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FALL 2010
Volume 1 Number 3

F refront

New Ideas on Economic Policy from the FEDERAL RESERVE BANK
of CLEVELAND

The Economic Importance
of Being Educated

INSIDE:
Early Childhood Education
Consumer Finance
Mortgage Counseling

P LUS :
Q&A with Laurence Meyer

F refront

New Ideas on Economic Policy from the FEDERAL RESERVE BANK
of CLEVELAND

6

FALL 2010

Volume 1 Number 3

CONTENTS
1 President’s Message
2 Reader Comments
4 Upfront
Battling the next phase of the housing crisis

6 Stop Investing in Stadiums… Start Investing in Kids
Interview with Art Rolnick

10 Mortgage Counseling, Plain Language, and
Financial Education: What Works?
Highlights from the 2010 Community Development Policy Summit

14

14 Five Big Ideas about Consumer Finance Education
Observations of a Federal Reserve researcher

18 Overextended, Underinvested:
The Debt Overhang Problem
Economists explain how debt kills investment

22 Interview with Laurence Meyer
Former Federal Reserve governor on the state of macroeconomics

18

28 Book Review
The Big Short: Inside the Doomsday Machine

22
The views expressed in Forefront are not necessarily those of the
Federal Reserve Bank of Cleveland or the Federal Reserve System.
Content may be reprinted with the disclaimer above and credited
to Forefront. Send copies of reprinted material to the Public Affairs
Department of the Cleveland Fed.
Forefront
Federal Reserve Bank of Cleveland
PO Box 6387
Cleveland, OH 44101-1387
forefront@clev.frb.org
clevelandfed.org/forefront

President and CEO: Sandra Pianalto
Editor-In-Chief: Mark Sniderman,
Executive Vice President and Chief Policy Officer
Managing Editor: Robin Ratliff
Editor: Doug Campbell
Associate Editors: Amy Koehnen, Michele Lachman
Art Director: Michael Galka
Designer: Natalie Bashkin
Web Managers: Stephen Gracey, David Toth
Contributors:
Dan Littman
April McClellan-Copeland
Filippo Occhino

Anne O’Shaughnessy
Andrea Pescatori
Jennifer Ransom

Editorial Board:
Ruth Clevenger, Vice President, Community Development
Kelly Banks, Vice President, Community Relations
Stephen Ong, Vice President, Supervision and Regulation
James Savage, Vice President, Public Affairs
Mark Schweitzer, Senior Vice President, Research
James Thomson, Vice President, Research

PRESIDENT’S MESSAGE
Sandra Pianalto
President and Chief Executive Officer
Federal Reserve Bank of Cleveland

Ever since the first signs
of economic recovery
appeared, I have expected
that the path forward will
be gradual and bumpy.
It certainly has been so far.
At this point, our journey
to full economic recovery
is really just beginning.
I can assure you, however,
that my colleagues and
I at the Federal Reserve are committed to using the tools we
have to pursue our dual mandate from Congress—to keep
prices stable and to promote maximum employment.
We will do our job as central bankers to help our economy
get back on track. It’s important to acknowledge, however,
that some long-term goals for economic growth require broad
commitment from all Americans. Above all, we must not forget
education’s crucial role in determining economic growth. The
results of research in this area, including some by economists at
the Federal Reserve Bank of Cleveland, are crystal clear: One
of the best ways for cities, states, and countries to increase their
per capita income is to raise levels of educational attainment.
Educating people may not sound terribly urgent during difficult
economic times, but when it comes to creating jobs and finding
people who have the skills to fill them, nothing is more important than education. Incomes are largely determined by how
productive people can be, and education plays a crucial role in
increasing productivity. Investing in education enables people
to produce more valuable services in a given amount of time.
On top of that, an educated populace is better equipped to
navigate our increasingly complicated financial markets.
That is why this issue of Forefront presents a package of articles
focused on the compelling returns to education.

We begin with an interview with Art Rolnick, former research
director at the Federal Reserve Bank of Minneapolis, who
forcefully lays out the unambiguous results of research on early
childhood education: Preparing children for kindergarten may
be the single most effective way to foster their future success.
Rolnick has taken the research a step further and developed a
pilot program for early education in St. Paul, Minnesota, which
may be expanded statewide. I look forward to seeing the results.
Early childhood education is a first step. Sustained investments
in education are likewise important. In “Five Big Ideas about
Consumer Finance Education,” the Federal Reserve Board’s
Jeanne Hogarth talks about the intersection between high-level
research and street-level results. Rounding out our coverage,
we examine financial education about the housing market
with a review of the Federal Reserve Bank of Cleveland’s 2010
Community Development Policy Summit. In particular, we
look at the effectiveness of mortgage counseling in helping
borrowers steer through the sometimes-opaque process of
buying a home.
The policymakers and shapers in these articles share a passion
and a dedication to achieving progress in education. They have
moved past agreement on our long-run priorities and dug deeper
into the nitty-gritty of achieving those priorities. They are taking
an honest look at what works and what doesn’t. I am hopeful that
their experiences will give others the courage to leave behind pro­
grams that do not deliver on achieving our education priorities.
As always, there are no quick fixes. Identifying education investments as sources of progress is easy, but achieving them requires
great commitment. These challenging economic times provide
an opportunity to make decisions guided by a long-term view.
So, as we slowly recover from the recession, let us lay the ground­
work for a long-lasting economic expansion. Let’s renew our
commitment to educating Americans. ■

F refront

1

Reader Comments
A Proposal: Using the CRA to Fight Vacancy and Abandonment
Update: On June 17, 2010, federal regulators, including the Federal Reserve,
announced a proposed change to the Community Reinvestment Act (CRA). The
change would encourage banks to support the Neighborhood Stabilization Program
administered by the U.S. Department of Housing and Urban Development. The
proposal is similar to, and was influenced by, the Federal Reserve Bank of Cleveland’s
recent recommendation aimed at easing the vacancy and abandonment crisis
(Forefront, Spring 2010). The Bank’s proposal would amend the CRA to increase
banks’ incentives to provide community groups with loans, services, and investments
that support neighborhood recovery efforts.

I commend the Cleveland Fed for entertaining this proposal
for modifying the system for determining the CRA ratings
of large retail banks, i.e., those with assets greater than
$1 billion. If adopted, the proposal would break new ground
in six important ways:
Mark Willis

■

■

■

■

■

■

2

Fall 2010

First, it would demonstrate that CRA can be amended on
a timely basis to address changing economic conditions.
Second, it would set a new precedent, albeit subject to
some significant restrictions, for giving these banks full
credit for activities regardless of the geography being
served.
Third, it would elevate the importance placed on nonlending activities such as demolition that also help to
stabilize and revitalize a community and thus improve
the ability of local individuals and institutions
to access credit.
Fourth, it would give these banks the ability to increase
the relative importance of the investment and service
tests in determining overall CRA ratings.
Fifth, it would offer, but not mandate, an alternative
way for these banks to serve communities that have
been particularly hard hit by the current housing crisis.
Sixth, it would provide an automatic trigger for
suspending or reinstating the special rules depending
on economic conditions and not contingent on future
votes that would require the regulatory agencies to
reach consensus in a timely manner.

Adopting the proposed regulatory changes, however, is
only part of the battle. Banks will need more details in order
to evaluate the relative merits of sticking with the current
system or going with the new option. Most banks already
have a good idea of what they need to do under the current
system to achieve the same rating again at their next exam.
For evaluating the new option, banks will need to understand,
for example:
■

■

■

■

How will credit be determined for REO donations—
number of properties donated, the market value of
the properties at the time of the donation, or some
other measure?
Will donations of property be given more than the
nominal credit now given to philanthropic grants under
the investment test?
Similarly, how much value will technical assistance be
given under the service test, which is now mainly about
bank branch services?
How much in “extra points” will be needed to get an
outstanding rating on one or more of the lending, investment, and service tests, and how will the scores on the
three tests be combined to determine the overall rating?

Without clear upfront answers to these types of questions,
it may be hard to get banks to make the hoped-for changes
in their CRA business plans.
Mark Willis
Resident Research Fellow
Furman Center for Real Estate and Urban Policy
New York University
New York, New York

Janneke
Ratcliffe

The Community Reinvestment Act did not cause the current
foreclosure crisis, but it might be able to ameliorate some of
its consequences. A recent proposal by the Federal Reserve
Bank of Cleveland would deploy the CRA to reward banks
for resolving the vacant and abandoned stock of real-estateowned (REO) properties, even if those properties were
located outside the CRA assessment areas usually used to
measure compliance.
The CRA was created in 1977 to counter the practice of
denying access to credit to particular communities. The
principle held that if banks were going to set up shop and
accept deposits from a community, then they should
reinvest those funds in that community. But recent developments in banking and financial services have made this
premise outdated.
Not only have a variety of alternative sources of financial
services arisen, but the neighborhood-centric concept of
traditional banking has given way to large interstate or even
multinational banking conglomerates. Consequently, the
collapse of the housing market has left banks holding onto
foreclosed properties far from their CRA assessment areas.
The proposal would allow banks to receive CRA consideration for donations or sale of REO properties to community
development groups, as well as technical assistance and

lending to such groups, as long as the investment needs
of the assessment area are satisfactorily met. This is an
entirely reasonable way to encourage stabilization, even in
neighborhoods where the bank does not have a branch office
but still has a financial stake due to mortgages made there.
That is not to say that branch offices have lost their importance. In the REO context, a local presence facilitates
cooperation with community groups and a better understanding of community needs, which can lead to more
productive efforts to stabilize neighborhoods. Efforts to
fight the tide of foreclosures should also provide impetus
for banks to aggressively and productively resolve REO
within existing assessment areas.
What is most significant about this proposal is its recognition
of the latent power inherent in the Community Reinvestment
Act through regulatory discretion. Flexibility within the
statutory framework is vital to the ability of the Act to keep
up with changes in the market and address evolving issues,
insofar as the spirit of those requirements remains strong.
Janneke Ratcliffe
Associate Director
Center for Community Capital
University of North Carolina
Chapel Hill, North Carolina

Small Businesses: Credit Where Credit Is Due?
I appreciate the information in your new Forefront magazine.
In the article entitled “Small Businesses: Credit Where Credit
is Due?” while good points were made, one significant,
troubling area of concern was missed: the negative effects
of over-regulation on businesses.
I have been a small-town banker for 25 years, and I understand “burdensome regulations.” But talking with small
business owners over the last 10 years, I have witnessed an
increasingly uphill battle for all businesses to comply with
ever-expanding regulations.
I personally know of many businesses in our local community
that have closed up shop because they could no longer
afford the costs of regulation. As such, prudent bankers
understand how these costs directly affect the bottom line
of business owners, and we add it to the risk factors when
making credit decisions. These concerns become ever more
relevant in a stagnant, down economy.
The state of Ohio is particularly tough on both regulations
and taxes—as illustrated in its ranking in the top five worst
states in the Union in which to do business. In addition to
being a banker, I also am involved in the management of
two other businesses as well as serve on several boards.

