Growth Models and Housing Finance Policy in the United States and Germany Alexander Reisenbichler

Home , Georg Brunnhuber, Hans Eichel, Jesse Shapiro, Kerstin Andreae, Ortwin Runde, Roland Koch

The Politics of Entrenchment: Growth Models and Housing Finance Policy in the United States and Germany

Alexander Reisenbichler

B.A. in Social Sciences & Philosophy, March 2010, Leipzig University M.A. in Political Science, May 2013, The George Washington University

A Dissertation submitted to

The Faculty of The Columbian College of Arts and Sciences of The George Washington University in partial fulfillment of the requirements for the degree of Doctor of Philosophy

January 19, 2018

Dissertation directed by

Kimberly J. Morgan Professor of Political Science and International Affairs

The Columbian College of Arts and Sciences of The George Washington University certifies that Alexander Reisenbichler has passed the Final Examination for the degree of Doctor of Philosophy as of December 14, 2017. This is the final and approved form of the dissertation.

The Politics of Entrenchment: Growth Models and Housing Finance Policy in the United States and Germany

Alexander Reisenbichler

Dissertation Research Committee:

Kimberly J. Morgan, Professor of Political Science and International Affairs, Dissertation Director

Henry J. Farrell, Professor of Political Science and International Affairs, Committee Member

Abraham L. Newman, Associate Professor, Georgetown University, Committee Member

iii Dedication

To my grandparents.

iv Acknowledgements

I have incurred many debts writing this dissertation, as this project benefited enormously from the support of many individuals and institutions. The Department of Political Science at George Washington University provided a terrific and supportive environment for developing this dissertation. And the generosity of the many experts, academics, archivists, and government officials that I met on both sides of the Atlantic was indispensable for completing this project.

The research on the American case would not have reached its depth without the support of many institutions. At the George Washington University, the Institute for

European, Russian, and Eurasian Studies (IERES) offered financial support and became my second intellectual home alongside the political science department. Similarly, Johns

Hopkins University’s American Institute for Contemporary German Studies (AICGS) provided financial support and helped me open the door to Washington’s think tank and policy world. I thank these institutions for their support, and continued friendship and collaboration.

The empirical research in Germany would have been impossible without the financial and research support of a large number of institutions and individuals. I would like to thank the Horowitz Foundation for Social Policy for its financial support. I also thank Karin Goihl and the Berlin Program for Advanced German and European Studies at the Free University Berlin for their generous support that financed a year-long research stay in Germany. I also thank the Berlin program cohort for commenting on parts of this research, and I was honored to be part of this outstanding group of aspiring scholars. I

v would also like to extend a hearty thanks to Susanne Lütz and the scholars and staff at the

Center for International Political Economy at the Free University Berlin for hosting me during my time as a fellow in Berlin. The intellectually stimulating discussions, many laughs, and lasting friendships are greatly appreciated. Anke Hassel and the Hertie School of Governance in Berlin also opened their doors during the early stages of this project.

There are many other individuals who have supported my research, teaching, and professional development. At the George Washington University, I thank Harvey

Feigenbaum, Harris Mylonas, Bruce Dickson, and Martha Finnemore. I’d also like to thank those who have taken the time to offer feedback when I presented parts of this research at academic conferences and workshops, such as Karen Anderson, Konrad Jarausch, Geoffrey

Gertz, Paulette Kurzer, Jonah Levy, Nathalie Morel, Paul Nolte, Waltraud Schelkle,

Herman Schwartz, and Christine Trampusch.

Working with my dissertation committee was a truly rewarding experience. Kimberly Morgan was a source of inspiration. From day one, she has been a mentor to me, providing guidance throughout graduate school and this dissertation. Her encouragement to explore this research question -- and faith that I could come up with an answer -- pushed me intellectually and got me deep into the empirical weeds. Without her thorough feedback and intellectual exchanges on draft after draft, this dissertation would not have reached the level it has. I thank her for her continued mentorship, generosity, and collaboration over the years. Henry Farrell and Abe Newman have pushed me to sharpen and think bigger about the argument and implications of this dissertation. Henry Farrell’s door was always open for me, and I greatly appreciate him helping me strategize next steps at each stage of my academic career. I thank Abe Newman for the many exchanges with

vi him on this dissertation and many other projects -- and for making the way over from

Georgetown to Foggy Bottom on several occasions. Intellectually, my dissertation committee has fundamentally shaped the ways in which I think about political economy and long-term political processes. I thank my committee members for providing a roadmap for how to move this project forward beyond the dissertation stage and for supporting my academic career well beyond this dissertation. Finally, I also thank Steven Teles at Johns

Hopkins University and Sarah Binder for reading this dissertation and offering valuable feedback that will help me move forward this project.

My family and friends offered the perfect balance of keeping my eyes on the prize of completing this project, while also putting things into broader perspective. On both sides of the Atlantic, I thank my friends for putting up with too many discussions about this project and, more important, the many fun hours away from it. My mom and grandparents have supported me for as long as I can remember. I thank them for their love and support, for cheering every small achievement along the way, and for understanding that my journey has taken me far away from home. Words cannot express the gratitude I feel toward them.

vii Abstract of Dissertation

The Politics of Entrenchment:

Growth Models and Housing Finance Policy in the United States and Germany

The financial fallout of 2008-09 demonstrated that housing finance markets can bring the global economy to its knees. Yet, surprisingly little is known about how and why advanced industrial countries offer public support for private housing markets. Why have some countries adopted state-based homeownership models with extensive public support for financing private homes, while others have chosen market-based models with only limited public support?

This dissertation addresses this question by analyzing the surprising variation of housing finance models in the United States and Germany from a comparative, historical perspective. Since the early twentieth century, the United States has subsidized mortgage debt and offered billions of dollars in tax breaks for homeowners as part of its state-based homeownership model. To a lesser degree, the postwar German state also supported homeownership through tax breaks and social housing programs, but eliminated these programs in recent decades in exchange for market-based solutions. Today, the housing finance market in the United States, the land of free market capitalism, is much more state- dominated than that of Germany, a social market economy.

I argue that macroeconomic growth models explain the opposing trajectories of the

United States and Germany. In the United States, the consumption-led growth model has entrenched housing finance policies, as they tend to stimulate demand, credit, and consumption. These synergies forged a broad-based policy consensus that produced the

viii long-term stability and entrenchment of the state-based homeownership model. In

Germany, the export-oriented growth model has not entrenched housing finance policies.

Policies that stimulate private housing and consumption do little to reinforce the export- led economy, which opened the door for partisan conflicts that resulted in both the retrenchment of homeownership policies and the adoption of market-based solutions.

Five historical case studies contrast the politics of housing finance policy in the tax, mortgage, and monetary areas in the United States and Germany from the early twentieth century to the present. The empirical research draws from in-depth fieldwork in both countries, including dozens of interviews with top government officials and interest groups, primary archival documents, and government records. This dissertation contributes to our understanding of how macroeconomic growth models shape the politics of the welfare state.

ix Table of Contents

Dedication……………………………………………………………………………….. iv

Acknowledgements………………………………………………………………………. v

Abstract of Dissertation………………………………………………………………... viii

List of Figures…………………………………………………………………………… xi

Chapter 1: The Politics of Entrenchment…………………………………………………. 1

Chapter 2: On the Chopping Block: Homeownership Tax Policy in Germany,

1950s-2010s………………………………………………………….…………. 56

Chapter 3: Third-Rail Politics: Homeownership Tax Policy in the United States,

1910s-2010s………………………………………………………………….... 109

Chapter 4: Subsidizing Homeowners or Renters? Social Housing Policy in

Germany, 1950s-2000s………………………………………………………... 151

Chapter 5: Comradely Housing Capitalism: Mortgage Debt Policy in the United

States, 1930s-2010s………………………………………………………….… 196

Chapter 6: Central Bank Stimulus for Housing Markets in the United States,

Germany, and Europe, 1930s-2010s………………………………………...… 258

Chapter 7: Conclusion…………………………………………………………………. 309

Bibliography…………………………………………………………………………... 322

x List of Figures

Figure 1.1: Tax expenditure on homeowners in the United States and Germany,

1999-2014……………………………………………………………………..... 15

Figure 1.2: Household consumption as a percentage of GDP, 1950-2016………………. 28

Figure 1.3: Exports as a percentage of GDP, 1947-2016………………………………... 29

Figure 1.4: Homeownership rates in the United States and Germany, 1930-2015……… 35

Figure 1.5: House price developments in the United States and Germany, 1990-2012…. 41

Figure 2.1: Tax expenditures on homeownership in Germany, 1963-1975……………... 74

Figure 2.2: Tax expenditures on homeownership in Germany, 1975-1998……………... 78

Figure 2.3: Homeownership tax allowance, 1999-2015…………………………………. 92

Figure 3.1: U.S. individual income tax rates, 1913-2015……………………………… 119

Figure 3.2: Effective federal funds rate and 30-year mortgage rates, 1954-2017………. 133

Figure 3.3: Estimated tax expenditure on mortgage interest deduction

(in billion USD), 1974-2015…………………………………………………... 141

Figure 3.4: U.S. mortgage debt outstanding (in million USD), 1984-2017…………….. 143

Figure 4.1: Total construction and social housing units in Germany, 1950s-2000s……. 157

Figure 4.2: Share of subsidized owner-occupied homes as part of social housing

programs in Germany, 1950s-2000s…………………………………………… 158

Figure 4.3: Approved social housing units in the German Länder between 1957

and 1988...... 171

Figure 4.4: Approved social housing units in the old and new federal states, 1991-

2004...... 187

Figure 6.1: Mortgage-backed securities held by the Federal Reserve, 2008-2017……... 259

xi Figure 6.2: Covered bonds and asset-backed securities held by the European

Central Bank, 2008-2017……………………………………………………..... 260

Figure 6.3: Covered bonds held by members of the Bank of German States (Bank

Deutscher Länder), 1950-1951………………………………………………... 293

xii Chapter 1: The Politics of Entrenchment

Introduction

The financial fallout of 2008-09 demonstrated that housing finance markets can bring the global economy to its knees and economic misfortune to ordinary people. Despite the housing crash of recent memory, surprisingly little is known about how and why advanced industrial countries support private housing markets as part of the welfare state. Time and again, governments in Western societies have faced consequential policy choices about how to shape the housing and investment decisions of ordinary people and investors in multi-trillion-dollar housing markets, but their policy solutions have differed in important ways. Why have some countries adopted state-based homeownership models with extensive public support for financing private homes, such as tax breaks and subsidized mortgage debt, while others have chosen market-based models with only limited public support? And what explains policy stability and change over time? Analyzing advanced economies along this dimension is intriguing, as it defies preconceived notions about government involvement in modern economies. Why does the United States, the world’s champion of free markets, currently offer extensive public support for homeownership finance, while Germany, a social market economy, provides only limited support? This dissertation addresses these questions by comparing the politics of housing finance policy in these two economic powerhouses from a comparative, historical perspective.

