Could you explain to us novices what long term effects will the subprime lending debacle have on our economy?

BY Paul Solman  January 17, 2008 at 11:24 AM EDT

Questions/Comment: Could you explain to us novices what long term effects will the subprime lending debacle have on our economy? What remedial measures need to be taken by the government and investors to limit the damage? Finally, which branch of the government is responsible for the oversight of mortgage lenders?

Paul Solman: Long term effects? Not clear. Television reporters used to end so many stories with “Time will tell” that it was effectively banned as a cliché. But in fact, once again, time will tell. It depends, that is, on how many mortgages go into default; how much that drives down housing prices; how those lower prices might then drive more home owners to go into default, lowering the value of the bonds written against those mortgages, and so on, down and down. (Although I will share a suspicion with you: even if the economy goes into a horribly deep recession, people will argue for decades as to whether the sub-prime “debacle” really caused it, and there will be substantive arguments on both sides. Life is too complex for simple causal explanations, I mean, even in retrospect.)

Remedial measures? Well, the Federal Reserve has been trying its darnedest — by lending money to troubled banks so they won’t go under; by lowering interest rates so lending and borrowing can continue unabated. The general idea: keep credit moving so the economy doesn’t stall.

Also, the administration has been trying, by coming up with a fund for buying the troubled mortgage-backed loans, so they won’t tank further in value. And big financial institutions have been trying to do the same.
Right now, though, it’s not clear if any and all of these institutions are going to succeed in preventing an economic contraction.

Final third of your question: what branch of government is responsible? Well, that’s a big problem because the Fed refused to clamp down on lending practices, just as Wall Street firms were moving into the home mortgage business. For further explanation, see our piece on the subject with Wellesley College’s legendary economics professor, Karl ‘Chip’ Case. (For a great article on Case, by the way, see David Warsh’s column on him.

Warsh’s column, Economic Principles, is required reading for many economists around the world, and a real pleasure.

Martin Neil Baily, guest vetter: The economic deregulation movement started in the 1970s and has been bipartisan. It has resulted in lower prices in several industries and has contributed to more competition and faster productivity growth. But not all regulation is bad. Sometimes good regulation is needed to make markets work better and to protect consumers.

A hero of the whole mortgage mess is Edward (Ned) Gramlich. As a Federal Reserve Governor he repeatedly warned regulators at the Fed and elsewhere that there were deceptive lending practices occurring in the mortgage market and that a crisis was coming. Sadly, no one would listen to him or act on his warnings. Ned died of cancer in September.

One reason for the crisis is that brokers were paid for making loans but suffered no losses when the loans went bad, and hence had no incentive to make sure the borrowers could service the mortgages – a market failure. The financial sector is regulated, in part, to avoid such market failures, but the regulators were asleep at the wheel. A fitting memorial to Ned Gramlich would be to make sure regulators have the mandate and resources to ensure that financial markets work to the benefit of all, while remaining dynamic and innovative.

For the story of Gramlich’s efforts, read this.