Regulations alone will make one’s head swim, but there
are so many that are redundant, unnecessary, or just plain
ridiculous. And believe me, these are having a very negative
effect on nearly every business out there.
Lending to a business to cover regulatory expenses, or to
compensate for the cost of complying with regulations—
when there is no monetary return on the investment—
is risky at best. But many business owners are faced with
exorbitant regulatory costs for new installs, upgrades, or
remodeling. There is no upside.
Just recently, I helped finance a local fellow opening a
very small donut shop. His cost to comply with the various
regulatory requirements was $18,000. He’ll have to sell a
lot of donuts to recoup that money, wouldn’t you say?
It’s time to consider ALL risks associated with business
lending. Perhaps if the Fed would point out the crushing
effects of over-regulation, some much-needed changes
would be made that most assuredly would increase business
profits. And that would bring a smile to bankers’ faces.
Thank you for your time.
Joe Wachtel
President
Monitor Bank
Big Prairie, Ohio
F refront

3

Upfr nt
Battling the Next Phase of the Housing Crisis

Anne O’Shaughnessy,
Community Development
Project Manager

The foreclosure crisis is breeding a
new one: a crushing load of REO,
or real-estate-owned, properties.
These are the foreclosed homes
that banks and other lenders have
on their books after failing to sell
them at sheriff’s auctions. In weak
housing markets, including many
in the Fourth District, these unsold
houses too often stand vacant and
neglected.
A new volume published by the
Federal Reserve Banks of Cleveland
and Boston and the Federal Reserve
Board of Governors highlights the
latest research and on-the ground
efforts to attack the REO problem
on several fronts. The collection of
articles, REO & Vacant Properties:
Strategies for Neighborhood Stabilization, was released in September

to coincide with a summit hosted by
the Federal Reserve in Washington.
The summit aimed to help communities and practitioners find the most
promising practices for addressing
neighborhood stabilization and the
disposition of REO properties across
the country.
Among the Cleveland-area
contributors to the volume were
researchers at Case Western Reserve
University. The researchers reported
a worsening scope to the problem
in northeast Ohio, offering new
evidence of how REO properties
further drag down communities.

4

Fall 2010

In “REO and Beyond: The Aftermath of the Foreclosure Crisis in
Cuyahoga County, Ohio,” Claudia
Coulton, Mike Schramm, and April
Hirsh found:
• Since 2007, almost all properties
in Cuyahoga County (home to
Cleveland) that come out of
foreclosure sales have ended up
as REOs.
• The number of REOs in the county
peaked in 2008 at just over 10,000
properties and had declined to
about 7,300 by late 2009.
• REOs are disproportionately
concentrated in lower-income
communities.
• From 2004 to 2008, the percentage of properties on Cleveland’s
east side that sold out of REO
at extremely distressed prices—
$10,000 or less—shot up from
4 percent to almost 80 percent.
What does this mean for the area’s
already-battered neighborhoods?
REOs are often vacant and subject
to vandalism and further devaluation. Their presence lowers the
values of neighboring properties
and destabilizes neighborhoods.

The authors’ findings also indicate
that most REO properties in the
county are owned by national lenders, some with no local branches.
Buyers include many out-of-state
investors, who may purchase these
properties sight unseen and take
a let-it-sit-I’ll-wait-till-the-marketrebounds approach. They tend not
to make any improvements, and
maintenance suffers.
By 2009, REO properties on
Cleveland’s east side were selling at
just 13 percent of their pre-foreclosure
market value. Given already-low
housing prices and the large volume
of REO transactions, the authors
wrote, “these post-REO sales price
figures have disastrous effects on
the values of neighboring properties
not in foreclosure and on the tax
bases of neighborhoods and
communities.”
Though solutions are hard to come
by, one promising local effort is
the Cuyahoga County Land Bank.
That’s the subject of Federal Reserve
Bank of Cleveland economist
Tom Fitzpatrick’s article in the REO
publication. Fitzpatrick explores how
modern land banks have developed
into powerful tools: Communities
acquire REO properties as a way
to stabilize, and in some cases
revitalize, at-risk neighborhoods.
Modern land banks tend to have
broader geographic coverage and
to wield wider powers to acquire,
deconstruct, demolish, and rehabilitate inventory, and keep dedicated
revenue streams—all improvements
on traditional land banks.

Rising Tide

Properties Entering and Leaving REO in Cuyahoga County
Number of properties
12,000
10,000
8,000
6,000
4,000
2,000
0
2004

2005

2006

Properties entering REO
Properties leaving REO

2007
■
■
■

2008

2009

2010

Local lenders
Government-sponsored entities
National lenders

Prepared by: Center on Urban Poverty and Community Development, Mandel School of Applied Social
Sciences, Case Western Reserve University.
Source: NEO CANDO (http://neocando.case.edu), Tabulation of Cuyahoga County Auditor data.

Other approaches highlighted in the
volume, such as the public–private
partnership spearheaded by Boston
Community Capital in specific
neighborhoods of the city, show the
distinct ways that communities deal
with the challenge of their REOs.
The REO volume represents the
Federal Reserve’s effort to listen to
stakeholders, analyze various policy
options for dealing with important
public problems, and then make
information available. ■

Related link
REO & Vacant Properties: Strategies for
Neighborhood Stabilization, the name of
both a national summit and its companion
publication, focuses on how policymakers and
community development practitioners can
help stabilize the neighborhoods most at risk
for decline. The publication contains 17 articles
that shed light on the scope of the problem in
specific areas of the country and showcases
some methods for dealing with the challenge
of vacant and REO properties.
www.clevelandfed.org/Community_Development/
publications/REO/index.cfm

F refront

5

Stop Investing in Stadiums…
Start Investing in Kids
An interview with Art Rolnick, whose research on behalf of the
Minnesota Early Learning Foundation aims to spur long-term
economic growth

Every metro area in the United States has one—an economic
development agency. The agency typically spends its time and
money putting together bids to woo manufacturing plants or
Fortune 500 headquarters. Sometimes, it supports tax initiatives to
build luxury sports stadiums. Representatives travel to other cities
to get ideas on how to grow jobs and wealth—with waterfront
developments, tourist attractions, and downtown condos.

Although sometimes these efforts create jobs, often they come at the expense
of jobs lost somewhere else. Or the promised “spillover benefits” never arrive.
But a growing number of experts are advocating for another kind of economic
development that is uniquely effective—early childhood education. The main
questions are how best to design the program and how to build greater public
support.
Art Rolnick, an economist and former research director at the Federal Reserve
Bank of Minneapolis, thinks he has the answer. Over the next few years, people
across the nation will be able to see the results for themselves.
Mark Sniderman, executive vice president and chief policy officer with the
Federal Reserve Bank of Cleveland, interviewed Rolnick via videoconference
on June 30. An edited transcript follows.

6

Fall 2010

Sniderman: We’re here this morning to
discuss early education. How did you
first become interested in this topic?
Rolnick: My involvement was serendipity. A group of us used to meet
about once a month for lunch here
in downtown Minneapolis—some
lawyers, businesspeople, academics,
and media people. About nine years
ago, we invited the executive director
of an organization called Ready for K
[kindergarten], which was established

Arthur J. Rolnick
Position:

Senior fellow at the Humphrey Institute in Minnesota
Past Position:

Senior vice president and director of research
at the Federal Reserve Bank of Minneapolis
Essays:

Include the nationally recognized
“The Economics of Early Childhood Development”

by a former governor of the state,
Al Quie, and a former mayor of
Minneapolis, Don Fraser. The organization was advocating for early childhood education and development.

Sniderman: What are the critical differences in the way the issues are framed
and how you evaluate some of the
choices that need to be made from the
economist’s perspective?

I listened to the talk. They presented
what I thought was a fairly weak argument. It was basically a moral argument, and it’s not that I disagreed with
it. But it was weak from an economic
point of view. I felt that if they were
going to really push this issue forward,
they should look at the economics of
investing in early childhood education.
Policymakers need a way to rank a
plethora of reasonable-sounding initiatives. They need a way to figure out
how much to invest in each. And that’s
where economics comes in.

Rolnick: We argued that early childhood development is economic
development, and the research shows
it’s economic development with a
high public return—very high.

I made that comment, and that was my
mistake! Because the board of Ready
for K, in particular the former governor
and mayor, started calling and asking
if I would come on the board and write
the background paper.
So I agreed to look into the economics
of early childhood education. I went
to work with my colleague Rob
Grunewald, who was our education
outreach person at the Federal Reserve
Bank of Minneapolis. After three
months we sent our report to Ready
for K. I thought I was done and could
resume my research on pre–Civil War
banking.
I was wrong. Since that report, over
the last nine years, almost every week,
Rob and I have received at least one
call or written invitation to speak
somewhere on this issue. We have
been to almost every state.

We looked at four well-known longitudinal studies. I’m going to talk about
one in particular, the Perry preschool
study. That was back in the early 1960s
in Ypsilanti, Michigan. In this study,
123 at-risk kids and their parents were
enrolled and randomly divided into
two groups. One group got a very
high-quality early education program,
including master’s-level teachers, small
classroom size, and home visiting. So
there was a program group and a control
group. Reports were produced every
10 years and we now have a 40-year
report, comparing the children who
eventually became adults who were in
the program, to the control group.
Rob and I asked a very simple question:
What was the return on that investment? It hadn’t been asked quite that
way before.
That’s what economists would normally ask about any proposed public
investment. We know the cost of the
two-year program; in today’s dollars it
was $22,000 per child. Now we need
to know the benefits. Well, children
that were in the program were less
likely to be retained in the first grade,
and that’s a significant saving. They
were less likely to need special ed.

Education:

Wayne State University, BS, mathematics;
University of Minnesota, PhD, economics
Bio:

Rolnick joined the Federal Reserve Bank in 1970. He
served as senior vice president and director of research
from1985 until his retirement this summer. In 2003,
Rolnick and colleague Rob Grunewald wrote a policy
proposal that advocates providing high-quality early
childhood education to at-risk children. That effort has
grown into a pilot program supported by the Minnesota
Early Learning Foundation.