When it comes to housing, the United States and Germany are polar opposites. The majority of Americans owns their homes, while for most Germans renting their homes is the happy norm. The United States is often labeled a nation of homeowners, as 65 percent

1 of American households owned their homes in 2013, where single-family homes in suburban areas have long been considered a vital part of the American Dream.1 In contrast,

Germany has developed high-quality, multi-family rental markets -- to which the country owes its reputation as a nation of renters and correspondingly low homeownership rate of

43 percent in 2013 -- with higher residential density and less suburbanization.2 The United

States stands out for its dynamic homeownership market, where surging house prices are celebrated as a sign of economic health, but also for its unaffordable rental markets.

Germany represents the mirror image of the United States -- rigid homeownership markets, with a preoccupation for price stability in the housing market, and affordable rental markets.

These larger developments are, to a substantial degree, shaped by public policies in the housing area. The United States has offered a long list of government measures to support homeownership since the early twentieth century -- extensive tax breaks and subsidized mortgage debt, to name a few. The country even nationalized significant parts of its multi-trillion-dollar housing finance market during the recent housing crash of 2008-

09, when it took over the mortgage giants, Fannie Mae and Freddie Mac, which have since remained in the hands of the U.S. government. However, other Western nations have embarked on fundamentally different paths that do not resemble the love story between the

American state and homeownership finance. To a lesser but substantial extent, Germany had also provided generous support for home finance in an attempt to create a nation of homeowners after WWII, offering sizable tax breaks for homeowners and mortgage debt subsidies as part of social housing programs. But the country has recently discontinued its

1 Source: U.S. Census Bureau. 2 Source: Federal Statistics Office Germany.

2 government support for homeownership finance. Today, the housing finance market in the

United States, the land of free market capitalism, is more socialized than that of most other advanced economies, including Germany. Why has the United States offered much stronger public support for homeownership markets than Germany, which has retrenched its support for homeowners in recent years?

This dissertation explains the varieties of housing finance policies in the United

States and Germany, with a particular focus on tax, mortgage, and central bank policy. This study develops an argument about how models of economic growth shape the politics of the welfare state in the housing area. Scholars tend to explain welfare state developments by privileging the power resources of social forces or the role of political institutions and interest groups. Yet, they have neglected the ways in which larger economic structures shape the social policy choices of political actors. The key to understanding the opposing housing finance policy trajectories in the United States and Germany lies in the deeper linkages of economic growth models and housing finance policy. Specifically, the degree to which growth models -- consumption-led or export-oriented models -- entrench existing housing finance policies shapes the future policy choices available to political coalitions.

This study pays particular attention to how these political processes of entrenchment unfold over long periods of time, as existing social policies and macroeconomic features shape the political terrain for future policy action. Analyzing these phenomena calls for a comparative, historical perspective that is able to reveal the preferences, constraints, and abilities of political actors when shaping social policy associated with specific historical phases. This project explains the political twists and turns of housing finance policies during three critical historical episodes since the early twentieth century: (i) from their

3 origins during the Great Depression in the United States and the post-WWII years in

Germany until the golden age of capitalism in the 1970s, (ii) a phase of liberalization and welfare retrenchment from the 1970s until the 1990s, and (iii) a period of economic crises and reform from the 1990s until the 2010s. The findings of this study then contribute to our understanding of how macroeconomic growth models shape the politics of the welfare state.

Why housing finance policies matter

Housing finance policies shape the everyday lives of ordinary people, larger developments in housing and financial markets, and the welfare state in advanced economies. The sheer economic size of residential housing and housing finance markets in advanced economies renders policies in this area important. In the United States, the residential housing market is valued at USD24 trillion3 -- a number comparable to the U.S. stock market -- while its

German counterpart amounts to more than EUR6 trillion.4 The U.S. housing finance market currently consists of USD10 trillion in outstanding mortgage debt, whereas that number is just above EUR1 trillion in Germany.5 This makes housing finance a key link between the financial sector and the real economy, such as construction and retail. Housing finance policies shape these multi-trillion-dollar housing markets by influencing the economic activities, investment decisions, and price developments in these markets.

Sound policies governing housing finance systems are key for the financial stability of advanced economies and the global economy. It is well documented that the global

3 Source: Housing Finance Policy Center, Urban Institute. 4 Source: Bundesbank Panel on Household Finances (PHF). 5 Sources: European Mortgage Federation (EMF); Housing Finance Policy Center.

4 financial crisis of 2008-09 was caused by a house price bubble in the U.S. housing market.

When the bubble burst, the resulting financial crisis exposed millions of ordinary people in the United States and around the globe to severe financial and social risk – that is, foreclosure, unemployment, a loss of life savings, and unsustainable debt. Some scholars and commentators have argued that lavish government support for home finance fueled the housing bubble and therefore contributed to the crisis in the United States.6 This is because government support for housing finance tends to channel investments into the housing sector, encourages the expansion of mortgage lending, and influences levels of financial risk in the larger financial system. Others have argued that the absence of generous government support for housing finance in Germany has helped the country avoid a similar housing bubble and home-grown financial crisis.7 While the extent to which housing finance policies have contributed to the financial crisis of 2008-09 remains the topic of fruitful scholarly and public debate, this study investigates the reasons for why there is variation in home finance policies in the first place. With an eye on financial stability, the stakes for policymakers are accordingly high when it comes to shaping multi-trillion-dollar housing finance systems embedded in global markets.

Housing finance policies also affect the everyday lives and social welfare of ordinary people. First, government support for housing finance helps families accumulate private wealth through the ownership of their home. Homeownership is a form of private social insurance or “piggy bank” that allows families to hedge against market and life risks: inflation, unemployment, or sickness. This private welfare function is all the more important in an age of welfare state retrenchment, when asset-based forms of social

6 Wallison 2015; Calomiris and Haber 2014. 7 Voigtländer 2009, 2014.

5 insurance have gained prominence in advanced economies.8 Homeownership allows ordinary people to save money they would otherwise spend on rent or sell their homes to cash in for their retirement. Second, government support for housing finance also tends to stimulate house prices, supporting the most valuable asset that ordinary people own over the course of their lives. In the United States, housing wealth currently amounts to

USD14tn.9 Armed with higher housing collateral, families may borrow money against their homes to finance consumption goods, start new businesses, pay for their children’s education, or health care bills. Others may sell their homes with large profits, which they can then use to trade up their homes or pass on to future generations. Finally, investments in homeownership expose ordinary people to financial risk, especially if housing constitutes the lion’s share of a household’s portfolio. Generous housing finance policies incentivize households to finance homeownership through mortgage debt, which encourages some ordinary people to take on high levels of debt or even enter risky mortgage deals. In difficult times, homeowners cannot easily liquidate their housing assets

-- unlike selling stocks to raise quick cash -- and may be forced to sell their homes well below what they had paid for or pay underwater mortgages worth more than their homes.

In sum, the choice of homeownership is not merely about appropriate shelter and domestic life, but also an investment with expected economic and social returns that entails significant financial risk.

As with other social policies, housing finance policies that support homeownership benefit some social groups over others. Above all, these policies privilege those with housing assets or aspiring to climb the property ladder – that is, middle to upper income

8 Crouch 2009; Hacker 2004. 9 Source: Housing Finance Policy Center.

6 households. But they do not necessarily benefit poorer households -- often minority households10 -- or those unwilling to buy, who experience the flip side of house price appreciations in unaffordable rental markets.11 The United States, for instance, has long suffered from affordability crises in the rental markets of metropolitan areas, such as the

San Francisco Bay Area, but U.S. policymakers have dedicated fewer resources to support rental markets than home finance markets. It is fair to say that government support for housing finance reinforces or, at a minimum, does little to stop larger trends in housing wealth inequality.12 Indeed, growing inequalities in housing are not just an American problem. To the contrary, they are on the rise on both sides of the Atlantic in the UK,

Canada, and Germany, where property prices in many metropolitan areas have increased at faster rates than household income.13 In the case of Germany, the recent influx of immigrants and refugees has created additional pressures on local housing markets, while global and domestic investors are buying up German properties in search for safe havens.14

The appropriate allocation of scarce government resources for the housing sector, and how to share these resources as a society, remains the subject of intense political conflicts in

Western nations.

Varieties of housing finance policies

Policymakers in advanced economies are able to choose from a broad menu of housing finance policies in the tax, mortgage debt, and monetary areas. This dissertation

10 Freund 2007; Desmond 2016; Thurston 2015; Hayward 2013. 11 Flynn and H. Schwartz 2017. 12 Also see Rognlie 2015. 13 Gyourko, Mayer and Sinai 2013. 14 Wijburg and Aalbers 2017.

7 distinguishes between state-based and market-based homeownership models to capture the range of housing finance policies. While state-based models are characterized by a set of policies that support and stimulate home finance markets -- such as large-scale tax benefits and mortgage debt subsidies -- market-based models comprise policies that do not privilege home finance markets over other sectors and investments. This dimension of variation is important because housing finance policies shape the political economies of housing in advanced economies by channeling investments into the housing market that go on to affect social groups and market actors, such as homeowners and renters or banks and interest groups. While most advanced countries have offered government support for housing finance at one point, there are important differences in policy support for housing finance across countries and over time. Some countries have had century-long histories with state- based homeownership models that seem unshakable today. Others have temporarily experimented with state-based models but switched to market-based approaches over time.

The first set of policies to support housing finance markets is tax expenditures, an often overlooked aspect of the (fiscal) welfare state. An efficient and neutral world designed by tax economists would not privilege housing or any other asset when it comes tax treatment15 -- in other words, tax breaks for homeowners would not exist. But more often than not, countries deviate from these economic fundamentals and offer long lists of housing tax breaks to ordinary people -- the mortgage interest deduction, property tax deduction, capital gains exclusion, foregone tax of imputed rent (i.e., a tax on the rental

15 In economic theory, if owner-occupied housing is defined as an investment good, then homeowners ought to be taxed on capital gains and imputed rent, a counterintuitive tax on the rent that homeowners would pay to themselves. At the same time, homeowners could then deduct some business expenses from their income that are related to their homes, such as mortgage interest or property taxes. If owner-occupied housing is defined as a consumption good, then homeowners are not taxed on imputed rent or capital gains, but they also cannot deduct business expenses from their income, such as mortgage interest or property taxes.

8 income one generates by living in one’s own home), and tax relief on the construction and financing costs of homes.16 These tax breaks come in different shapes and vary across countries when it comes to their size and nature. Yet, in essence, they are all sizable government payments, often amounting to thousands of dollars per household, that households receive for their housing-related expenses at the end of the tax year. Housing tax breaks are some of the largest items in countries’ income tax codes and cost taxpayers billions of dollars per year.

