but it is also what causes economics to miss an essential part of our national economy. Once economics becomes economic policy, we can no longer afford to rely solely on the big picture, because what the big picture leaves out is people. At this point we must supplement our economic questions of behavior with moral questions of choice.

At first glance, economics and morality would seem like complete opposites — and in some ways they are. Good economics requires moral considerations to be disregarded; similarly, good morality pays little attention to economic consequences. Yet economics and morality are both in the same fundamental business: decision-making. Economics is about how factors of self-interest influence decisions; morality is about how factors beyond self-interest influence decisions. In the case of the foreclosure crisis, we have seen how pure self-interest cannot give much help; such self-interest dictates that owners of "underwater" properties should abandon their homes, and that banks should simply try to squeeze as much money out of homeowners as possible.

Fortunately, few people (or banks) make decisions in such an amoral way — so economics, as it turns out, is not the only option. By appealing to values of justice, responsibility, and compassion, the government can positively influence lending and borrowing decisions, and at the same time uphold individual choice against government control and compulsion.

My proposal is this: that the government should fund and supervise a strong campaign to encourage voluntary individual decisions that will reduce foreclosures. The idea is to energize and support homeowners and banks in making their own, case-specific choices in favor of sustainable lending, responsible payment, compassionate flexibility, and reasonable negotiation. This process might be mediated and encouraged by public officials, but it would not be government-controlled in any way. Instead, the government's primary role would be to increase awareness through advertising and build support from communities, organizations, and banks. The message style would be somewhat akin to World War II-era advertisements: "Uncle Sam wants you, homeowners, to be more responsible about making your payments. Uncle Sam wants you, banks, to give your customers more breathing space. And Uncle Sam wants both of you to negotiate better mortgage agreements, agreements that you can both feel good about and abide by." In a word, I propose a serious, publicity-centered effort to impress both homeowners and banks with the moral importance of having a good lender-borrower relationship.

An approach to the foreclosure crisis based on individual choice would have powerful advantages. First, by emphasizing good-faith negotiation, it would allow resolution of foreclosure issues on a case-by-case basis rather than requiring a complex and somewhat arbitrary set of national rules. Second, by relying on moral incentives, it would ensure that relief goes to committed homeowners rather than speculators. Finally, by making the government the enabler rather than the director, it would minimize both the cost of the program and its potential for politicization. By relying on the precision of personal choice rather than the blunt tool of economic incentives, this plan would avoid many of the fiscal and political pitfalls that an economic program might entail.

Probably the most serious objection to this proposal is that its effect is uncertain. There is some truth to this claim. Proposals based on economics seem comforting because they come in dollar amounts that can be directly related to results. This plan involves no such predictions. It may have great effects; it may have minimal effects; it may even have no effects at all. But the same is also true of most economic and regulatory options: many well-intentioned government programs have had serious unintended consequences. This plan is different because its outcome depends on the decisions of citizens; its effects are inherently democratic. The scale of its effect cannot be known beforehand. What can be known is that it will not be vulnerable to systemic error, because there is no "system" that can go wrong!

A second potential objection to the proposal is that its method of encouragement and moral suasion is somehow inappropriate. It may indeed sound odd, in the twenty-first century, to be advocating a moral approach by the government to the problems of creditors and debtors. Yet these problems have always had a significant moral dimension. The "rule of law" in any society depends not only upon that society's legal system but also upon the attitude of its citizens toward the law. A contract is binding not only because breaking it has legal consequences, but also because the parties are in moral agreement that a contract should not be broken. Obviously the government should not require morality — but it may certainly encourage morality. And such encouragement can have powerful effects, because morality is the background against which individuals make decisions; it is the language of personal choice.

Taken together, however, the above objections point to this plan's greatest advantage: its creative nature. In this crisis, the usual economic tools of regulation and incentive have already been tried, to little effect; now is the opportunity to try something else, something new. If it succeeds, it will seriously mitigate the crisis without too much trouble on the government's part. If it fails, then little has been lost: a program of this type is much easier to end than one that pays out large amounts of government money. In the case of failure, there is still the economic option to fall back on. But by shifting the economic baseline — the attitudes of citizens —this plan has the potential to bypass completely the economic considerations that make conventional solutions to the foreclosure crisis so difficult. That potential, alone, makes it a plan well worth trying.

Nobody wants a foreclosure. Nobody wants a foreclosure crisis. Although there is disagreement as to the best solution, the bottom line is that if no one agrees, everyone loses. Homeowners and banks both want to avoid foreclosure, but homeowners will accept it rather than make their mortgage payments, and banks will accept it rather than lose those same payments. Both are perfectly rational preferences — yet there is room for both to bend, to their mutual advantage. That is exactly what this proposal is designed to enable. By coupling individual choice (the freedom to act on one's own wants and needs) with moral consideration (the ability to take the wants and needs of others into account), this proposal encourages both borrowers and lenders to act on their mutual wants for the common good. The result: better and more accommodating behavior on both sides, without the need for direct government intervention. Call me idealistic, but I believe that the American values of individual freedom and moral responsibility are still strong in our society. With their help, this strategy for fighting foreclosure just might work.

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