That’s a significant saving. They were
more likely to be literate by the sixth
grade, graduate high school, get a job,
pay taxes, stay off welfare. And the
largest benefit of all, for the children
who were in the program, the crime
rate went down 50 percent relative to
the control group.

We found that in the Perry preschool study,
the annual rate of return, inflation-adjusted,
was 16 percent. I don’t think you could find
a better public investment.
Economists can put dollar values on all
these benefits and back out the return
on investment based on the benefits
and the costs. We thought it would
be high. We compared it to the stock
market. The annual yield in the stock
market, post–World War II, is about
5.8 percent, so we thought we would
be doing well if we could beat 5.8 percent. We found that in the Perry preschool study, the annual rate of return,
inflation-adjusted, was 16 percent.
I don’t think you could find a better
public investment. (In a more recent
study, James Heckman finds a somewhat lower, but still high, 10 percent
return.)
Sniderman: What have you learned
about what it takes for a program to be
successful? Does it extend beyond the
classroom?
Rolnick: Let me clarify. When we’re
talking about early childhood development and education, we’re talking prenatal to five years old. Learning begins
right away. The neuroscientists show
F refront

7

Minnesota Early Learning Foundation
Established in 2005, the Minnesota Early Learning
Foundation is a nonprofit organization dedicated to
developing cost-effective strategies to prepare children
for success in kindergarten. Over the last three years,
MELF has raised more than $19 million privately to
fund an early childhood education program called
Scholarship Plus. In the foundation’s pilot program,

www.melf.us

that if the child is in a stressful environment during these early years, the
brain doesn’t develop properly. There
was a famous study by Dr. Bruce Perry
on the orphans in Romania. They
were put in cribs and virtually ignored,
except for feeding time. At age three,
their brains were about a third smaller
than what they should have been.

I think we have the research on our side.
I think we have the economic case on our
side.... Unfortunately, we still have a long
way to go politically to make all this happen.
One of my mentors, Dr. Jack Shonkoff
at Harvard, makes a strong case that
the debate between nature and nurture
is over. We know that environment
matters a lot for normal brain development, starting at prenatal. In other
words, there is a critical mental and
physical health component to early
childhood education.
We have a lot of research that says if a
child is in a healthy and loving environment, in which there’s bonding between
the parents and the child, where there’s
positive interaction, so the child starts
out cognitively and socially ready for
school, there’s a high probability that
the child will succeed in life. If not,
there’s a high probability she will not.
Here is my frustration. We have a
lot of information that there is an
extraordinary public return to early
childhood education and a small
return to investing in professional
sports teams. Indeed, we spend
billions of public dollars around this
country building sports stadiums and
arenas. There is virtually no return on
8

Fall 2010

low-income parents in a St. Paul community are
eligible for no-strings-attached scholarships worth
$13,000 to enroll three- and-four-year olds in highly
rated preschools. This summer, 625 parents were
signed up. Now, the foundation is working to expand
the program across the state. Participants also are
assigned a “mentor” to work with them on an array of
parental issues, including nutrition and health.

these investments, because they would
have been built without public subsidies. I think we have the research on
our side. I think we have the economic
case on our side. I think we have the
healthcare case on our side. Unfortunately, we still have a long way to go
politically to make all this happen.

things happen. We proposed a simple
idea—scholarships. We advocated for
providing two-year scholarships to
families living in poverty so they could
send their children to high-quality
early childhood programs for threeand four-year olds. That’s where we
began our proposal.

Sniderman: You have stirred up some
controversy in terms of the program
design that you had in mind. I wonder
if you could describe the more unusual
approach that you’ve been advocating.

Then critics said that’s fine, but it doesn’t
start early enough. Well, we actually
call our program “Scholarship Plus,”
and the plus is a mentor, a home-visiting
mentor that begins prenatal. We advocate that this home-visiting mentor,
the first one coming to the door, is a
home-visiting nurse because of the
health aspects. That mentor stays with
the family, or triages if necessary, so
the family has an ongoing mentor
who works with them on nutrition,
prenatal care, and parenting skills.
Studies show that when you have
home-visiting mentors working with
teenage moms especially, you can
reduce infant mortality and the number
of low-birth-weight babies. So you get
at that health component, you get at
that initial bonding component, you
make sure there is positive interaction
between the baby and the mom. That’s
the beginning of our program. Then
when the child turns three, the child
receives a two-year scholarship.

Rolnick: You’re right; some have
questioned our second essay.

When we looked at the research, a
number of challenges were suggested:
• One is that if we’re going to come up
with a public policy, it would have to
be one that we could scale up so we
apply it to all at-risk kids.
• Another challenge is we didn’t think
we could get sustainable results if
we didn’t engage and empower the
parents.
• A third challenge is that you’ve got to
be able to measure results. You can’t
just tell the public, “Trust us.” You
have to be able to show that these kids
are actually benefiting.
• Finally, there was the challenge from
the neuroscientists who said you
can’t just start at three—you’ve got
to start at prenatal or birth.
Based on those challenges, Rob and
I came up with a policy proposal that
focused on the demand side of this
market. As economists, we’ve been
taught that markets are powerful
forces. If you’ve got customers with
economic power, the market will make

The conventional approach is more
top-down. It focuses on programs,
not on parents. However, I don’t care
how many good programs you have
out there. If you haven’t engaged the
parents in the program, you’ve failed.
Start with the parents, focus on the
parents, and empower the parents with
resources; the market will provide the
quality programs.

We actually have a pilot project that
is testing these ideas, and what we’re
showing is that, sure enough, the
market responds. We have a fourstar rating system; you have to be a
three- or four-star-rated program to
get our scholarship kids; our scholarships pay up to $13,000 a year. Our
critics said there wouldn’t be enough
capacity; they were wrong. Capacity
of high-quality programs has grown
with demand, as predicted. (See the
Minnesota Early Learning Foundation
website for a description and evaluation
of this project.)
Some private early ed programs have
moved into the neighborhood, very
good programs. Head Start and Montessori have expanded their programs;
in the St. Paul schools, early ed capacity
is growing. The market is responding.
Our parents are not having a problem
finding programs. There were some
issues when we were first handing out
the scholarships, but once the word
got out, capacity started to increase.
We’re getting the kind of results that we
hoped for, and we’re getting engaged
parents involved in the process.
Sniderman: Can you describe some of
the challenges early ed is facing in
gaining more acceptance and funding?
Rolnick: We think from an education
perspective, the case for early ed is
strong. But if you were just looking at
early childhood development from a
health perspective, you would wonder
why more public resources are not
being invested in our most at-risk
children. The research is overwhelming.
So why are resources not increasing,
especially in a state like Minnesota?
We’re an education state, very progressive state, very wealthy state. The
problem politically is that these kids
don’t vote, at least not in our state!
Their parents generally don’t vote.
These problems are long-term, they’re
opaque; you don’t really see them until
many years down the road. If I build a
stadium, you see that tomorrow. It looks
like you’re creating jobs even though
you’re really not; you’re just moving
them around. So it is an interesting
political issue.

More generally, there is a disconnect
between our public priorities and the
research. There is the research that
shows there’s a high public return
to making sure our at-risk kids start
healthy and ready to learn at kindergarten, versus the research that shows
that investing public money in entertainment and other private businesses
has a very low public return. And it’s
not just sports teams that pit one city
or state against another. But in the
name of creating jobs, we use public
subsidies to try to lure one company
from one state or one city to another.
This kind of economic development,
which seems to dominate conventional
practice, is winning the day. That’s
where most of our economic development dollars go across the country—
and it’s billions of dollars—while early
ed struggles just to maintain its funding.
Sniderman: As you mentioned, Art, some
of the programming is very challenging
to find funding for. What sense do you
have about federal-level support and
interest in early care and education for
kids in the areas that we’ve been talking
about?
Rolnick: On both sides of the political
aisle, there’s an understanding of the
latest research on early childhood
education and the potential return
to society. I say both sides of the aisle
because during the campaign, both
candidates cited James Heckman’s
work out of the University of Chicago,
who has done path-breaking research
on the importance of investing early
in children’s education, and cited the
Minneapolis Fed’s research as well.
The Obama Administration has made
a strong commitment to early childhood education. They’re supporting
something called a “challenge grant”
that’s working its way through Congress.
In addition, there is money in the healthcare bill for home-visiting nurses.

So I think there is a lot of encouraging
movement in Washington. I do think,
though, it’s up to the cities and states,
the local communities, to be more
aggressive in this area. I think there
could be federal dollars if they are.

I think it’s going to take a partnership,
the private sector with the local communities and the federal government.
But I think it’s important for communities to get their priorities in order to
make it clear that this is an area we
can’t afford not to invest in.

In the name of creating jobs, we use public
subsidies to try to lure one company from
one state or another city to another. This
kind of economic development, which
seems to dominate conventional practice,
is winning the day....while early ed struggles
just to maintain its funding.
Sniderman: I think it will be fascinating
to come back five years down the road.
There will be a lot more children who’ve
had the opportunity to participate in
the programs in Minnesota and some of
the other places that you’ve mentioned.
We’ll certainly be in a position to know
quite a lot more than we do today about
how effective these programs are and
what some of the critical elements are
that go into making up high-quality
programs. I know you’re excited about
what the future is going to bring as well.
Rolnick: I hope five years from now
we’ll be out of business! We’ll have
convinced the public that this is what
you should do, the scholarships and
mentors will be there for all poverty
kids, and then I can go back and finish
some of my pre–Civil War banking
papers.
Sniderman: Thanks a lot for your time
this morning; I really appreciate it.
Rolnick: Thank you, Mark. ■

Watch video clips of this interview
www.clevelandfed.org/forefront

Read the full interview online
www.clevelandfed.org/forefront

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9

P O L I C Y
S U M M I T

Mortgage Counseling, Plain Language,
and Financial Education: What Works?
Amy Koehnen,
Associate Editor

It’s no secret that the housing crisis still has a hold on America: New foreclosure filings rose 8 percent during the first
six months of 2010 compared with the same period in 2009. What may be less clear is that international, national, and
local housing experts are striving to break that hold. These efforts were top of mind at the Federal Reserve Bank of
Cleveland’s 2010 Community Development Policy Summit—Housing Policy: Who Pays, Who Plays, and Who Wins?—
held on June 10 and 11.

The summit convened top administrators from the
Department of Housing and Urban Development and
other regulatory agencies; researchers from universities
and think tanks; and community development experts.
They put on the table such topics as the cultural ideal
of the American Dream and ways to build wealth in the
wake of the housing crisis.