It is instructive to briefly illustrate the different types of housing tax breaks from a comparative perspective. The mortgage interest deduction is the most prominent housing tax break in the United States and in other counties, such as Denmark, Sweden, and the

Netherlands. Despite its prominence in these countries, the deduction is not featured in the tax codes of many other advanced economies, such as Germany, Canada, and the UK. The same is true for the property tax deduction, which is a major federal tax break in the United

States, but is not currently included in the tax codes of Germany, Canada, and the UK.

While all of these latter countries do join the United States in offering some tax relief for the gains on the sale of homes, U.S.-style tax breaks are not generally the most important tax subsidies in other advanced economies. In Germany, the largest housing tax break, until its elimination about a decade ago, was relief on the financing and construction costs of homes, a tax break never adopted in the United States.

The second set of policies to support housing finance is debt subsidies in the mortgage market. Subsidizing mortgage debt tends to stimulate housing activity by

16 Poterba and Sinai 2008. The mortgage-interest deduction reduces the tax bills of homeowners by allowing them to deduct mortgage payments from their taxable income. The property tax deduction reduces the taxable income of homeowners by allowing them to deduct property tax payments from their income. The capital gains exemption allows homeowners to sell their homes with a tax-free profit.

9 increasing the mortgage lending of banks and lowering mortgage interest rates. In other words, these housing finance policies make mortgage debt cheaper and more accessible compared to what it would be without government support. Policymakers can choose from a number of major policy tools to subsidize mortgage debt. As with tax policies, these policies differ with regard to their size and nature. Some governments have extended home loans directly to homeowners at below-market rates, subsidized mortgage interest payments, or offered cheap sources of funding for private banks that could be passed on to homeowners in the form of cheaper loans. Other governments have instead insured the mortgages of homeowners against default, allowing homeowners to benefit from lower mortgage rates while private banks are guaranteed risk-free mortgage payments. Finally, governments have chosen to provide guarantees in the secondary mortgage market, where investors buy and sell securities collateralized by mortgage debt. More specifically, government agencies can buy primary mortgage loans from banks, pool these loans together into securities backed by mortgages (i.e., mortgage-backed securities), and then sell these securities to investors in the secondary mortgage market with a government guarantee -- a practice known as securitization.17 This practice tends to increase the liquidity and lending activities of banks and allows them to extend mortgage loans at lower mortgage rates, because government agencies take mortgage debt off banks’ balance sheets while government guarantees reduce the risk of lenders in the mortgage market.

Government guarantees put taxpayers on the hook for billions or, in some cases, trillions of dollars in mortgage debt.

17 This practice is not limited to government agencies, as private banks can also originate and sell mortgage- backed securities without a government guarantee.

10 Advanced economies have differed remarkably as to what kinds of mortgage debt subsidies they have chosen. The United States has long provided extensive government guarantees to support the primary and secondary mortgage markets. While the Federal

Housing Agency (FHA) and the Veterans Administration (VA) offered mortgage insurance for homeowners in the primary mortgage market, the government-sponsored enterprises,

Fannie Mae, Ginnie Mae, and Freddie Mac, have securitized millions of mortgages and sold them as mortgage-backed securities in the secondary mortgage market. To a lesser extent, other countries also have offered government guarantees through government agencies. In Canada, for instance, the Canadian Mortgage and Housing Corporation

(CMHC), a government agency, has issued mortgage insurance in the primary mortgage market and securitized housing bonds in the secondary market. The key difference is that

Canadian government agencies are less dominant actors in the mortgage securitization market when compared with their American counterparts.18 Germany has chosen a different approach altogether. Instead of relying on government guarantees in the mortgage market -- the existing practices of securitization in the secondary mortgage market are largely private19 -- the German state extended subsidized loans or interest-rate subsidies on loans to homeowners as part of the country’s longstanding social housing programs that were eliminated in recent years.20

18 Mordel and Stephens 2015. 19 Instead of issuing mortgage-backed securities, German banks use covered bonds, pooling together mortgages and other assets, to refinance their lending activities, and they buy and sell these bonds with private investor protections. 20 Government programs and agencies in these countries have not been limited to subsidizing homeownership as opposed to rental markets. U.S. government agencies, such as the FHA and Fannie Mae, can offer mortgage insurance on rental properties and securitize rental housing loans in the secondary market, but they have done so only marginally. The social housing programs in Germany, in contrast, subsidized renters more strongly than homeowners.

11 The third set of policies to support housing finance is monetary stimulus. Central banks conventionally influence housing markets through lowering or raising interest rates.

Yet, they also provide unconventional, targeted support for housing to meet larger macroeconomic policy goals.21 One important way of targeting the housing sector is to purchase large amounts of mortgage debt in the open market -- a practice that tends to both lower long-term mortgage rates and generate housing demand, which, in turn, stimulates activity in the larger economy. The Federal Reserve (Fed), for instance, has bought close to two trillion dollars in mortgage debt to achieve these effects in response to the financial crisis of 2008-09.22 In contrast, the European Central Bank (ECB) has bought comparatively little in housing-related debt since the onset of crisis.23 These often temporary programs differ from tax and mortgage policy in that they are not decided in the legislative arena. Yet, much like fiscal welfare policy, these programs support private housing markets in advanced economies. 24

Housing finance puzzles in the United States and Germany

Taken together, housing finance policies add up to larger policy pathways in advanced economies, such as in the United States and Germany. Individual policies are important in their own right, but they are even more meaningful when considered as part of larger state- based or market-based homeownership models. Comparing these larger housing finance policy trajectories in the United States and Germany reveals that the United States adopted a state-based homeownership model, whereas Germany arrived at a market-based model.

21 Lombardi and Moschella 2015; Bindseil 2014; Krishnamurthy and Vissing-Jorgensen 2011. 22 Krishnamurthy and Vissing-Jorgensen 2011. 23 The ECB’s housing-related debt holdings amount to roughly EUR250bn in 2017. Source: ECB. 24 Binder and Spindel 2017.

12 Yet, these models are not set in stone and instead the result of dynamic, long-term policy trajectories. Since the early twentieth century, U.S. governments have built up a state- based homeownership model characterized by extensive public support for housing finance in the areas of taxation, mortgage debt, and central banking. This stands in stark contrast to Germany, where policymakers initially adopted a state-based25 model with generous public support for homeowners in the postwar period, but then slowly switched to today’s market-based model with very limited government support. In contrast to their American counterparts, German policymakers retrenched government support for homeownership in the tax and mortgage areas from the 1980s until the mid-2000s. This dissertation contrasts these opposing housing finance policy trajectories, starting with the Great Depression in the United States and the early post-WWII years in Germany.

In terms of taxation, the United States provides almost every major tax break possible to homeowners: the mortgage interest deduction, property tax deduction, and the capital gains exclusion. Most of these tax breaks have been in place since the introduction of the federal income tax code during the early twentieth century. The tax breaks have since not only survived major tax reforms, but policymakers even extended them in successive steps over time. For decades, they have been among the largest tax breaks in the U.S. tax code, totaling USD127bn in 2015. The popular mortgage interest deduction currently assists roughly 20 percent of U.S. households -- that is, 40 million households -- with their

25 It is important to note that, unlike the United States, Germany long extended generous subsidies to both homeowners and the rental market. In the words of Voigtländer (2009, 370), this placed “the rental housing and homeownership markets in Germany ... on an equal footing.” While the country’s state-based homeownership model did not privilege home finance over rental markets, it did privilege housing over other markets and investments. Much like subsidies for homeowners, rental subsidies were scaled down from the 1980s until the mid-2000s, when the country switched to its market-based homeownership model. However, this study mostly focuses on public policies supporting homeownership finance.

13 mortgage payments.26 The German state had also offered tax subsidies for homeowners – i.e., the homeowner allowance tax benefit, property tax reductions, and capital gains tax reductions -- from the early postwar years until recently. The homeowner allowance, for instance, was the single largest tax break in the history of the country, amounting to

EUR11.4bn in 2004. Between 1996 and 2000, the tax break benefitted 2.6 out of 38 million households.27 However, German policymakers eliminated the property tax reductions in the late 1980s and, just prior to the financial crisis of 2008-09, the popular homeowner allowance. As a result, Germany currently does not offer any large-scale tax subsidies for homeowners.28 To illustrate these difference, figure 1.1 contrasts the tax expenditures of the two most important tax breaks for homeowners in the United States and Germany -- the American mortgage interest deduction and the German homeowner allowance. Figure

1.1 demonstrates that the American mortgage interest deduction has been more generous than the German homeowner allowance since at least the late 1990s. Relatedly, Germany reduced the tax spending of their most important tax break for homeowners to effectively zero by the early 2010s, a scenario that seems impossible in the United States.

26 Source: Tax Policy Center. 27 This number likely understates the number of recipients, as it only account for new recipients in that time period. 28 German homeowners are exempt from paying a tax on capital gains if they have owned their home for at least three years before selling it. Yet, this tax break is not listed in the government’s annual subsidy reports.

14 Figure 1.1: Tax expenditure on homeowners in the United States and Germany, 1999-

2014.29

350

300

250 Mortgage Interest Deduction

200

150 (In PPP) (In

100

Per capita tax expendituretax capitaPer Homeowner Allowance Germany 50 United States 0

In terms of mortgage debt policy, the United States has offered generous government guarantees in the primary and secondary mortgage markets. In the primary mortgage market, the Federal Housing Administration (FHA), the U.S. Department of

Veteran Affairs (VA), and the U.S. Department of Agriculture (USDA) have long insured millions of mortgages of middle and lower income families and veterans against default.30

For instance, the FHA insured a mortgage volume of USD245bn for more than one million homeowners in 2016, the VA guaranteed USD153bn for about 630,000 veterans in 2015, and the USDA insured USD24bn for about 166,000 homeowners in rural areas in 2015.31

These government programs date back to the early and mid-twentieth century and have changed only marginally over time. In the secondary mortgage market, similarly, U.S.

