The Corner

Economy & Business

What Kudlow Got Right in 2007

Larry Kudlow at CPAC 2015 (Gage Skidmore)

Lawrence Kudlow’s appointment to be director of the National Economic Council has brought out the critics, who have combed through his copious writings to find every wrong call he has made over the decades.

One passage that has come in for some ridicule, though, doesn’t deserve it. Here’s Kudlow, writing in November 2007:

Too much is being made of both the sub-prime credit problem and the housing downturn. A recent Bank of England study shows that residential mortgage-backed securities in the U.S. total $5.8 trillion. Of that, only $700 billion, or 12 percent, are sub-prime. Even when you add in $600 billion of so-called Alt-A mortgage paper, most of which will not default, the total of these home loans is still less than 20 percent of all mortgage-backed paper.

What’s more, the entire market in sub-prime debt is just 1.4 percent of the global equity markets. On any given day, a 1.4 percent drop in world stocks would erase the same amount of value as the collective markdown of all sub-prime-backed bonds to $0. It’s just not that big a deal.

An extremely strong consensus has formed that Kudlow was wrong about this: that subprime mortgages led to a housing meltdown, financial crisis, and severe recession. But the consensus is wrong.

Here’s how David Beckworth and I put it in 2016:

What the housing-centric view underemphasizes is that the housing bust started in early 2006, more than two years before the economic crisis. In 2006 and 2007, construction employment fell, but overall employment continued to grow, as did the economy generally. Money and labor merely shifted from housing to other sectors of the economy.

This housing decline caused financial stress by sowing uncertainty about the value of bonds backed by subprime mortgages. These bonds served as collateral for institutional investors who parked their money overnight with financial firms on Wall Street in the “shadow banking” system. As their concerns about the bonds grew, investors began to pull money out of this system.

In retrospect, economists have concluded that a recession began in December 2007. But this recession started very mildly. Through early 2008, even as investors kept pulling money out of the shadow banks, key economic indicators such as inflation and nominal spending — the total amount of dollars being spent throughout the economy — barely budged. It looked as if the economy would be relatively unscathed, as many forecasters were saying at the time. The problem was manageable: According to Gary Gorton, an economist at Yale, roughly 6 percent of banking assets were tied to subprime mortgages in 2007.

It took a bigger shock to the economy to bring the financial system down. That shock was tighter money. . . .

It was against this backdrop of tighter money that the financial stress of 2007 turned into something far worse in 2008. With nominal spending falling at the fastest rate since the Depression, households, businesses and banks all had incomes lower than they had expected. That made servicing debts and paying wages harder than expected. It also lowered asset values, since those were premised on expected streams of future income.

And, of course, the crashing economy made the housing crisis worse, too. That’s why the standard account of the crisis took hold. It’s true, after all, that housing fell and then, along with the economy, plummeted. Untangling cause and effect is tricky. But the timeline is a better match for the theory that the Fed is to blame. The economy started to tank not right after housing began to fall, but right after money tightened.

We could have had a decline in housing without a Great Recession. That’s what we went through for two years. What we could not have had without a Great Recession was a decline in nominal spending. If it had cut rates faster, or merely refrained from talking up future rate increases, the Fed might have kept that decline from happening or at least moderated it. Australia had a housing boom and debt bubble, too, but kept a steadier monetary policy. The consequence was a mild correction, but nothing like our Great Recession.

I have no idea whether Larry agrees with this analysis. But from my standpoint, the main thing he got wrong in 2007 was failing to predict the severity of the monetary-policy mistakes of 2008. And I would not judge this mistake too harshly because even in retrospect, so few people see those mistakes and their import clearly.

Ramesh Ponnuru — Ramesh Ponnuru is a senior editor for National Review, a columnist for Bloomberg Opinion, a visiting fellow at the American Enterprise Institute, and a senior fellow at the National Review Institute.

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