10

Fall 2010

As the experts merged data and anecdotes to frame the
crisis, one theme stood out: the importance of financial
information for consumers. Conversations centered on
three key ways to help people make better decisions about
their money:
• Use clear language
• Ensure that consumers achieve broad financial literacy
• Provide targeted education programs as necessary

How much better off would Americans be if policymakers
moved on all three fronts? At the Policy Summit, several
speakers described how consumer finance education
efforts are likely to take shape in the near future.

The Fine Print
If you’ve ever bought a house, you’ve probably felt the
anxiety of many prospective homebuyers: What did that
say? How much do I owe? What did I just sign? Mortgage
documents are enough to boggle the mind of the besteducated lawyer. Indeed, federal officials have attributed
the mortgage crisis in no small part to people’s failure to
understand the fine print.
By contrast, consider what happened in Canada during
the past few years. Unlike the United States, Canada did
not undergo a dramatic increase in mortgage defaults, and
none of its banks required a government bailout. One
major reason, according to Virginie Traclet, a researcher
in the Bank of Canada’s Department of Monetary and
Financial Analysis, is the way financial disclosures are
written in Canada—clearly and plainly. Lenders are
bound by disclosure requirements as well as banks’
voluntary codes of conduct to use plain language. The fine
print is there, but it is not nearly as fine as what American
borrowers must try to decipher. (To be sure, many other
factors contribute to the difference in default rates. A
paper written at the Federal Reserve Bank of Cleveland,
for example, suggested that comparatively lax lending
standards in the U.S. probably played a critical role.)
In 2000, the Canadian federal government proposed
the Cost-of-Borrowing Regulations, requiring banks
to disclose credit product information, such as interest
rates and fees, to consumers. In the same year, the
Canadian Bankers Association (CBA)adopted a voluntary
code of conduct—the Plain Language Mortgage Documents CBA Commitment—regarding the use of clear
writing in mortgage documents. In September 2009,
the federal government amended its disclosure regulation
to include a plain-language provision requiring that “all
disclosure under the Regulations be made in a manner
that is clear, concise, and not misleading.”
As many have observed, buying a home is the biggest
investment most people will make in a lifetime, and
mortgage documents are the most complex. Mortgage
debt accounts for the largest share of household debt.
So making informed choices is imperative.

Straight Talk
“Plain language,” says Traclet, “can have a significant
effect on households’ making an informed decision when
they choose a mortgage product and, ultimately, this can
contribute to financial stability.”
Arguments against simplifying disclosures abound, with
the most strident coming from lenders. They include
the objections that creating and testing new disclosures
costs money; requiring disclosures is a market intervention, and interventions do not always improve market
outcomes (that is, result in better decision-making); and
if more borrowers understood the terms of their loans,
some might decide not to take out those loans or would
demand terms more favorable to themselves. In this last
point, it is argued that the revenue, profits, and stability of
financial services providers would decrease (although it is
hard to see how giving borrowers bargaining power could
hurt society).

Federal officials have attributed the mortgage crisis in no
small part to people’s failure to understand the fine print.
But improving disclosures can also help lenders. Plain
language can reduce staff time by eliminating confusion
and improving communications. “[If] the performance of
mortgages is linked to borrowers having chosen a mortgage
product whose risk characteristics they understand and
can thus service over the lifetime of the mortgage, then
banks would have a natural interest in providing such
easy-to-understand facts and risks,” Traclet says.
Itzhak Ben-David, an assistant professor of finance at the
Ohio State University’s Fisher College of Business, agrees:
“It is important to explain to borrowers about interest rate
resets in adjustable-rate mortgages, and latent fees, like
prepayment penalties,” he explains. “It is also important to
inform borrowers of the likelihood of default given their
debt-to-income ratio (DTI). For example, ‘One out of five
borrowers with DTI of 40 percent at origination could
not make his payments and had to give up his house.’”
What if that language appeared prominently in mortgage
documents? How many borrowers would line up for a
mortgage if they’re told they have a one-in-five chance of
defaulting on it?

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11

Financial Education Matters
So plain language is a start. But we probably need more
to help consumers make sound financial decisions. For
example, research suggests that households do not necessarily understand how higher interest rates would affect
their mortgage payments. In June 2009, the Organization
for Economic Co-operation and Development noted
that insufficient financial education tools were partly to
blame for the financial crisis and that the consequences
of uninformed credit decisions can be “disastrous.”
Michal Grinstein-Weiss, an assistant professor at the
School of Social Work at the University of North Carolina
at Chapel Hill and a participant of the Cleveland Fed’s
2010 Policy Summit, points out that homebuyers,
especially minority and low-income ones, often lack
information when it comes to the home-buying process.
In fact, one survey found that 40 percent of African
American and Latino respondents incorrectly believed
that a 20 percent down payment was mandatory to
qualify for a mortgage, and more than 50 percent of this
same group believed that holding the same job for five
or more years was required.
Grinstein-Weiss has been studying the effects of financial
education on participants in the American Dream
Demonstration, a longitudinal, randomized controlled
experiment conducted in Tulsa, Oklahoma, from 1998–
2003. Conceived, organized, and implemented by the
Corporation for Enterprise Development in Washington,
DC, and funded by 12 private foundations, this experimental program helped low-income people save for a
home, school, or business through Individual Development Accounts (IDAs) by matching their savings deposits
with public and private funds. In addition, IDA participants attended free classes on general financial education,
such as budgeting and money management, as well as
asset-specific financial education classes, such as what to
look for in a mortgage.
The results were positive: The number of financial education hours each participant clocked was associated with
a 99 percent increase in average monthly net deposit and
a 1 percentage point increase in deposit frequency. Participants claimed that it was the financial education—not
the monetary incentive of the IDA program’s match rates—

12

Fall 2010

that made the most difference in their success. “If one part
of the program was eliminated,” Grinstein-Weiss quotes a
participant, “eliminate the match.”
Other studies support the importance of financial education: One found a significant correlation between the level
of financial knowledge and sound management practices.
People who were familiar with financial concepts and
products were more likely to balance their checkbook
every month, budget for savings, and maintain investment
accounts. Another study determined that financial
knowl­edge is the single best predictor of such behaviors
as budgeting, saving, and shopping responsibly. (For
additional examples, see related story: “Five Big Ideas
about Consumer Finance Education,” page 14.)

The Effects of Mortgage Counseling
But some other studies, including work from the Federal
Reserve Bank of Cleveland, suggest that general financial
education programs do not tend to change people’s financial behavior. Many researchers contend that programs
should target a specific audience or area of financial
activity and that this education should be completed just
before the person needs to use it (for example, just before
buying a home).
Nonprofit organizations have been offering home-buying
programs and credit counseling for years, with generally
beneficial effects. One study that analyzed nearly 40,000
affordable mortgage loans targeted to lower-income
borrowers found that pre-home-purchase counseling
reduced 90-day delinquency rates by 19 percent on average.
In another study, researchers found that credit counseling
had a positive effect on creditworthiness, especially for
those with the lowest credit scores. Another preliminary
study found that new or recently delinquent credit card
holders were more likely to pay on time and to have lower
revolving balances after receiving online instruction in
credit management.
Grinstein-Weiss asserts that the content of the financial
training should be tailored to building the skills of lowincome people so they can overcome the challenges of
trying to save. Asset-specific financial education and
homeownership counseling, she says, may also improve
participants’ loan performance.

Getting Basic
The emphasis on plain language is not new.
Interest in making government documents
clear has a history in the United States, dating
back at least to 1966, when federal employee
John O’Hayre wrote Gobbledygook Has Gotta
Go. But until recently, the use of plain language
remained voluntary. Part of the U.S. Credit

Card Accountability, Responsibility, and
Disclosure Act of 2009 is the Plain Sight/Plain
Language Disclosures: “Credit card contract
terms will be disclosed in language that
consumers can see and understand so they
can avoid unnecessary costs and manage
their finances.” But this legislation does not
apply to mortgage documents, even though
it’s been demonstrated that a large portion
of homeowners do not understand their
mortgages and that modest efforts to simplify
mortgage disclosures increase consumers’
understanding.

An image from the 1966 book
Gobbledygook Has Gotta Go.

Should Counseling Be Mandatory?

What’s Next?

Itzhak Ben-David set out to discover whether mandatory
asset-specific counseling—in this case, mortgage counseling—does in fact affect loan choice and performance.
He came up with some surprising results.

Not all of the chips have fallen when it comes to determining what types of consumer financial information work
best. In Canada, the government has launched a task force
on financial literacy that will deliver its findings in December. Here in the United States, the Financial Literacy and
Education Commission launched an enhanced financial
literacy website, www.mymoney.gov, last April. The
nation’s new Consumer Financial Protection Bureau is
also likely to make education a key part of its agenda.

Ben-David’s study was based on an experiment in which
high-risk mortgage applicants in 10 Chicago ZIP code
areas were required to receive financial advice from HUDcertified counselors. The results show that a few months
of financial education improves financial decisionmaking.
And when mortgage counseling is mandated, the default
rate for borrowers with low credit scores declines by
4.5 percent.
Here’s the surprising part: When borrowers who want
to take risky mortgage products are required to attend
counseling, the demand for risky products drops sharply.
“Borrowers choose less-risky products to avoid going to
counseling,” Ben-David notes. “In a way, the legislation
achieves its goal (to restrict the quantity of risky products)
by threatening borrowers with counseling, not by the
information included in the counseling itself.”
So it seems that mortgage counseling—or even its
threat—can be effective. But should it be mandatory?
Not for everyone, says Stephan Whitaker, an economist
with the Federal Reserve Bank of Cleveland. “It would
waste the time of a lot of people who don’t need it,” he
maintains. “Targeted requirements triggered by something (location in CRA assessment area, unusual loan
product, or receipt of federal/state/local subsidy) seem
more plausible.”

What the experts made clear at the Policy Summit is that
plain language, broad financial education, and mortgagespecific counseling are each beneficial in their own way
and serve to complement each other. “Looking forward,”
notes Ruth Clevenger, Community Affairs officer for
the Federal Reserve Bank of Cleveland and the chief
architect of the summit, “improved access to, and raised
levels of, financial education will be critical to a sustained
recovery from the financial crisis for individuals and
communities.” ■

2010 Policy Summit
For the agenda and bios of participants at the Federal Reserve Bank
of Cleveland’s 2010 meeting, see
www.clevelandfed.org/Community_Development/events/PS2010/index.cfm

Resources
For links to resources mentioned in this article, go to
www.clevelandfed.org/forefront

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13

Five Big Ideas about
Consumer Finance Education
April McClellan-Copeland,
Community Relations and Education

Educating consumers on how to make better financial
decisions may seem simple: Provide the information, and
better decisions will follow. But Jeanne Hogarth, a former
high school teacher turned national expert on consumer
finance education, knows better. Developing financial
education programs that make a difference in people’s
lives is challenging work. It’s not always clear why some
of these programs improve outcomes and others don’t.