29 Sources: own calculations; U.S. Treasury; German Ministry of Finance. 30 A. Schwartz 2014. 31 Sources: FHA, VA, USDA.

15 government support for home finance has increased in recent decades. The government agencies Fannie Mae, Freddie Mac, and Ginnie Mae now offer explicit government guarantees on mortgage-backed securities issued by these agencies -- that is, guarantees against investor losses resulting from the default on the underlying mortgages. But this was not always so. Before the financial crisis of 2008-09, Fannie Mae and Freddie Mac had been privately owned for decades, while enjoying the status of federally chartered government-sponsored enterprises (i.e., this status allowed them to sell mortgage-backed securities with an implicit government guarantee).32 But their quasi-governmental status also left some ambiguity about whether the U.S. government would bail these enterprises out or allow them to fail in the event of a major crisis. The financial crisis of 2008-09 resolved that ambiguity. In one of the largest bailouts in the country’s history, the U.S. government seized control of the battered mortgage giants Fannie Mae and Freddie Mac.33

The government takeover significantly expanded the footprint of the U.S. government in the mortgage market. Today, almost ten years later, Fannie Mae and Freddie Mac, two

Fortune 50 companies, remain in government control, and with it, more than half of

America’s residential mortgage market worth USD10tn.34 The two mortgage giants and

Ginnie Mae currently guarantee roughly USD6tn in mortgage debt, for which taxpayers are on the hook.35 Germany’s mortgage programs were decidedly different and less generous. Instead of government guarantees, the federal government in Germany supported

32 Fannie Mae was created as a government agency in the 1930s. In the late 1960s, it was privatized, but retained its status as a government-sponsored enterprise. The Johnson administration created Ginnie Mae in 1968 and Freddie Mac in 1970, two additional government-sponsored agencies. Fannie Mae and Freddie Mac’s status as private, but government-backed, enterprises left some ambiguity as to whether these companies would be private or public enterprises. Ginnie Mae has always been backed by the full faith of the U.S. government since its creation in 1968. 33 The bailout cost taxpayers USD187bn. 34 Acharya et al. 2011. 35 Source: Housing Finance Policy Center.

16 homeowners through large-scale social housing programs since the early postwar years, extending subsidized loans or interest-rate subsidies on loans. Between 1956 and 2000, the programs subsidized an impressive number of seven million housing units, roughly one- third of the 21 million units built during that time. Importantly, social housing programs were offered to homeowners and the rental sector, but the balance between homeowners and renters was uneven, supporting about 2.5 million owner-occupied units and 4.5 million rental units. Over time, and despite benefiting millions of homeowners and renters, the federal social housing programs were scaled down and eventually eliminated in the mid-

2000s. Today, there are only minor mortgage debt subsidies left at the federal level in

Germany.36 This stands in stark contrast with the United States, where federal programs have subsidized multi-family rental housing only marginally and continue to offer extensive support for homeowners.

When it comes to monetary policy, the United States has adopted large-scale programs to support its housing market in response to the recent financial crisis of 2008-

09. Specifically, the Fed has bought an impressive amount of USD1.8tn in mortgage- backed securities, with the goal of reducing long-term mortgage rates and stimulating housing demand and consumption in the larger economy. While the magnitude of these current programs is unprecedented, the Fed had already offered targeted support for housing markets in the 1930s and the 1970s. The European Central Bank has supported housing finance markets much less in response to the crisis and bought only EUR250bn in housing-related assets, such as covered bonds or asset-backed securities. In Europe, too,

36 For instance, the Kreditanstalt für Wiederaufbau (KfW), a government-owned development bank, extends small-scale subsidized loans to homeowners. Some Länder continue to offer programs for homeowners, including some subsidized loans, but these programs differ significantly across the federal states.

17 there was precedent for supporting housing through monetary stimulus. The German

Bundesbank, for instance, purchased housing-related covered bonds in the 1950s to help recover the country’s capital market. In sum, almost ten years after the recent crisis, monetary stimulus remains an important pillar of supporting housing finance in advanced economies.

This raises a number of puzzles about the opposing policy trajectories of both countries. The first puzzle relates to the vast footprint of the American state in the housing finance market. The United States is often labeled a quintessential liberal market economy, with limited government involvement in the economy. Yet, over the course of the twentieth and twenty-first centuries, the United States has developed the most extensive government infrastructure to support housing finance in the advanced world, especially when compared to Germany, a social or coordinated market economy. This continued policy support for housing finance is all the more remarkable given that the U.S. home finance market caused the most severe financial crisis in recent memory. While the powerful U.S. banking industry was forced to undergo comprehensive financial reforms under the Dodd-Frank

Act in 2010, the housing finance market was mostly omitted from financial reforms -- to the contrary, the sector now receives more government support than ever. Today, scholars and commentators label the U.S. housing finance market as “socialized”37 or a form of

“comradely capitalism.”38 The second puzzle relates to the policy retrenchment of longstanding and popular social policies in Germany. For decades, students of the welfare state have emphasized the path dependence of social policies that create strong interest

37 See, for instance, Mervyn King, the former head of the Bank of England, quoted in: McLean (2015, 9). 38 The Economist, “Comradely capitalism: How America accidentally nationalised its mortgage market,” August 20, 2016.

18 groups and beneficiaries willing to defend them. While Germany had adopted and sustained decades-long government support for homeowners, it dramatically reduced tax and mortgage policy support for homeowners over time. What explains the seemingly unshakable government support of housing finance in the United States that has built up over almost a century vis-à-vis the policy retrenchment of longstanding home finance policies in Germany?

Existing approaches

Existing scholarship in political science -- and the social sciences more generally -- has largely neglected housing finance policy as a major area of the welfare state. Some ink has been spilled on the importance of social and public housing,39 but political scientists have rarely analyzed public policies in the larger housing market for homeownership.40 While a growing body of work has started to focus on how housing policies have contributed to the recent financial crisis of 2008-09,41 there remains little systematic comparative and historical research on why there is variation in home finance policies in the first place.42

Economists, similarly, have done important statistical work on the consequences of different home finance policies, such as the mortgage-interest deduction,43 but have failed to explore their historical origins and changes as well as the political conflicts surrounding them.44 This is all the more surprising given that housing finance contributes to an essential

39 Pierson 1994; Harloe 1995; Torgersen 1987. 40 For some notable exceptions in political science, see McLeay (1984), Howard (1997, ch. 5), H. Schwartz and Seabrooke (2008), Thurston (2015). 41 Wallison 2015; Calomiris and Haber 2014; Rajan 2010; McCarty, Poole, and Rosenthal 2013. 42 H. Schwartz and Seabrooke 2008. 43 Poterba 1984; Hendershott and Slemrod 1982; Poterba and Sinai 2008. 44 Legal scholars have provided excellent historical descriptions of the evolution of the mortgage interest deduction in the United States, for instance. See Ventry 2009.

19 part of human welfare -- access to adequate housing.45 Despite the paucity of political science research on housing finance, the most prominent political economy and welfare state theories still yield insights into what could explain the opposing housing finance policy trajectories in the United States and Germany.

Scholarship on political institutions and the welfare state has long emphasized the stability of social policy trajectories in advanced economies. One prominent line of research contends that political actors would be able to block major policy reforms in political systems with strong veto players, such as in federalist polities.46 Both the United

States and Germany have federalist systems that are known to produce policy inertia. Peter

Katzenstein famously labeled Germany a “semi-sovereign state”47 that would be unable to adopt major economic reforms, while the U.S. political system is often characterized as gridlocked.48 A related line of institutional scholarship on the welfare state has long privileged the path dependence of -- or incremental changes in -- social policies over time.49

Policies should either generate increasing, efficiency-enhancing returns from which these economies benefit50 or persist despite inefficiencies, as strong constituencies, coalitions, and interest groups defend and extend these policies.51 Some social policies, such as tax expenditures on homeowners, might also grow relatively undetected in the “hidden” territory of the welfare state -- due to changes in the general tax code, for instance -- which

45 The Universal Declaration of Human Rights of 1948 and the International Covenant on Economic, Social and Cultural Rights of 1966 recognized adequate housing as part of the right of an adequate standard of living. 46 Katzenstein 1987; Scharpf 1988; Campbell and Morgan 2005. 47 Katzenstein 1987. 48 Binder 2015; Steinmo 1993. 49 Pierson 1996; Streeck and Thelen 2005. 50 Pierson 2000. 51 North 1990; Howard 1997; Hacker and Pierson 2010.

20 creates vested interests in these policies once they are more “visible.”52 These approaches have in common that they contend that existing social policies create resources for interest groups that allow them to defend these policies in future political battles, a policy feedback loop that makes it more difficult to reverse the course of policy trajectories over time.53

Both the United States and Germany are home to powerful housing interest groups, such as the realtors in the United States or the building societies in Germany, which stand to benefit from housing finance policies.54 In sum, scholarship on political institutions and welfare states suggest that institutional factors and feedback effects should produce long- term policy stability in both countries.

Yet, the policy trajectories of housing finance policy in the United States and

Germany have diverged over time. After decades of strong government support for homeowners, the German state discontinued its policy support for home finance in the mid-

2000s, while the American state doubled down on its government support around the same time. The general shortcoming of these approaches is that they treat interest group power as given, arguing that they are inherently powerful in defending social policies,55 particularly the ones that benefit the rich.56 Certainly, interest groups are important in shaping social policy in the housing area, but, as this dissertation will show, much of their strength depends on their power position and linkages with the larger macroeconomic features of economic growth models. Policy trajectories that appear stable for long periods of time, seemingly protected by semi-sovereign political institutions and powerful interest

52 Howard 1997. 53 Pierson 1993; Howard 1997; Thurston 2015; Campbell 2012. 54 For analyses highlighting the strength of housing groups in the United States, see Hornstein (2005); Freund (2007). For studies showing the influence of the interest groups in Germany, see Egner (2004) and Kohl (2017). 55 Pierson 1996; Howard 1997; Campbell 2012; Mettler 2010. 56 Hacker and Pierson 2010.

21 groups, often have deeper cracks that can lead to their eventual demise. This dissertation investigates the conditions under which interest groups can get their way by focusing on their links with economic growth models.

Another important body of work on the power resources of social forces and party politics may be more promising in explaining the opposing policy trajectories in the United

States and Germany.57 These approaches suggest that major social and political blocs are the key drivers of social policy, including in the housing area.58 It is fair to say that these theories would predict that center-right political forces favor the creation and expansion of housing finance policies that support homeownership, while center-left political forces are more likely to favor their retrenchment.59 This is because homeowners tend to be more affluent voters represented by center-right parties, whereas center-left political parties tend to represent less affluent voters and renters, prioritizing affordable rental housing over homeownership.60 The opposing housing finance policies in the United States and

Germany may therefore be the result of shifting power resources within each country.

Yet, this begs the question: why have similar political parties in the United States and Germany developed widely different preferences about housing finance policy? It is certainly the case that center-left forces in Germany, such as the Social Democratic Party

(SPD), pushed for the retrenchment of homeownership finance policies (and favored policy support for rental housing), but the center-left Democratic Party in the United States has never developed a strong preference for retrenchment (nor for rental housing support).61

57 Esping-Andersen 1990; Korpi 2006; Allan and Scruggs 2004; Huber and Stephens 2001; Iversen and Stephens 2008; Garrett 1998. 58 Ansell 2014; H. Schwartz and Seabrooke 2008. 59 Fulda and Kohl (unpublished ms.), for instance, find that German homeowners are more likely to vote for center-right parties, whereas renters are more likely to vote for center-left parties. 60 Also see Ansell 2014. 61 Harloe 1995; Reisenbichler 2016.

