The Mysterious Effective Demand tweeted and blogged on a paper by University of Arizona Professor Brent T. White. I haven’t read the full paper, but the portion quoted by Effective Demand presents a pretty simple and predictable argument that “Millions of American homeowners are “underwater” on their mortgages – owing more than the value of their homes – and would be better off walking away.”
This sad state of affairs is presumably brought about by an evil collaboration between “irresponsible lenders,” governments, and credit counselors who “scare and shame borrowers into making what is in many cases a bad financial decision to stay in their home.”
Before we begin, we need to recognize that Professor White is a law professor and not an economist. We can therefore forgive his bombastic quotes and apparently incomplete analysis.
Unfortunately, we now need to take a small detour to discuss the economics of lending. There are two types of credit default: strategic and inability to pay. Since Professor White’s article is about people who could pay, we are discussing strategic default.
It is well understood and generally accepted among economists that, absent an enforcement mechanism, the risk of strategic default results in the under-allocation of credit. Fewer loans are made than are optimal. For the law professors across cyberspace, that means that some people who should get credit won’t get credit.
So, society has created disincentives for strategic default. Over time, those disincentives have been weakened. We no longer have debtor prisons, and the stigma attached to bankruptcy or foreclosure has declined. However, we still have disincentives. Default on a home may make it difficult to finance another home, or to obtain future consumer credit. Foreclosure is also a very public process, and it could damage some people’s reputations.
With these disincentives, it is often entirely rational for a homeowner to pay for an under-water home.
But I don’t think Professor White was truly saying that homeowners were being irrational. From the quotes I’ve read, I think Professor White was complaining about the very existence, small as they are, of disincentives for strategic default.
That’s just muddled thinking. I would ask that we consider the possibility that current disincentives for strategic default may be too small. I’m not advocating debtor prisons. There are plenty of disincentives between debtor prison and what we have now. Eliminating limited liability comes to mind. As things now stand in California, a person can walk away from under-water home while having, say, $1 million in the bank. Having to pay any deficiency when ability exists would be a formidable disincentive to strategic default.
If we do accept wholesale strategic default, as Professor White apparently advocates, credit availability will decline.