“That gives the research community an opportunity to
do a lot more of the experimental studies that allow us to
tease out what’s effective.”

Even so, Hogarth, manager of the Consumer Education
and Research Section of the Federal Reserve Board’s
Consumer and Community Affairs Division, puts great
stock in the virtues of financial literacy. Her research
strongly suggests that knowledge has a positive effect
on financial behavior. Yet she wants to see results from
more studies. “Nowadays there is more of a push to have
evidence-driven, empirically based programs,” she says.

In thinking about how people manage their money,
economists tend to imagine a population of rational beings
who base all of their decisions on expectations for the
future. Hogarth disagrees. Midway through her career, she
says, she had an “aha” moment that made her rethink the
traditional approach to consumer finance research.

Hogarth, a native of Northeast Ohio, recently visited the
Federal Reserve Bank of Cleveland and shared some of
her perspectives.

Money Management Is Partly Psychology

About Jeanne Hogarth
Jeanne M. Hogarth is a
native of Northeast Ohio.
She earned a bachelor’s
degree in education at
Bowling Green State University in 1971 and then
taught high school in Olmsted Falls. She left the
area in 1981 after earning a master’s degree and a
doctorate in family and consumer economics from
the Ohio State University.
Today Hogarth manages the Consumer Education
and Research Section of the Division of Consumer
and Community Affairs at the Board of Governors
in Washington, DC.
During the 2009–10 academic year, Hogarth was a
visiting professor at Iowa State University. She is a
member of the Association for Financial Counseling
and Planning Education and the American Council
on Consumer Interests.

“One of the most interesting things I’ve learned is that
a lot of financial education isn’t about economics—and
that might be heresy!” Hogarth said. “It’s really about
psychology; it’s about how people think and feel.”
Behavioral economists have explored how psychology
affects whether people participate in 401(k) plans. The
optimal choice for a worker’s financial well-being is always
the same: to participate. But studies have shown that when
companies make “opting in” automatic—meaning that
workers must actively decline 401(k) participation—
more people participate. That’s the sort of result that
traditional economists might not have predicted.
This realization has encouraged Hogarth to think about
how to help people deal with the psychological issues they
confront when they make home loans and retirement and
investment decisions. “Your risk tolerance is not a financial
thing; it’s a psychological thing. And yet it has a huge impact
on what happens. Because if you’re not tolerant of risk,
you’re not going to get a very high rate of return,” she says.

Financial Education Seems to Work
Hogarth’s faith in financial education has grown over
the years, thanks to some of her own research. In 2003,
Hogarth and two of her colleagues at the Board of
Governors, Casey Bell and Dan Gorin, began studying
the effectiveness of a two-day financial education program
for military personnel at Fort Bliss in El Paso, Texas.
Staff from the San Diego City College taught the course,
which covered budgeting, credit, consumer awareness,
car buying, insurance, and retirement savings.
For the study, the soldiers were split into two groups—
those who took the financial education course and those
who did not. Both groups had to come from the same
population and had to be tracked over many years; these
are hard-to-satisfy requirements in natural experiments. To
determine the effect of financial education, the researchers
monitored13 positive behaviors (such as comparison
shopping and starting an emergency fund) and 15 negative
behaviors (such as paying bills late). They found that
soldiers who participated in the financial education group
showed more positive behaviors and fewer negative
behaviors than those who did not.

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15

Hogarth has been generally pleased with the study and its
findings. “Financial education did seem to have an effect
on specific financial management behaviors,” she wrote
in a paper presented at the 2009 Federal Reserve System
Community Affairs Research Conference.

“The bottom line is that we want good financial outcomes
for consumers,” Hogarth said. “We want them to have financial
security. We want them to feel comfortable about managing
their money.”

The Earlier the Better
Not only should consumers have access to financial education programs, but the earlier the better. In a 2006 paper,
for example, Hogarth cited a study (Bernheim, Garrett,
and Maki) that showed that consumers who graduated
from high schools in states with mandated financial education averaged higher savings rates and higher net worth.1
The benefits also persisted over time. The research on
soldiers stationed at Fort Bliss showed that those who had
bank accounts when they were growing up became better
money managers as adults, as did those whose parents
talked with them about family finances early in life.

Financial Literacy Doesn’t
Always Mean Financial Capability
But being knowledgeable about financial management
does not guarantee that people will put that knowledge to
good use. Hogarth pointed out that educators have spent
a lot of time and effort trying to distinguish between
financial literacy and financial capability without reaching
a consensus.
Hogarth has her own take on the difference: “I think that
literacy connotes a certain level of knowledge,” she said.
“Capability takes it one step beyond knowledge to actions.
I might know intellectually how to play baseball, but if I’ve
never gotten onto a field and tried to swing a bat at a ball,
I wouldn’t necessarily be capable. But when I actually get
out there and start practicing, my capability kicks in. That’s
how I differentiate literacy from capability.”

1. Bernheim, B. Douglas, Daniel M. Garrett, and Dean M. Maki. 2001.
“Education and Saving: The Long-term Effects of High School Financial
Curriculum Mandates.” Journal of Public Economics 80(3): 435–65.

16

Fall 2010

“The bottom line is that we want good financial outcomes
for consumers,” Hogarth said. “We want them to have
financial security. We want them to feel comfortable about
managing their money.”

Focus Future Research
on Behaviors and Outcomes
Hogarth has seen research nail down a connection between
consumers’ knowledge and behavior—if you know more,
you do better. But another question looms large for Hogarth
and others who study consumer behavior. Sometimes
people exhibit all the “correct” financial behaviors, but
their outcomes are underwhelming.
Hogarth illustrates the point with an example: “Let’s say
I max out my 401(k) every year. With the recent decline
in stock market values, I’ve actually lost money. I’m doing
all the right things, but my outcome isn’t so great.
“Sometimes the outcome isn’t caused by the things you do
or don’t do,” she explains. “It’s because of external factors
such as unemployment or a decline in housing values.
The struggle for researchers is connecting behaviors to
outcomes while also controlling for external factors. I don’t
know that we’ve figured out how to do that.”
Hogarth acknowledges that it is difficult to track financial
outcomes five to 40 years in the future. She points to
the Social Security Administration, which has set up three
centers for financial security research. The Financial Literacy
Research Consortium, as the centers are collectively
called, will create innovative materials and programs for
Americans at various phases of their lives. For example,
mid-career professionals and near-retirees will be helped
to understand the role of Social Security benefits and to
plan for retirement.
“I think the centers will really help financial educators
provide evidence-based research to policymakers,”
Hogarth said. “There are many, many projects that have
been funded through the three centers that will bring
some fresh insights on the links between financial knowledge, financial capability, and financial outcomes.” ■

Q&A with Jeanne Hogarth
Interviewed by Jennifer Ransom,
Community Relations and Education
Forefront: Do you think the field of
behavioral economics is helping to
marry psychology and economics?
Hogarth: Behavioral economics has

been tremendously important in
raising our awareness of how people
operate, what they’re thinking, what
they’re doing. But we also know that
default options can be set up. One of
the classic ones, the major tenet of
financial management, is pay yourself first. The idea of using payroll
deductions to save into a retirement
or savings account is good behavioral
economics. You get automated savings;
you build up your emergency fund,
your college fund, your new car fund,
or whatever it is; and you use some
of the “out of sight, out of mind”
psychology to the help your economic
situation.

Forefront: Can you talk about the
tension that can arise when banks or
other private-sector firms want to go
into schools to help educate students
about finance?

Forefront: What’s your thinking on
the highest and best role of the Federal
Reserve System in helping to achieve
good financial outcomes for consumers?

Hogarth: There’s an interesting conflict

interesting model for creating awareness and then creating comprehension,

here. Research shows that kids who
have bank accounts while they’re
growing up are better money managers
as young adults. It’s obviously very
important for kids to open accounts,
but the question is how to do that
without coming across as a giant
marketing attempt by a bank. I don’t
know if there’s a really good answer to
that. You could partner with multiple
banks in your community. Or you
could work through your local
bankers’ association or trade association to raise awareness in the schools,
and then invite the students to do
some comparison shopping for a
bank account.

Hogarth: In marketing, there’s an

Jeanne Hogarth discussed her research during a visit to the
Federal Reserve Bank of Cleveland in June. Watch video clips
of our interview at www.clevelandfed.org/forefront.

and having that feed into decisionmaking. I think that’s actually a pretty
good model for the Federal Reserve
System. In many of our initiatives,
we’re at the awareness level. We’re
just trying to alert people that there’s
something out there that they might
want to be paying attention to. The
Fed also has a lot of resources that
can help people deepen their comprehension. But in the end, you have to
realize that most people’s decisions
are personal. ■

Published works
Jeanne Hogarth’s webpage, which includes published works, at the
Federal Reserve Board of Governors.
www.federalreserve.gov/research/staff/hogarthjeannem.htm

Q&A
Watch clips of our interview with Jeanne Hogarth.
www.clevelandfed.org/forefront
F refront

17

Overextended,
Underinvested:
The Debt Overhang
Problem

Doug Campbell
Editor

Too much corporate debt can be a bad thing. This rather
obvious intuition is backed up by mounds of research, not
to mention ample observations from the recent financial
crisis. In the run-up to the meltdown, for example, Wall
Street investment banks ratcheted up leverage ratios to
$30 in debt for every $1 in equity. We all know how that
strategy turned out.
Economists have long studied how unwieldy debt levels
can kill businesses: Steep interest payments siphon off
available cash; highly leveraged firms face higher borrowing
costs because of the increased possibility they will default,
and so on. If experts can develop accurate predictions
of how companies will behave in different over-indebted
situations, policymakers might be better able to take
appropriate policy actions during financial crises.