22 The major shortcoming of these approaches is not their focus on party politics, which matters greatly in shaping social policy in the housing area, but that they often treat party preferences as given.62 This dissertation shows that the beliefs, interests, and ultimately preferences of political parties are often shaped by the larger macroeconomic features of growth models, which helps explain why similar political parties in Germany and the

United States have held fundamentally different preferences about housing finance that eventually translated into the opposing policy trajectories between the two countries.

Scholars may also invoke cultural accounts to explain the divergent housing finance policy paths between the United States and Germany.63 These approaches tend to emphasize the role of cultural values in explaining policy trajectories. Put simply, if homeownership is an ingrained element of a country’s DNA that holds positive beliefs about homeownership, such as making for better citizens, communities, and social capital,64 then we would expect strong and consistent policy support for homeownership.

In the United States, homeownership has unquestionably been an important pillar of political culture as part of the American Dream defined, in part, by single-family homes in suburban areas.65 In Germany, there is widespread belief among commentators and scholars that homeownership, contrary to renting, has neither been an essential element of the country’s political culture nor a priority for policymakers.66 These differences in

62 This tends to be the case in pooled times-series, cross-sectional research, demonstrating how social policy outcomes correlate with left-right power resources. See, for instance, Huber and Stephens (2001); Allan and Scruggs (2004). Yet, the preferences of the left and right are often imputed rather than demonstrated. These accounts also have difficulty in explaining preference change of political parties over time. 63 Jackson 1985, 2006; Dreier and A. Schwartz 2014; Avramenko and Boyd 2013. 64 DiPasquale and Glaeser 1999. 65 Jackson 1985. 66 Voigtländer 2009.

23 cultural values would then explain today’s contrasting policy outcomes of minimal support for homeownership in Germany and extensive support in the United States.

Yet, this view is immediately confronted by Germany’s longstanding policies of supporting homeownership until the early 2000s. Indeed, the focus on private property and homeownership was a mainstay of Christian Democracy in the country’s postwar history.67

In social terms, homeownership reinforced conservative, male-breadwinner family views of domestic life in single-family homes, especially for uprooted families after WWII.68

Politically, it reflected an anti-collectivist ideology based on freedom and ownership during the Cold War.69 Economically, it promoted ways of accumulating private wealth.70 In regional terms, homeownership is an important part of the identity of some German regions, such as Baden-Württemberg or Lower Saxony, which pride themselves on being

“lands of homeowners.”71 Particularly the Christian Democratic Union (CDU), the most successful party in the country’s postwar history, has embraced these values and become the staunchest advocate and defender of policies to support homeownership.72 It is therefore reasonable to say that homeownership has been an important part of German postwar political culture -- a view that is supported by numerous national polls since the

1950s, reckoning that the vast majority of Germans prefers to own their homes as opposed to renting.73 But even if we accept that homeownership has been an important part of the

German and American political cultures, then why did Germany do away with these

67 Diefendorf 1993; van Kersbergen 1995. 68 Möller 1996. 69 Diefendorf 1993; Schulz 1994; Beyme 1999. 70 van Kersbergen 1995. 71 Lüning 2005. 72 The Free Democratic Party (FDP) also defended the homeownership subsidies, promoting ownership as a way to achieve economic freedom. 73 See, for example, Hilde Hoff, “Neue Umfrage: Wie möchten Sie wohnen?” Die Zeit (3 November 1955); Joerg Eckart, “Das Eigenheim im Grünen,” Die Zeit (12 June 1964).

24 longstanding and popular traditions by eliminating policy support for homeownership, while the United States expanded its government support? While cultural accounts are undoubtedly valuable in highlighting how societies frame homeownership as part of their identities, they have difficulty in explaining why major policy changes occur in the absence of cultural or value changes.

A related body of work on the tradeoff between homeownership and welfare states tends to emphasize that countries offer generous support for homeownership to substitute for less generous welfare states.74 This is because supporting homeownership would facilitate private social insurance in the absence of generous welfare states.75 Countries with minimal welfare states, such as the United States, would encourage homeownership, while countries with generous welfare states, such as Germany, would instead subsidize rental housing.76 Yet, a closer look reveals that it does not take minimal welfare states to support homeownership. Instead, Germany had long encouraged homeownership as part of its generous, conservative welfare state. These accounts have difficulty explaining why major home finance policy changes occur in the absence of major welfare state changes, neglecting the political conflicts around housing finance policy.

Finally, can the politics of race account for the divergent outcomes? While race is a major societal cleavage impacting the welfare state in the United States,77 it is much less salient in Germany.78 It is well established that housing finance policies in the United States have long privileged suburban and white households over urban and minority households,

74 Kemeny 1980, 1981; Castles 1998; Conley and Gifford 2006. 75 Crouch 2009; Prasad 2012. 76 Kemeny 1980, 1981, 2006. 77 Lieberman 1998. 78 Dancygier 2010.

25 as both private markets and public institutions, such as the FHA, discriminated against minority households.79 Yet, racial factors are better at explaining the limited reach of the

U.S. welfare state80 -- that is, the absence of strong public support for rental markets and the neglect of minority groups81 -- than why the United States adopted large-scale support for homeownership in the first place. Other countries without significant racial divides, including Germany, also offered strong public support for homeownership finance.

In sum, existing explanations in political economy and the welfare state miss a key factor in explaining the divergent housing policy paths in the United States and Germany

-- that is, the role of economic growth models in which welfare states are embedded.

The politics of entrenchment

The central argument of this dissertation is that economic growth models shape the politics of the welfare state in the housing area. The key to understanding the opposing, long-term housing finance policy trajectories in the United States and Germany lies in the interlinkages between economic growth models and housing finance policy. In the United

States, the consumption-led growth model has entrenched housing finance policy, which has empowered a coalition of policymakers and interest groups promoting the long-term stability and expansion of policy support for homeowners. Over time, housing finance policies in the United States generated positive feedback effects that reinforced the politics of entrenchment by producing larger numbers of homeowners, stronger interest groups, and housing consumption that stimulated growth in the larger economy. In Germany, the

79 Freund 2007; Hayward 2013; Desmond 2016; Thurston 2015. 80 Lieberman 2014. 81 Freund 2007.

26 export-led growth model has not entrenched housing finance policy, which has opened the door for competing policy coalitions -- center-right political forces in support of homeownership and center-left forces in support of affordable rental housing. The political struggles between these coalitions explain the movements of the German housing finance policy trajectory from initial stability to eventual retrenchment. Over time, housing finance policies in Germany generated negative policy feedback that widened the rift of non- entrenchment, as they failed to both produce larger numbers of homeowners and transform the German political economy of housing into one dominated by owner-occupation. The remainder of this section develops these arguments in greater detail.

Scholars in comparative political economy have long pondered what makes national economies tick.82 This dissertation builds on a growing body of scholarship on economic growth models, such as the work by Jonas Pontusson and Lucio Baccaro, that has privileged the main demand-side drivers of economic growth models: household consumption and exports.83 Certainly, private consumption and exports are important elements of every advanced economy, but advanced economies differ in how much value and relative importance they ascribe to consumption and exports as components of their larger economies, which allows us to distinguish between consumption-led and export-led growth models. While consumption-led economies are based on wage or credit growth to stimulate private demand, export led-economies are based on wage restraint and cost competitiveness to produce export-led growth.84 The American growth model is a

82 Hall and Soskice 2001; Kitschelt et al. 1999; Shonfield 1965. 83 Baccaro and Pontusson (2016) observe that there are additional growth models. While government spending is an important component of demand, “state-led” growth has become less important in the post- Fordist era of fiscal conservatism. Second, “investment-led” growth, driven by business investments in physical capital, constitutes a rather small part of demand in advanced economies. Also see Prasad 2012. 84 Baccaro and Pontusson 2016; Johnston and Regan 2017. Other countries have a more balanced mix between consumption- and export-led growth, such as Sweden.

27 quintessential consumption-led growth model that relies on private demand, wage growth, and credit,85 whereas the German growth model is an archetypical export-led growth model characterized by cost competitiveness, wage restraint, savings, and taming consumption.86

The composition of consumption and exports within these economies varies, but private consumption as a share of the economy has been significantly larger in the United States than in Germany (see figure 1.2), while exports as a share of the economy have been larger in Germany than in the United States since at least the 1950s (see figure 1.3).

Figure 1.2: Household consumption as a percentage of GDP, 1950-2016.87

Private consumption % GDP % consumption Private 50

45 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Germany United States

85 Baccaro and Pontusson 2016; Barnes 2016; Prasad 2012; Crouch 2009. 86 Kreile 1977; Mertens 2015; Logemann 2008, 2011, 2012. 87 Sources: World Bank; FRED. For data for Germany prior to 1970, see Logemann (2012, 23).

28 Figure 1.3: Exports as a percentage of GDP, 1947-2016.88

50 45 40 35 30 25 20 Exports % GDP % Exports 15 10 5 0 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012

United States Germany

What is the role of housing in these growth models? Housing yields tremendous insights into the study of growth models, as housing markets can be an important transmission belt for growth in the larger economy.89 Economists have convincingly demonstrated that the housing market is a key transmission sector of the American consumption-led economy, whereas its German counterpart is much less central to the growth model.90 In sum, building on earlier insights in comparative political economy and economics, this dissertation shows how different economic growth models shape the world of social policy in the housing area, a connection rarely explored in political science research.

88 Sources: World Bank; FRED. For data for Germany prior to 1970, see Abelshauser (2011, 217). 89 Mishkin 2007; Bernanke and Gertler 1995. 90 Geiger, Rupprecht, and Muellbauer 2016; Leamer 2007; Mishkin 2007.

29 Macroeconomic growth models have important and underexplored linkages to the world of social policy.91 Fundamentally, economic growth models create complementarities with social policies -- institutional linkages I conceptualize as entrenchment. Entrenchment is strong if social policies reinforce a country’s growth model and interlock with its macroeconomic features, such as stimulating demand in consumption-led economies or boosting cost competitiveness in export-oriented economies. In contrast, entrenchment is weak if there is a mismatch between social policies and a country’s larger macroeconomic features, such as when social policies promote economic goals that do not tie in with the country’s growth model. Fundamentally, the nature of these linkages between macroeconomic features and existing social policy at t1 structures the politics of future social policy at t2, as it shapes the preferences, power position, and choices of political coalitions for future policy action. Strong forms of entrenchment empower policy coalitions of policymakers and interest groups to preserve and expand existing social policies along the larger policy trajectory, whereas weak forms of entrenchment open the door for competing policy coalitions to bring about path-shifting changes to the larger policy trajectory, including policy retrenchment.

Processes of entrenchment unfold over long periods of time and exert feedback effects.92 This dissertation shows not only how the interaction between growth models and social policy at t1 shapes policy choices at t2, but also how these policy choices at t2 reconstitute linkages between growth models and social policy that then shape the future policy choices. On one hand, they shape entrenchment by influencing the capacities,

91 Also see Blyth and Matthijs (2017) for an approach that focuses on macroeconomic regimes in explaining policy outcomes in international political economy. They show that certain macroeconomic regimes empower some political coalitions over others in pursuing their policy goals. 92 Fioretos, Falleti, and Sheingate 2016; Thurston 2015; Skocpol 1992; Campbell 2012.

30 interests, and beliefs of core constituencies and coalitions of support -- i.e., political parties, homeowners, interest groups, government agencies, etc. -- such as expanding the number of beneficiaries ready to defend and extend social policies in the future. On the other, these policies mesh with private markets, which can either reinforce or work against a country’s growth model. Social policies therefore produce different policy feedbacks, contingent upon their entrenchment in economic growth models. This dissertation captures the temporality of the politics of entrenchment in three historical phases: (i) the origins of modern housing policies to support homeownership during the Great Depression in the

United States and the post-WWII years in Germany, eras of welfare state expansion until the late 1960s; (ii) the political evolution and institutional changes of housing finance policies during an era of economic liberalization and welfare retrenchment until the 1990s, and (iii) a period of economic shocks and reforms from the 1990s until the late 2000s, such as German reunification and the financial crisis of 2008-09, when housing finance policies in both countries moved in opposite directions. In sum, policy decisions in earlier periods, and their evolving interlinkages with economic growth models, have profound effects on the capacities and interests of political coalitions when shaping housing finance policy in later policy phases.

In the United States, the consumption-led growth model entrenches housing finance policies. There is widespread agreement among economists that housing is a transmission belt to stimulate consumption in the U.S. economy, where consumption constitutes roughly

70 percent of GDP.93 This transmission is fueled by housing finance policies that, in the words of Marriner Eccles, a former chair of the Fed, “act as the wheel within the wheel to

93 Gemici 2016; H. Schwartz 2009; Jorda, Schularick, and Taylor 2014, 2015; Schularick and Taylor 2012; H. Schwartz 1994; Fuller 2015.

31 move the whole economic engine.”94 In more technical terms, increasing government support for homeowners is an external impulse that fuels the transmission belt95 by influencing the user cost of housing capital (i.e., the rate of capital return after taxes), future house price expectations, and consumer spending.96 The relationship between housing finance subsidies and consumption is straightforward: first, housing subsidies lower the user cost of housing capital, because tax and other mortgage subsidies help lower the cost of debt.97 Hence, the demand for housing should increase along with house prices and consumption. Second, if subsidies are expected to decrease in the future, then this also lowers the expectation of future house price appreciation, which increases the user cost of capital today.98 This is because future house price expectations are part of the current user costs, which would then lead to a decline in housing demand, construction, and consumption. Third, housing subsidies that tend to increase housing demand and house prices increase the wealth of ordinary people, which then stimulates household consumption. Finally, home finance subsidies that tend to increase housing values also have the effect of easing credit constraints, because consumers have more valuable collateral against which to borrow.99 Relatedly, increasing house prices and collateral allows homeowners to take out equity from their homes to pay for services such as health care, consumer goods, or to start small businesses, which further stimulates

94 Eccles 1951. 95 Meltzer 1995. 96 Mishkin 2007; Meltzer 1995. 97 Poterba 1984; Hendershott and Slemrod 1982; Poterba and Sinai 2008; Hendershott and Shilling 1989. 98 Shiller 2000. 99 Bernanke and Gertler 1995.

32 consumption.100 In sum, housing finance subsidies tend to stimulate housing demand, house prices, credit, and consumption in the U.S. economy.101

Politically, the deep interlinkages between the consumption-led U.S. economy and housing finance policy -- through the housing transmission channel -- empowers a hegemonic policy coalition of political leaders and interest groups to preserve and extend housing finance policies.102 For political leaders of both major parties, housing finance policies are a growth strategy of grave concern in every electoral district. Given the localized, district-based U.S. electoral system, Congressional leaders of both parties have incentives to stimulate housing demand in their districts, in order to create jobs and profits in real estate, construction, and finance.103 These policies also protect the key financial asset of their core constituents, for which policymakers receive electoral rewards or, at a minimum, avoid blame for hurting the housing wealth of their constituents. Similarly,

White House administrations have incentives to retain or increase housing finance subsidies, in order to stimulate the wider, national economy. Inversely, policymakers have few incentives to retrench housing finance subsidies, which could hurt aggregate consumption and the wealth of their constituents. As Mian and Sufi convincingly demonstrate, falling house prices can have cascade effects that lead to declining consumption levels in the larger economy, forcing ordinary people with significant amounts of debt to cut back on spending.104 This entrenchment also empowers housing interest groups -- realtors, homebuilders, and mortgage bankers – to amplify the electoral

100 Greenspan and Kennedy 2005. 101 Mian and Sufi 2014. 102 Blyth and Matthijs 2017. 103 Rajan 2010 104 Mian and Sufi 2014; Bernanke 1983.

33 concerns of policymakers with their expansive reach and well-organized grassroots structures in most electoral districts.105 What makes the members of this coalition strong is that the deep linkage between the consumption-led growth model and housing finance policies places them in a power position to preserve and extend government support for home finance. For these reasons, coalitions of housing activists, the multi-family rental sector, and housing technocrats promoting a shift away from home finance subsidies toward affordable rental or public housing face limited opportunity structures and access to the policymaking process.

The interwoven relationship between the growth model and housing finance policy is an important source of positive policy feedback that helped cement and extend government support for homeownership over time.106 On one hand, it helped grow a strong core constituency of homeowners (see figure 1.4), interest groups, and federal bureaucracies willing to defend home finance subsides by also sidelining competing policy coalitions in support of affordable rental housing. On the other, it contributed to placing housing at the center stage of the American growth model of consumption and credit.107

These policies helped build a political economy around owner-occupied housing that, in the words of Jane Jacobs, is “diverted so heavily into one kind of [suburban housing] growth.”108 While housing finance policies reinforce one another in stimulating consumption in the larger economy over time, this process is not without risks. Given the strong linkages of the U.S. growth model and homeownership policies, positive and negative transmission effects might reverberate through the economy, including those

105 Hornstein 2005; Freund 2007. 106 Pierson 1993; Mettler 2002; Campbell 2012. 107 Schularick and Taylor 2012; Jorda, Schularick, and Taylor 2015. 108 Jacobs 1961, 308.

34 caused by economic shocks in the housing sector.109 In sum, the feedback effects of entrenchment have made these policies increasingly difficult to reverse or replace, as they became more tightly coupled with the growth model.

Figure 1.4: Homeownership rates in the United States and Germany, 1930-2015.110

Homeownership rates Homeownership 35

25 United States Germany 20 1930 1940 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

The first historical phase lasted from the Great Depression until the post-WWII period, an era of welfare state expansion, when major housing finance policies first developed in the United States. The Great Depression was a full-blown housing crisis that, when ordinary people started defaulting on their mortgages, led to a massive decline in aggregate demand and consumption.111 At that time, a strong policy coalition of political leaders from both major parties and housing interest groups formed, recognizing the potential of the housing market for stimulating economic growth in the larger economy.

109 Blyth and Matthijs 2017, 214. 110 Sources: U.S. Census Bureau; Federal Statistics Office Germany. 111 Bernanke 1983; Mishkin 1978.

35 Supported by this coalition of social forces, the Hoover and Roosevelt (FDR) administrations adopted housing finance policies -- mortgage guarantees in the primary and secondary mortgage markets through the FHA and Fannie Mae, for instance -- to revive mortgage lending and stimulate consumption through the housing market.112 In the 1940s, the FDR administration expanded housing benefits to veterans in order to anticipate an economic downturn once war-time production declined. These housing finance policies quickly generated complementarities with the larger growth model. Economically, these policies helped establish a political economy built around owner-occupation in (mostly white) suburban areas -- while sidelining rental housing in urban areas -- and stimulated consumption in the U.S. economy. Politically, these programs helped expand the core stakeholders of these policies by raising the homeownership rate from 40 to 60 percent between the 1940s and the 1960s and by adding the government agencies Fannie Mae and the FHA to the dominant housing coalition.

The second historical phase is characterized by welfare retrenchment and the growing financialization of the U.S. mortgage market until the late 1980s.113 While other areas of the welfare state, including public housing, started suffering from retrenchment, policies to support homeownership remained sacrosanct, enjoying the support of the dominant housing finance coalition. First, in the late 1960s and early 1970s, the Johnson and Nixon administrations expanded the role of the American state in the housing finance market by creating Fannie Mae’s two government-sponsored cousins -- i.e., Ginnie Mae

(publicly-owned) and Freddie Mac (privately-owned) -- and by allowing all three agencies

112 The FDR administration also established the Home Owners Loan Corporation (HOLC) in 1933, which temporarily (until 1936) purchased mortgages that were at risk of default and refinance these mortgages into long-term, amortizing mortgages with a fixed interest rate. 113 Aalbers 2008.

36 to buy and sell mortgage-backed securities in the secondary mortgage market.114 This provided additional sources of mortgage funding in times of rising interest rates and illiquid mortgage markets.115 At the same time, the Johnson administration “privatized” Fannie

Mae while retaining its status and benefits as a government-sponsored enterprise -- a political move that took the agency off the government’s balance sheet and generated funding to help finance the Vietnam War.116 The soon dominant role of Fannie, Freddie, and Ginnie as sources of mortgage finance at the center of the American home mortgage market also benefited homeowners in every electoral district, which made them very important to every member of Congress.117 Second, housing tax breaks became the third rail of U.S. politics in this period. Taxpayers had been able to deduct interest on consumer loans, including on mortgage interest, since the adoption of the U.S. federal income tax in

1913, but these tax breaks were initially marginal given that most people did not pay income tax before WWII.118 The housing tax breaks had increased in size and importance since the 1950s, when the tax base was broadened and homeownership increased. The mortgage interest deduction then blended in seamlessly with existing housing finance policies that stimulated the American growth model of consumption. Despite the efforts of economists, bureaucrats, and rental housing advocates to dismantle the tax breaks, the subsidies survived major tax reforms, including the Tax Reform Act of 1986, when policymakers of all stripes promoted the MID as a core policy tool to stimulate housing

114 Koppel 2003; Quinn 2009; Green and Wachter 2005, 2007. 115 In the 1960 and 1970s, funds did flow out of savings and loans banks (S+Ls) into other areas, such as Treasury bonds, whose yields increased at that time. These larger economic developments contributed to the S+L crisis in the late 1980s. See Pizzer, Fricko, and Muolo 1989. 116 Quinn 2009. 117 The housing finance revolution – a shift from local, deposit-based mortgage financing towards national mortgage securitization in capital markets -- tied in with this the larger development. 118 Ventry 2009.