More than 30 years ago, economist
Stewart Myers wrote the first formal
theory of how excessive corporate debt
can lead firms to underinvest in projects
that otherwise might be profitable. As Myers
described it, firms with large debt loads are likely to see
their existing debt trade at less than face value. So most
proceeds from new investments will flow not to the firm’s
owners but to the firm’s creditors. An owner’s line of
reasoning thus becomes distorted: Why bother to pursue
costly new projects if most of the future benefits accrue to
someone else?
Now, two Federal Reserve economists have taken a
potentially important step forward in understanding the
debt overhang problem. Filippo Occhino and Andrea
Pescatori suggest an even greater role for public spending
and perhaps monetary policy to offset the investment
aversion that develops among debt-saddled firms.1

1. Occhino is with the Federal Reserve Bank of Cleveland; Pescatori was formerly
with the Federal Reserve Bank of Cleveland, and is now with the International
Monetary Fund.

18

Fall 2010

The Case for Debt Relief
The debt overhang distortion sometimes provides a

But if the creditor sees this distortion, it may decide

compelling case for at least selective debt forgiveness.

to provide some forgiveness on the firm’s debt,

When a lender realizes that a firm is very likely to

perhaps decreasing the liability values to $8 million.

default, it may decide to offer the borrower a break in

In that case, the $1 million project makes sense for

an effort to recoup more of its loan than it otherwise

both sides—with the project, the firm gains $1.5 mil-

would in the event of liquidation.

lion. Meanwhile, the debt holders collect $8 million,

The key is to reduce the distortion enough so that
the borrowing firm decides it would benefit by continuing to invest in new projects. As with the example
of distortion below, $1.5 million of the benefit from

whereas they would have received only $7.5 million
in the event of default. This logic is behind much
of the debt relief efforts seen on behalf of faltering
sovereign nations.

new investment will go directly to the creditors, and

“Without forgiveness, firms may have no hope and

only half a million goes to the firm’s equity owners,

give up,” Occhino says. “But if part of the debt is

making it a money-loser.

forgiven, then you give firms hope, they put in effort,
hire, invest, and the value of the firm increases. So
both benefit.”

The Debt Overhang Distortion
Debt has developed a poor reputation, but it is usually
quite useful. It allows firms to take on projects they otherwise couldn’t, ultimately adding value to the economy.
In fact, debt is a positive feature of developed financial
markets. But too much debt—that’s another matter.
The financial crisis
speaks to the peril of
the debt overhang
distortion. Through
most of the past two
Filippo Occhino
Andrea Pescatori
decades, the level of
credit market debt in the U.S. economy grew at about
the same pace as the level of corporate assets. Then, in
the latter part of 2007, debt and assets forked in different
directions, with debt continuing to rise but assets nosediving. The problem wasn’t so much that businesses were
taking on more debt; it was that their assets were fast
becoming worthless. The mortgage securities market was
the first to plunge, eventually taking down asset values
across the board.

Unleashed were the problematic channels through which
high leverage ratios wreak havoc—the overwhelming
interest payments, the difficulty in securing new financing,
the impulse to save more and spend less, and the irresistible
urge of distressed firms to underinvest in the face of
crushing debt. This last channel piqued the interest of
Occhino and Pescatori.

Because debt and credit affect business investment decisions
within their model, the economists can study what happens
when the value of a firm’s assets abruptly falls, as in the recent
financial crisis.
Here is how the debt overhang distortion works: Consider
a firm whose asset values plunge from $10 million to
$7.5 million. The value of its liabilities remains at $9 million. Along comes an opportunity with a projected cost of
$1 million and projected benefit of $2 million. The problem
is that $1.5 million of that benefit will go directly to the
creditors, and only half a million will go to the firm’s equity
owners. In other words, it’s a money-losing scenario for the
equity owners, even if pursuing the project keeps the firm
alive. (See “The Case for Debt Relief” above for a possible
solution to the problem.)

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19

Limitations of Standard Models
A leading critique of traditional business cycle models—particularly in

The real economy—employment, output, and so forth—registers no

the wake of the financial crisis—is that they don’t address the financial

change from frictions when financial variables like debt and equity get

side of the economy—the flow of funds from investors to firms through

out of whack. This failure to replicate the real world obviously limits the

banks and markets.

utility of such models in helping guide policy.

Because the financial side has no relevance, standard macroeconomic

Efforts to address this shortcoming began during the late 1990s. Federal

models allow firms to accumulate huge sums of debt with no need for

Reserve Bank of Cleveland economists Chuck Carlstrom and Tim Fuerst

policy prescriptions to keep the economy from suffering. That’s because

were among the first to study how firms with weak balance sheets paid

in these models, the frictions caused by excessive debt don’t exist.

higher borrowing costs and how this “external finance premium” affected

Instead, the economy automatically adjusts to new equilibriums.

the business cycle.

Realistically, the equity holders are performing a simple
cost-benefit analysis, and even after weighing the firm’s
goodwill, future growth potential, and revenue opportunities, the project still doesn’t add up. The pragmatic
decision is to skip or postpone the project and default on
the debt. It’s the same motivation that leads homeowners
to walk away when their mortgage debt far exceeds the
value of their homes. (Although the firm defaults in the
example, this is not necessary for the distortion effect to
persist. The underinvestment problem happens when
there is a substantial risk of default, even if default does
not necessarily occur.)

What’s more, crushing debt may persuade firms to pursue
far riskier projects than optimal. If the project pays off, then
the owners see a benefit; but if it crashes and burns, then the
creditors take the biggest hit.
This particular distortion can be devastating. A recent
study on the effect of the debt overhang distortion found
that every 10 percent increase in leverage decreases the
amount firms invest in projects by up to 20 percent. In
other words, businesses become zombies—they continue
to exist, but no longer expand. This can have a dampening
effect on the wider economy.

20

Fall 2010

A New Way to Look at the Problem
Traditional macroeconomic models are limited by their
failure to account for financial frictions (see “Limitations
of Standard Models” above). To get a better handle on
the size of the distortion, Occhino and Pescatori looked
at debt overhang from a new angle.
The innovation in Occhino and Pescatori’s work is to
explain how the debt overhang distortion affects interactions between the business cycle and balance sheet
variables. Because debt and credit affect business investment decisions within their model, the economists can
study what happens when the value of a firm’s assets
abruptly falls, as in the recent financial crisis. While it
is not a be-all-end-all solution to the lack of financial
markets in macroeconomic modeling, it is a step toward
better establishing the linkages.
Occhino and Pescatori show how a macroeconomic
shock to, say, productivity, finds its way onto firms’
balance sheets in the form of damaged asset values. This
increases firms’ risk of default, which triggers the debt
overhang problem. Now, firms have smaller incentives to
invest, knowing that proceeds from investments will go
first and foremost to creditors. Decreases in investment
further raise the probability of default, creating a vicious
circle in which the initial effects of the adverse shock to
productivity become both amplified and more persistent
over time.

Policy Implications
The model results square with the general thrust of the
data. In the model, as in the real business cycle, credit
spreads widen and default rates mount as the economy
nosedives. And, as in the data, the model suggests that
corporate balance sheets remain impaired for a long time.
What’s more, crushing debt may persuade firms to pursue
far riskier projects than optimal. If the project pays off,
then the owners see a benefit; but if it crashes and burns,
then the creditors take the biggest hit.

The pace of the current economic recovery will depend in
no small part on how well policymakers can address the
distorting impact of debt, to mop up the mess left behind
by the financial crisis. Understanding why overburdened
businesses behave the way they do is pretty important,
and that is why steps like Occhino and Pescatori’s could
prove valuable. ■

In many macroeconomic models, that would be the end
of the story. The efficient response would be to do nothing
and simply wait for the market to reallocate resources and
find a new equilibrium. But Occhino and Pescatori’s
model recognizes the impact of financial frictions. This
opens the door to policy prescriptions, because investment
is dropping more than it should. If this disinvestment
becomes contagious, the economic harm could become
widespread.
At a macroeconomic level, a straightforward way to
address this problem is with expansionary fiscal policy.
Increased public spending and decreased tax rates could
spur increased production, strengthening firms’ balance
sheets and at least partly offsetting the debt overhang
distortion. A similar approach could be considered with
expansionary monetary policy, but Occhino and Pescatori
do not explore this option as there is no money, strictly
speaking, in their model. That’s something for future work.
“In an economic downturn, if you move to expansionary
policy you can eliminate this extra decrease caused by
debt overhang,” Occhino says.
Other reforms are being debated in the aftermath of
the financial crisis. Caps on the levels of leverage that
firms can carry on their balance sheets might seem like
another approach to limiting the debt overhang distortion.
Occhino thinks the risk of overstepping here is significant.
“For most firms, borrowing is beneficial,” he stresses. “What
is needed is something to ease the distortion, something to
keep firms from avoiding investments during downturns.”

More on debt overhang
See our dedicated webpage for a short video and links to additional
articles on debt overhang.
www.clevelandfed.org/forefront/2010/09/debt_overhang_landing.cfm

Recommended readings
Carlstrom, Charles, and Fuerst, Timothy. 1997. “Agency Costs, Net
Worth, and Business Fluctuations: A Computable General Equilibrium
Analysis.” American Economic Review 87(5): 893 – 910.
Myers, S.C. 1977. “Determinants of Corporate Borrowing.” Journal of
Financial Economics (5): 147 – 75.
Occhino, Filippo, and Pescatori, Andrea. 2010. “Debt Overhang and
Credit Risk in a Business Cycle Model.” Federal Reserve Bank of
Cleveland Working Paper 10.03.

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21

CHRIS PAPPAS

Interview with
Laurence Meyer

22

Fall 2010

Meyer was a professor of economics for 27 years and former
department chairman at Washington University. In 1982, he
launched the economic consulting firm Laurence H. Meyer
and Associates and earned a reputation as one of the nation’s
leading forecasters. He was named to the Federal Reserve
Board of Governors in 1996. His term on the Board lasted until
2002, after which he rejoined his old firm, now called Macroeconomic Advisers.

“ By the time I completed my first economics class in college,
I knew I wanted to be an economist.” The college was Yale and
the narrator was Laurence Meyer, writing in his 2004 book,
A Term at the Fed: An Insider’s View. Meyer did indeed go on
to become an economist. And not just any economist, but a
top-flight academic, a central banker, and a principal of one of
the globe’s leading economic forecasting firms.

Meyer is a fellow of the National Association of Business
Economics, a director of the National Bureau of Economic
Research, a scholar with the American Council on Capital
Formation, and a member of the Panel of Economic Advisers
for the Congressional Budget Office. He received a BA from
Yale University and a PhD from the Massachusetts Institute
of Technology.

What may separate Meyer from so many other economists
is his ability to communicate well. The Boston Sunday Globe
noted that “Meyer writes about complex economic issues in
a clear style.”

Mark Sniderman, executive vice president and chief policy
officer at the Federal Reserve Bank of Cleveland, interviewed
Meyer on June 9, 2010, in Cleveland. An edited transcript
follows.