37 credit, house prices, and consumption. This sent a strong message for future tax reformers.

Housing tax breaks -- even if inequitable or inefficient -- are sacred cows in the tax code, as their entrenchment with the growth model feeds into the housing transmission belt and benefits larger numbers of homeowners (i.e., the homeownership rate increased to 66 percent by 1980).

The final historical phase is the expansion of subprime lending and the global financial crash of 2008-09, a seamless continuation of financial liberalization while simultaneously increasing the footprint of the American state in the housing market. From the 1980s until the 2000s, administrations of all stripes, supported by the dominant housing finance coalition, have reworked the rules to extend mortgage credit lending to previously underserved parts of the population. The goal was to stimulate housing, credit, and consumption by tapping lower-income and minority households and communities, but these policies also helped fuel a house price bubble in the early 2000s. By then, housing finance policies -- constitutive of the American mortgage market -- were the heart of the

U.S. growth model, which was increasingly based on credit-led consumption. When the housing bubble burst during the 2008-09 financial crisis -- an economic shock large enough to potentially upset the country’s housing policy equilibrium -- the Bush administration deemed the battered mortgage giants Fannie Mae and Freddie Mac too important to fail and seized control of them, a decision supported by the dominant housing finance coalition.

Around the same time, the Fed started accumulating what would amount to almost two trillion dollars in mortgage debt securitized by Fannie and Freddie -- an authority policymakers extended to the Fed in the late 1960s -- with the goal of reviving the housing market and stimulating economic growth. The Fed’s intervention added yet another major

38 layer of public support for home mortgages. Today, Fannie and Freddie remain in government control and, with it, the lion’s share of the American mortgage market.

In Germany, the export-oriented growth model does not entrench homeownership policies to the same degree. Unlike its American counterpart, the German growth model relies on price stability, wage restraint, and cost competitiveness, while private consumption is less central to the German economy, constituting only 54 percent of

GDP.119 Policies that tend to stimulate private housing and consumption do little to reinforce the German export-led and production-oriented growth model, as they (i) channel investments away from productive areas of the economy,120 (ii) lack transmission effects in the wider economy,121 and (iii) produce housing momentum in an economy that benefits from stability in the housing market.122 The interlinkages between the growth model and housing finance policies are therefore weak. First, Germany’s export-led economy has collective bargaining institutions that produce wage restraint in the wider economy.

Johnston and Regan convincingly argue that, because export-led models tend to “depress national incomes (the most important determinant a bank considers when issuing prime mortgages) by prioritizing wage moderation, they should also witness repressed mortgage demand.”123 In other words, the German coordinated bargaining structure dampens the transmission between housing and the wider economy. Second, subsidies that lower the cost of mortgage debt only marginally stimulate house prices in the country’s conservative, illiquid mortgage market.124 This is because the German mortgage market is characterized

119 Kreile 1977; Mertens 2015; Logemann 2008, 2011, 2012. 120 Wallich 1955. 121 Voigtländer 2014; Muellbauer 1992; Geiger, Rupprecht, and Muellbauer 2016. 122 Johnston and Regan 2017 123 Johnston and Regan 2017, 335. 124 Voigtländer 2014.

39 by tighter lending and refinancing standards as well as higher down payments and transaction costs, fewer market participants as a result of low homeownership, and lower levels of mortgage debt when compared with the United States.125 For similar reasons, and together with skepticism among ordinary people, it is uncommon for German homeowners to withdraw home equity to finance consumption.126 Rising house prices, in any event, are not in the interest of export-oriented manufacturers, who are concerned with maintaining cost competitiveness and stable prices, including in the housing market.127 Third, Geiger,

Rupprecht, and Muellbauer have shown that higher house prices in the country only marginally stimulate -- or even reduce -- aggregate consumption, as house price appreciations require higher down payments and savings in Germany’s conservative mortgage market.128 They further show that rental prices increase along with higher house prices and, as a result, large numbers of renters reduce spending, in order to save for higher down payments or in anticipation of future rent increases. Finally, house prices in Germany have not corresponded with the business cycle to the same degree as in the United States.129

House prices largely stagnated in recent decades and even functioned as a source of stability during the 2008-09 financial crisis (see figure 1.5).130 Given the loose institutional coupling between the macroeconomic growth model and housing finance policy, “shocks are relatively hard to transmit.”131 In sum, there are much fewer macroeconomic linkages between the German export-oriented growth model and homeownership finance policy.

125 For instance, the mortgage debt to GDP ratio has been between 40-50 percent, whereas it has been between 60-80 percent from 2003-2013 in the U.S. 126 Voigtländer 2014. 127 Baccaro and Pontusson 2016, 189. 128 Geiger, Rupprecht, and Muellbauer 2016 129 Leamer 2007. 130 Kofner 2014. 131 Blyth and Matthijs 2017, 219.

40 Figure 1.5: House price developments in the United States and Germany, 1990-2012.132

160

140

120

100

80 Germany United States House price index (1990=100) indexprice House 60

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Politically, the weak interlinkages between the export-led growth model and housing finance policies creates opportunity structures for counterbalancing policy coalitions of policymakers and interest groups – a center-right policy coalition promoting government support for home finance and a center-left coalition privileging policy retrenchment. Unlike their American counterparts, German parties did not develop a broad- based consensus of considering housing finance policies as growth strategies.

As macroeconomic concerns are much less salient when it comes to housing in Germany, this allows for profound partisan and societal differences around the issue. The center-right policy coalition favors the stability or expansion of housing finance policies because center-right parties view homeownership as part of their conservative family values of domestic life in single-family homes and as a way to promote economic freedom and

132 Sources: Knoll et al. 2017; own calculations.

41 wealth through ownership, especially for their middle to upper income constituents.133

Their natural allies are building societies (i.e., Bausparkassen), whose business model is the promotion of mortgage lending.134 The center-left policy coalition favors the retrenchment of housing finance policies because center-left parties prioritize affordable rental housing for large parts of the population over homeownership, given their lower to middle income constituents.135 Non-profit rental associations are longstanding allies of left parties promoting affordable rental housing, with a preference for shifting housing subsidies to the rental sector.136 Federal state governments -- key political actors in

Germany’s federalist system137 -- often focus on regional priorities and the sensitivities of their local housing markets, without strong ideological ties to either camp.138 This wider political opportunity space allows parties, federal states, and interest groups to form coalitions around housing finance policy, where policy outcomes are contingent upon the power resources and preferences of these coalitions.

The mismatch of the export-oriented growth model and housing finance policy has generated negative policy feedback in Germany. First, housing finance policies have not succeeded in significantly expanding the country’s share of homeowners ready to defend home finance subsides (see figure 1.4). Concomitantly, they have not helped establish a hegemonic homeownership finance coalition of policymakers and interest groups that could sideline the center-left policy coalition focusing on affordable rental housing.

Second, these policies also have not been able to shift the German political economy of

133 Fulda and Kohl (unpublished ms.). 134 Egner et al. 2004. 135 Diefendorf 1993. 136 Kohl 2015. 137 Campbell and Morgan 2005. 138 Katzenstein 1987; Scharpf et al. 1976; Campbell and Morgan 2005.

42 housing towards owner-occupation, nor did they transform the German housing market into a transmission belt for the wider economy. The result is that housing finance policies and the export-led growth model have remained loosely coupled over time, with fewer positive or negative transmission effects that might reverberate through the economy.139

Under such conditions, the coalitional conflicts of the political left and right resulted in a wobbly policy equilibrium, which is contingent upon the political bloc in power. The absence of deep macroeconomic linkages between social housing policies and the German growth model then made these policies vulnerable to retrenchment.

The first critical historical phase was the postwar period in Germany, an era characterized by welfare state expansion until the 1970s. As a result of WWII, large parts of the country’s housing market were destroyed. Searching for ways to overcome the housing crisis and rebuild the country, two opposing coalitions adopted competing visions for how to rebuild the country’s housing market. While the center-right housing coalition favored the creation of a nation of homeowners, a rival, center-left policy coalition prioritized the public provision of affordable rental housing. The policy result was a grand compromise, adopted by the center-right Adenauer administration in the 1950s, including generous housing subsidies for both homeowners and renters as part of large-scale tax breaks and social housing programs, in order to overcome the massive housing supply shortages.140 Yet, housing finance policies to support homeownership did not reinforce the country’s growth model of export-oriented manufacturing.141 And they did little to

139 Blyth and Matthijs 2017. 140 Diefendorf 1993; Beyme 1999. 141 Germany’s growth model in the Fordist era (1945-1970) already privileged export-oriented manufacturing, savings, and price stability – and not mass consumption and credit. See Wallich 1955; Eichengreen 2007; Logemann 2012; Prasad 2012; Mertens 2015; Kreile 1977.

43 transform the political economy of housing into one predominantly based on owner- occupation, as homeownership remained out of reach for many ordinary people in a conservative mortgage market, while the continued support for the rental market made renting an affordable alternative.142 It is notable that the rate of homeownership did increase from 28 percent in 1950 to 34 percent in 1965,143 but this increase was not enough to eclipse competing policy coalitions that have emphasized affordable rental housing.

While the country’s housing and capital markets had recovered by the late 1950s and

1960s, the postwar years helped cement a mixed policy equilibrium supporting investments in rental and owner-occupied housing, reflecting the two larger social blocs on the political left and right.

The second historical phase was a period of economic liberalization and welfare retrenchment until the late 1980s. After the country’s economic and housing miracles of the late 1950s and early 1960s, policymakers started celebrating a balanced housing market

-- a perceived equilibrium between housing demand and supply -- as most people lived in affordable rental or owner-occupied housing by the 1970s. Yet, as the days of major housing supply shortages came to an end, housing finance policies lost their macroeconomic significance and further decoupled the growth model. The center-right housing policy coalition viewed this as an opportunity to both scale down social housing subsidies for the rental market -- subsidies which had consequently become miniscule by the late 1980s -- and retain the moderate social housing programs for homeowners. More importantly, the tax breaks for homeowners, adopted in 1949, soon became the most

142 The country’s political economy of housing had specialized in building and financing multi-family homes since the mid-19th century. See Kohl 2015; Wandschneider 2015. 143 Source: Federal Statistics Office Germany.

44 important housing policy tool and largest tax subsidy in the country, largely sustained and expanded by the center-right political bloc. Yet, the mismatch between the German growth model and housing finance policies, although sustained by strong center-right political forces, started to show cracks and marked the beginning of political battles about the future of homeownership policies, when center-left political forces increasingly singled out homeownership subsidies for their inequitable consequences, costliness, and undesirable regional effects, such as urban sprawl.