Sniderman: Larry, thanks so much for
talking with me this afternoon. I’m
looking forward to a great conversation.
Let me start with the financial crisis. I’m
interested in your views at a big-picture
level. How did this all happen?
Meyer: It’s probably not a good idea to
think that there’s one single flaw in
the system that was exposed. I think
that there were several factors. One
was rapid financial innovation—new
financial products that weren’t tested
by market downturns and that changed
or morphed as they were being
developed. This is the explosion of
subprime. It morphed from being one
thing to being something completely
different and much riskier later on.

And the same thing with securitization,
a new technique, very valuable, and a
very good idea, but then it morphed
again into very complex forms of
structures that nobody could understand. I think those financial innovations are very important, and they set
up the system with expanding risk and
concentrated risks that weren’t well
understood.
Second, there’s always a trigger that
happens, and the trigger was declining
home prices. Many of us believed that
home prices never fall. There’s a good
historical record of that. I think we all
appreciate now that the subprime
market was not viable if home prices
fell. But since we didn’t think home
prices would fall, we didn’t worry
about it.
Then third, we just took too narrow
a view of the subprime problem. I
myself, and I think more generally
many macroeconomists, had this
focus that it’s about subprime—
relative to total mortgages, housing
relative to the economy—we’re talking
about tenths [fractions]. How can that
be a problem?
We didn’t see the fundamental
connection between property busts
and collateral in the banking system,
bringing the banking system toward
insolvency, toward the edge of the
abyss. Put on top of that the buildup
of leverage in the system—this acts

as a multiplier. All these things were
going to happen, and now they happened, and the unwinding was much
uglier than it otherwise would have
been. Practices evolve more quickly
than knowledge. Maybe we weren’t
humble enough about what we understood as bankers, as supervisors, as
rating agencies, or as macroeconomists.
Sniderman: What does that tell us
about the state of macro modeling?

integrate that. And the other is credit
spread variables—Baa corporate rate
relative to, say, a Treasury rate. The
reason that’s important is that a risk
variable gives an indication of the risk
appetites and risk aversion that come
into the system when there are financial crises. And that variable tends to
be very important in spending equations as well.

Meyer: It tells us something very
important—something we certainly
should have learned—that macro
modeling should not be static. It
has to evolve over time, and we’re
continuously learning. We find holes,
and we try to close those holes.

But we know in the future there will
be crises coming, or shocks in areas
that we didn’t anticipate. We’ll find
new holes that we have to fill. In this
case, there were really so many.
This notion of the financial accelerator
wasn’t just a cute idea that the [Federal
Reserve] chairman [Ben Bernanke]
came up with. It was central to our
understanding of how the macroeconomy works, particularly when
there are intense changes in financial
conditions. So you do get these adverse
feedback loops that the financial
accelerator is all about.
Most of us as macro modelers came
out of a tradition in which the transmission of monetary policy, the
financial sector, is about real interest
rates, about equity values, about the
dollar, with virtually no variables that
we would call credit variables—they
just weren’t there. In milder times,
that was OK. That probably got the
job done. But when the situation
was the drying up of credit markets,
dysfunctional credit markets, you
simply had to give the model more
information than otherwise.
Two things seem valuable that we’ve
tried to integrate into our models.
First would be “willingness to lend
variables” from the senior loan officer
survey. Imprecise as it may be, it is
a measure of lending terms beyond
rates. That’s very important and
that wasn’t there, and I think we can

We didn’t see the fundamental
connection between property busts
and collateral in the banking system,
bringing the banking system toward
insolvency, toward the edge of the
abyss. Put on top of that the buildup
of leverage in the system—this acts
as a multiplier.
Sniderman: Should we expect to be
living with our mainstream workhorse
macro models for some time, and should
we feel good about that? Is there enough
progress there?
Meyer: I love that question! So I think
we have two kinds of modeling traditions. First there is the classic tradition.
I was educated at MIT. I was a research
assistant to Franco Modigliani, Nobel
laureate and the director of the project
on the large-scale model that was used
at the time at the Federal Reserve
Board. This is the beginning of modern
macro-econometric model building.
That’s the kind of models that I would
use, the kind of models that folks at
the Board use.

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23

Laurence H. Meyer
Current Position:

Economic Forecasting Awards:

Vice Chairman, Director, and Co-Founder,
Macroeconomic Advisers

Business Week, 1986
Blue Chip Economic Indicators, 1993 and 1996

Past Positions:

Education:

Professor of Economics, Washington University
Federal Reserve Governor, 1996–2002

Yale University, BA, 1965
Massachusetts Institute of Technology, PhD, 1970

Associations:

Board of the National Economic Bureau of Economic Research
Fellow of the National Association of Business Economists

There’s also another tradition that
began to build up in the late seventies
to early eighties—the real business
cycle or neoclassical models. It’s
what’s taught in graduate schools.
It’s the only kind of paper that can
be published in journals. It is called
“modern macroeconomics.”

It’s very simple. It’s one part science;
that’s the model. One part art, that’s
your judgment. And one part luck.
That’s how you become a really good
forecaster!
The question is, what’s it good for?
Well, it’s good for getting articles
published in journals. It’s a good way
to apply very sophisticated computational skills. But the question is, do
those models have anything to do
with reality? Models are always a caricature—but is this a caricature that’s
so silly that you wouldn’t want to get
close to it if you were a policymaker?

24

Fall 2010

My views would be considered outrageous in the academic community,
but I feel very strongly about them.
Those models are a diversion. They
haven’t been helpful at all at understanding anything that would be
relevant to a monetary policymaker
or fiscal policymaker. So we’d better
come back to, and begin with as our
base, these classic macro-econometric
models. We don’t need a revolution.
We know the basic stories of optimizing
behavior and consumers and businesses
that are embedded in these models.
We need to go back to the founding
fathers, appreciate how smart they
were, and build on that.
Sniderman: Wouldn’t inflation expectations be a counter-example? That has
become an important variable in many
classical macro models that policymakers
use to help them construct their inflation
forecasts. Isn’t that at least one place
where we see this interplay between the
research agenda in macro modeling and
the practical use of models?
Meyer: A brilliant question! And you’re

absolutely right. This is a good example
of interplay between the classic and
modern macro approaches. It is true
we had a push toward smaller models.
This happened because if you want to
use these forward-looking expectations,
in the form in which modern macro
does, forward-looking expectations
that are model-consistent, it’s really
hard to do if you have a huge macroeconometric model. It’s very easy

to do in the smaller, modern macro
models. But I think what you saw is
exactly what you are suggesting, that
it jumped out of those models and
became a key area for research and
integration into the large-scale macroeconometric models.
But that doesn’t mean policymakers
should say, “I like these modern macro
models because they treat expectations
the way we should.” The Federal
Reserve Board’s classic econometric
model treats expectations the way you
think they should, but it’s a richer,
more valuable model for policymakers,
number one. And number two, do you
really think that you want to model
individuals as having their forwardlooking expectations based on solving
a model out 20 years? I don’t think that
makes any sense at all. You need small
models to do that, but the reality is
that expectations are formed, they’re
forward-looking, but we don’t have any
idea what the true world looks like.
Our models are caricatures. Everyone
has got a different model in his head. I
think we learn something about trying
to get forward-looking expectations
into our model. We model the Phillips
curve in a way that is very important.
We have long-term expectations
directly in the model, playing a very
important part. That’s something that
we didn’t used to do. That’s the way the
profession advances in these classical
models as they become refined.

Sniderman: One thing models can do is
provide different scenarios about what
the future might look like; models that
provide simulations thousands of times
to give us a distribution of outcomes that
could help us understand the future
possibilities a little more richly. Should
we as policymakers be looking for more
modeling of that spirit, that spirit of
scenario-planning and distributions
about outcomes?
Meyer: I think the answer is absolutely
yes. It’s not such a simple task to build
a sensible, interesting, alternative scenario. I think we should be constantly
refreshing and coming up with sensible
ideas in each forecast round of what
are clearly risks that are on the horizon
we want to work into our alternative
scenario.

Even more important, we’ve got to sit
down every once in a while and say,
“Hmm. What’s the worst thing you
could think of happening? Tell me
something really bad. Find a hot spot.”
Maybe it’s something nobody is
thinking about. Maybe we could have
thought about this incredibly rapid
growth in subprime and structured
products and said, “Whoa, what could
that mean?” Or we could have thought
about sovereign debt developments that
were going on and were percolating in
Europe. It’s not just looking at these
incremental things—what happens if
this fiscal plan is changed? what happens
if oil prices go up?—but looking at
these worst-case scenarios.
Sniderman: Of course, that’s not the
model itself issue; that’s the human
element.
Meyer: Absolutely. You always have
to come back to that. So many times
people ask me, “What are the rules for
forecasting, what are the ingredients?”
And I say, “It’s very simple. It’s one part
science; that’s the model. One part art,
that’s your judgment. And one part
luck. That’s how you become a really
good forecaster!”

Sniderman: We’ve seen a lot of innovations during the financial crisis in terms of
monetary policy. Are there any features
in monetary policy design that you think
should remain more permanently?
Meyer: To begin to address this question, it’s useful to make a distinction
between what I call liquidity policy
on the one hand and monetary policy
on the other. By liquidity policy, I
mean providing enough liquidity when
there’s a panic and the market just
wants to hold a lot more liquidity. To
prevent that from having powerfully
negative impacts on the economy, you
give it to them.

The Federal Reserve and central banks
around the world acted as liquidity
providers of last resort. They all found
ways to do that. The Fed was extraordinarily creative, very aggressive.
You have to give an A-plus to all those
operations. They saved the day. You
also have to give high marks to the
fact that the liquidity programs were
designed so they would naturally go
out of business as the panic dissipated.
And now the Fed has closed the door
on them because no one was there
anymore.
So that’s gone—beautiful. Central
banks all around the world did a great
job. Now we’re talking about monetary
policy and we say, “That’s just a lot
more complicated!” And we have a
disagreement about what’s really
part of this. Does it matter what the
size of the balance sheet is? Does it
matter how many reserves you have
in the system? Or do you just need to
raise rates, using interest on reserves?
I’m sure you and I could have a nice
debate on that.
We’ve never had this superabundant
level of reserves. We’ve never had this
size of a balance sheet. So, for reasons
I think we can understand, there’s a
desire to do all of these things—shrink
the balance sheet, drain reserves, and
raise rates. But we’ve never taken these
things away. We put them in, and now
we’re trying to take them away. We’ve
never done that before.

So we don’t know, really, what the
impact is if we begin to do asset sales
today. How can we unwind that
balance sheet without having such
adverse circumstances on the markets
that we regret it? We’re learning about
that, too. I think views have changed
dramatically even over the last six
months or so with market participants

Does it matter what the size of the
balance sheet is? Does it matter how
many reserves you have in the system?
Or do you just need to raise rates,
using interest on reserves? I’m sure
you and I could have a nice debate
on that.
much less concerned about the market
consequences of asset sales. There are
three things that we have to get done,
and we have tools for every one of
them. For draining reserves, we have
reverse repos and term deposits. For
shrinking the balance sheet, we can
just let it run off or we can sell assets.
And for raising rates, even there we
have complementary roles of both
raising interest on reserves and managing reserves at the same time.
The Fed was more aggressive and more
effective than any other central bank
in the monetary policy dimension.
That’s because other central banks,
whether they admitted it or not, were
doing what we call quantitative easing.
They were just pushing reserves into
the system.

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25

What the Fed did and other central
banks didn’t do, because the Fed was
in unique circumstances, was make
use of the mortgage-backed securities,
or MBS, market. The Fed was allowed
to hold MBS in its portfolio, and yet
MBS was a market that had become
illiquid and distressed. It was tied to
the housing market, which was under
incredible pressure. The Fed was able
to go into that market and have big
impacts because the market was so
distressed and illiquid.

The good news here is that although
we don’t have good supervision and
regulation procedures for dealing with
equity bubbles, we do for property
bubbles. We’ve got a lot of ways of
handling that. We could lower the loanto-value ratio—essentially increase
the down payment that people have to
have on their homes to build a better
capital cushion. We could do a whole
variety of things on the regula­tory side.
We could increase capital requirements
against those properties that seem to

I think it’s important for the public to understand two things: the
responsibilities of the Fed—what you should be holding it responsible
for and what you shouldn’t be holding it responsible for—and then the
limits of what any central bank can do.  
That’s the good news. The bad news
is now we’ve still got all those assets
on the balance sheet. How do we get
rid of them? Being the most aggressive
and effective during the stimulus means
that you’re the most challenged when
it comes to exiting.
Sniderman: There’s been a long-running
debate about how central banks should
deal with asset bubbles. One of the issues
that’s come out in the wake of the
financial crisis has been the interplay
between using regulatory tools and
techniques as opposed to, or in conjunction with, monetary policy. Do you have
thoughts on that spectrum?
Meyer: This is a very important and
evolving area of thought among
central banks. We really should start
by making a distinction between
types of bubbles, between equity
bubbles and property bubbles. We
lost something like $7 trillion in the
bust of the tech bubble. Sounds like
a lot, but the economy just shrugged
it off—with a very shallow and very
short recession.

Equity bubbles are just not a big deal.
But property bubbles are absolute
killers. We know that from historical
experience. The difference is that
property is held by leveraged institutions, are the collateral of the banking
system, and if you make your banking
system insolvent, you’ve got real
problems.
26

Fall 2010

be more risky because of bubble-like
conditions. We could do a whole
variety of things that in principle
should be, could be, effective.
The question is, would we recognize
that a bubble was emerging in time to
implement supervisory and regulatory
policies that could have some effect?
My views have changed a lot since I
was on the Board. I’m a firm believer
now that you can always catch bubbles
and identify them in time to do
some­­thing about them before they
get dangerous. The question is, what
to do? The first line of defense—and
this is certainly what the chairman
[Bernanke] and others have said—is
supervisory and regulatory policies.
But we have to be realistic. It might
work; it might not. And so the big
question for central bankers is therefore, what do you do if it doesn’t
work? Do you have to do something
in addition? That’s the real issue—

do you want to use monetary policy
itself, and do you want to lean against
bubbles even when the broader
macro­­economic conditions would
not lead you to, for example, want to
tighten? That is a taxing issue.
The issue is less whether you can
identify a bubble than what do you
do if you think it’s emerging. I’ve come
away with a very different under­
standing of the risks of allowing
bubbles to go unchecked. But that’s
property bubbles. I’m not so concerned
with equity bubbles. Property bubbles
—that can be handled to some extent
by supervision and regulation, but I
think we should be very open minded
here. We’re searching, we’re debating,
we’re not sure what monetary policies
should or could do in those circumstances. If we come to that place again,
I’m sure there will be a very good
debate in the Federal Reserve System,
as there should be, before deciding
whether to be more pre-emptive than
was the case before.
Sniderman: What is it that you wish the
general public would better understand
about central banks and their role in the
economic system in which we live?
Meyer: What should the public know?
First of all, the public has its representatives in Congress. And Congress
has a very important job overseeing
the Fed. I’ve said this many times—
wouldn’t it be good if Congress learned
a little bit more about monetary policy
and how it works? I’m always amused
and distressed about how poor the
questions are during Congressional
oversight committee hearings. The
first part of the public I’d like to see
understand more about monetary
policy is the Congress, particularly
members of the oversight committees.

Other than that, I think it’s important
for the public to understand two things:
the responsibilities of the Fed—what
you should be holding it responsible
for and what you shouldn’t be holding
it responsible for—and then the limits
of what any central bank can do.

It’s partly the limitations of our knowledge. It’s partly the limitations of what
central banks’ tools can accomplish
in the real world. But I would say to
understand what they do, what their
responsibilities are, and then understand how they try to achieve those
objectives and appreciate that there
are limits. When you want to hold
central banks accountable, understand
that perfection in central banking
is no more possible than it is in any
other profession.
Sniderman: Maybe you can leave us
with some thoughts on things you’ve
been reading these days?
Meyer: My wife and son always
warned me that if anybody asked me
that question, I shouldn’t even answer
it because they view my reading list as,
shall we say, not intellectual enough to
go along with my reputation.

I have two sets of readings on my
night table. One is books on the
financial system and recent history
in particular. Too Big to Fail [Andrew
Ross Sorkin], is like a story unfolding
before you, and I’m in the middle
of that one. The Black Swan [Nassim
Nicholas Taleb] has fascinating stories
about the weight that should be given
to improbable events, brainstorming
on catastrophic things that could
happen, and how to protect yourself
in advance from those possibilities.
And then I’ve got the book by Michael
Lewis, The Big Short [reviewed on page
28 of this issue], that’s on my list.
Finally, I read mysteries, spy novels,
and my current group is by the author
from Sweden, Stieg Larsson, The Girl
with the Dragon Tattoo and all the ones
that followed. Fantastic reading. These
books are insanely popular all around
the world. This is a series that has really
caught my attention, and I’ve got one
more of those to go.
Sniderman: Thanks for taking the time
to talk with us today. ■

Watch video clips of this interview
www.clevelandfed.org/forefront

F refront

27

Book Review

The Big Short:
Inside the Doomsday Machine
by Michael Lewis
Norton 2010

Reviewed by
Dan Littman,
Economist
Federal Reserve Bank of Cleveland

In the past year, at least 20 books on the financial crisis
have crossed my desk. I have read parts of all of them.
Some are excellent—insightful, behind-the-scenes looks
at the people and policies that contributed to and then
reacted to the crisis. Other books, alas, are not so splendid
—way too technical, so inside baseball that they make
no sense to the lay reader.
So if you are only now getting around to deciding which
tales to read about the financial crisis, I am here to help. A
good place to start is The Big Short: Inside the Doomsday
Machine. Michael Lewis, an editor at Vanity Fair, writes a
novelistic account of the crisis that follows four hedge fund

28

Fall 2010

managers who predicted the housing market crash as early
as 2004. The quartet aggressively took “short” positions
on mortgage-backed securities through the purchase of
a type of insurance called a credit default swap (CDS).
Essentially, they were betting the market would tank, and
how right they were.
The protagonists initially met resistance from investors and
bankers: Why were they wagering against a market that
was seemingly going so well? They also faced difficulty in
getting CDSs offered on mortgage-backed securities in
the first place. At the time, CDSs were not widely used as
insurance against mortgage-backed securities.

Said one of the money managers: “Nobody we talked to
had any credible reason to believe the failure of subprime
CDOs [collateralized debt obligations] was going to
become a big problem; no one was really thinking about it.”

With that in mind, here are some other good books you
might consider to fill out your knowledge about the
financial crisis:
■

It didn’t take long for the investors to prove their doubters
wrong. Their bets against the market would eventually
pay off in the form of hundreds of millions of dollars.
At the same time, of course, others were losing hundreds
of millions with the tailspins of Bear Stearns, Lehman
Brothers, Freddie Mac and Fannie Mae, and AIG.
The Big Short is strong in conveying the drama in the
midst of the crisis. And it is so effective at telling the
human story that the “hard stuff ” is much easier to
understand than in other texts. Lewis excels in explaining
the complicated investment strategies of those buying
mortgage-backed securities and selling CDSs, and,
conversely, those buying CDSs and shorting mortgage
investments. On top of it all, Lewis is effective in describing
the often complex and arcane investment instruments
themselves. Readers will learn a lot from reliving the
crisis from an insider’s point of view.
Yet The Big Short is not a perfect book. While Lewis
provides important evidence about what happened in
the run-up to the financial crisis, he is not terribly helpful
in explaining the underlying historical forces in housing,
finance, and government policy that brought us to the
brink. Nor is his book deep in discussing the effectiveness
of the immediate policy response in the context of other
choices the Federal Reserve, the Treasury, and others had
available.

■

■

■

Gillian Tett, Fool’s Gold: How the Bold Dream of a
Small Tribe at J.P. Morgan Was Corrupted by Wall
Street Greed and Unleashed a Catastrophe. Tett,
the U.S. editor of the Financial Times, summarizes
how the credit default swap was “invented” and how
it evolved to become a key contributor to the financial
crisis.
Carmen Reinhart and Kenneth Rogoff, This Time
Is Different: Eight Centuries of Financial Folly. The
authors—both economists—provide a rigorous and
indispensible historical perspective on the recent crisis.
Sebastian Mallaby, More Money Than God: Hedge
Funds and the Making of a New Elite. The hedge
fund industry is the focus of this author, an official at
the Council on Foreign Relations.
David Wessel, In Fed We Trust: Ben Bernanke’s War
on the Great Panic. Wessel, economics editor at the
Wall Street Journal, delivers a fly-on-the-wall account
of Federal Reserve actions during the financial crisis. ■

Translating the dramatic action in The Big Short to how
regulators ought to change their behavior and their rules
to forestall a future crisis requires wider reading of the
available literature.

F refront

29

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