The final period is characterized by the country’s reunification and welfare state reforms from the 1990s until the late 2000s. Reunification was an external shock to the

German economy and its housing market. To modernize the East German housing market and stimulate the Eastern economy, the center-right government under Chancellor Kohl revived the social housing programs and expanded tax breaks for both homeowners and renters. In the late 1990s and early 2000s, however, subsidies for homeowners came under intense fire from reinvigorated center-left forces, who had just managed to form the first center-left coalition government in the history of the country in 1998. The center-left bloc opposed these policies as they would reinforce the housing market imbalances and wealth differences of East and West Germany. It also considered these policies to be part of larger structural problems of the reeling export-oriented economy in the 2000s,144 straining the country’s budget, steering funds away from more productive sectors, and distorting investments in the economy, all of which was seen as partly holding back the German economy. Concomitantly, the limited success of these policies in raising the country’s

144 While the German economy doubled the share of exports as a percentage of GDP from 23 percent in 1985 to 47 percent in 2015, it was considered the sick man of the euro in the early 2000s. Also see Baccaro and Pontusson 2016.

45 homeownership rate made them politically vulnerable. Where the political right was able to compel the left into supporting homeownership policies until the 1990s, center-left parties pressured their center-right counterparts into eliminating home finance policies in the early 2000s. The retrenchment of these policies -- made possible by the rift between the national growth model and home finance policies – was then part of larger structural reforms to boost competitiveness, labor market mobility, and economic growth.

Theoretical contributions

This dissertation makes a number of theoretical contributions to the fields of comparative politics and political economy. First, it concurs with an important body of work on the public-private welfare state in American and comparative politics.145 Authors in this camp have convincingly argued that modern welfare states do not merely consist of traditional social expenditure programs, but also tax expenditure and government guarantees that assist private markets in providing human welfare. This line of scholarship has focused especially on health care, pensions, and education, but it has neglected housing as an important area of welfare state research.146 This dissertation introduces housing as an essential part of the public-private welfare state, as it is a quintessential example of how public policies mesh with private markets. Tax breaks for homeowners and the various mortgage programs, such as government guarantees for home loans, squarely fit into debates on the public-private welfare state.147 This project demonstrates that social policies in the housing area not only support private housing markets in advanced economies, but

145 Morgan and Campbell 2011; Hacker 2002; Thurston 2015; Gingrich 2011. 146 With the notable exception of Thurston (2015). 147 Also see Howard 1997.

46 they can also be entrenched with larger economic structures. Finally, the literature on the public-private welfare state is advanced in the United States, but this phenomenon is rarely studied in other parts of the world, such as Western Europe. This study analyzes aspects of the public-private welfare state in one of Europe’s core economies, Germany, which can inform future comparative research in other European countries.

This study concurs with a growing body of scholarship on economic growth models of consumption-led and export-oriented growth models in comparative political economy.148 These approaches advance upon the prominent varieties of capitalism framework, which focuses on the supply-side, institutional complementarities of market economies -- such as skills and training systems, corporate governance structures, and industrial relations systems – that would add up to the ideal-type American liberal and

German coordinated market economies. Yet, these approaches are relatively static, as they cannot easily account for changes in these institutional equilibria over time.149 Instead, the growth model perspective focuses on the demand-side factors of economies, such as exports and consumption, the composition of which can change within and between economies. It is also more dynamic in accounting for balanced growth models, where the relative importance of exports and consumption is balanced. While the growth model framework is powerful in explaining what makes economies tick, it is silent on the world of politics. This project connects the growth model framework with the politics of the welfare state, showing that growth models help us understand the preferences and capabilities of political and economic elites when adopting social policy. It is therefore

148 Baccaro and Pontusson 2016; Johnston and Regan 2017. 149 Hall and Soskice 2001.

47 important to consider the ways in which the welfare state is embedded in larger economic growth models.

Economic growth models are an underexplored source of policy feedback in historical institutionalism. This project concurs with the common starting point in the policy feedback literature – that existing social policies shape the capacities and interests of political actors for future policy action, often resulting in policy stability or expansion.150

But this view might be incomplete if we neglect the larger economic structures in which the welfare state and political actors are embedded.151 It matters whether interest groups are entrenched as part of the larger growth model, as much of their strength is dependent on their power position and linkages within the growth model. Similarly, growth models shape the social policy preferences of political parties, defining their understanding and beliefs about social policy, growth strategies and electoral concerns. Policy feedback effects may therefore emerge under conditions of entrenchment, but fail under conditions of non-entrenchment. Finally, this study develops portable implications about entrenchment that can be applied to other policy areas outside housing, as economic growth models also shape the politics of social policy in many other areas. Health care, for example, is a major economic sector in the United States that is inextricably linked with social policies. It is not inconceivable to discover that the U.S. growth model entrenches market-stimulating health care policies that fuel consumption.152

The ways in which national growth models entrench social policies has implications beyond national borders for the global economy. Scholars and commentators have long

150 Skocpol 1992; Pierson 1993; Campbell 2012; Mettler 2002; Thurston 2015; Fioretos, Falleti and Sheingate 2016. 151 Blyth and Matthijs 2017. 152 Hacker 2002.

48 criticized global economic imbalances when it comes to world capital flows.153 The U.S. housing market is an example par excellence of these imbalances, because it is both a domestic engine for economic growth and an attractive asset for global investors, which has led to significant capital inflows from abroad. In other words, given the low savings rate in the United States, the country imports savings from emerging and advanced economies to fund consumption and economic growth through housing and other markets.154 These investments from abroad stimulate the U.S. housing market by boosting housing prices and wealth and lowering the cost of mortgage debt, which, in turn, encourages U.S. households to spend more and save less. Herman Schwartz (2009) convincingly argues that this makes the United States and world economy vulnerable to reduced investor confidence and domestic crises in the U.S. housing market. This project adds an important dimension to this insight -- that the entrenched linkages of the American growth model and housing finance policy complicate comprehensive and sound housing finance reform that could reduce global financial risk. It therefore contributes to important debates in international political economy on the domestic sources of global economic imbalances and how national growth models are embedded in the global economy.

Empirical approach

Analyzing the key dimensions of variation in this study requires careful case selection. The theoretical framework of this dissertation conceptualizes variables, mechanisms, and phenomena in “general” terms that are not unique to the cases at hand.155 The dependent

153 Obstfeld 2012; also see Ben Bernanke, “The Global Savings Glut and the U.S. Current Account Deficit,” Remarks at the Sandridge Lecture, Virginia Association of Economists, Richmond, VA, March 10, 2005. 154 Roach 2014. 155 Slater and Ziblatt 2013.

49 variable -- state-based or market-based homeownership models -- mirrors the variation of a broader population of advanced industrial countries and is not confined to the United

States and Germany.156 Similarly, the study’s independent variables -- consumption-led or export-oriented growth models -- are general variables that can be assessed in any number of cases. What explanatory leverage do we gain from comparing housing finance policy in the United States with Germany?

The United States and Germany are no strangers to the comparative political economy literature. They are economic powerhouses in the global economy and key members of the Group of Seven (G7) largest economies. More importantly, scholars have long been intrigued by their distinctly successful postwar economic models that have produced growth and prosperity. The pair of countries was most prominently featured in the varieties of capitalism (VoC) framework, in which the two economies represent efficient, ideal-type -- liberal or coordinated -- market economies in the global economy.157

The insights generated from this comparison have inspired an entire research agenda, comparing these and other cases on various dimensions, such as their labor market institutions, corporate governance structures, and collective bargaining institutions.158

Importantly, the counterintuitive variation in homeownership and housing finance models in this study -- a state-based model in the United States and a market-based approach in

Germany -- is at odds with the VoC framework.159 Explaining this variation therefore generates new insights into what makes these and other economies tick. This dissertation

156 Ibid. 157 Hall and Soskice 2001. 158 Thelen 2004; Streeck and Thelen 2005; Gourevitch and Shinn 2005; Hancké, Rhodes, and Thatcher 2007; Hall and Thelen 2009; Nölke and Vliegenthart 2009. 159 Similarly, Colleen Dunlavy (1994) has convincingly contrasted the two countries in their government involvement in building railroad infrastructures in the 19th century, where the Prussian state favored private solutions, whereas the American state privileged public solutions.

50 builds on this longstanding tradition in political economy that has directly contrasted the

United States and Germany.

There are not only economic but also political reasons for a controlled comparison of the two cases. Both the United States and Germany have federalist political structures that produce a number of strong veto players in their respective political systems. This similarity in political structures is particularly important for policy-focused analyses that emphasize the politics of public policy.160 Given the high degree of veto players in each political system, we may not easily attribute the opposing policy trajectories of both countries to institutional structures. The study’s historical focus generates observations over time that allow us to examine the conditions under which policy change or stability occurs in political contexts with strong veto players.

It is no less important to address the caveats about the comparison between the two countries. Some might take issue with treating the two cases as independent from one another, given that the United States might have influenced policy outcomes in postwar

Germany.161 Yet, in the case of housing, Germany has not followed the American model of mass consumerism and credit and instead embarked on a fundamentally different housing trajectory without converging to the U.S. model. 162 Others might raise concerns about differences in size and population density between the two countries. Yet, geographical and demographic factors do not pre-ordain housing policies, as each society has to make their own political choices about where and how to house its people. Kenneth

160 Hacker and Pierson 2014. Morgan and Campbell (2005), for instance, argue that the varieties of federalist structures in the United States and Germany can have distinct effects on their welfare states, such as in the pension area. 161 De Grazia 2005; Maier 1977. 162 Logemann (2012), in particular, shows that postwar Germany did not follow the path of creating a mass consumer society along American lines, as it did not expand mortgage and consumer credit to levels seen in the United States.

51 Jackson rightly notes that “the pattern of metropolitan growth was not inevitable in any country, and that geography was not, by itself, destiny.”163 The goal of this study is to examine the political forces behind critical housing policy decisions.

Why does the analysis start in the early twentieth century and does not extend further back in history? The study’s starting point in each case is the adoption of national, large-scale housing finance policies – the Great Depression in the United States and the end of WWII in Germany. Prior to these critical junctures, neither country had meaningful national housing finance legislation. It is certainly true, as Sebastian Kohl demonstrates, that the historical legacies of housing finance markets date back to the 18th and 19th centuries in both countries,164 but the most significant modern housing finance legislations emerged in the early 20th century and were shaped by the political debates and contexts around that time. Subsequently, the study examines the mechanisms of path dependence and institutional changes -- that is, the “big, slow-moving”165 processes of the politics of housing finance policy in three critical time periods. The first episode highlights the origins and expansion of housing finance policies in the context of the golden age of capitalism – with high levels of employment and economic growth -- and welfare state expansion from the 1940s until the late 1960s. The second phase discusses how housing finance policies fared in the age of economic volatility -- including in unemployment, inflation and interest rates, and growth -- and welfare state retrenchment from the 1970s until the 1990s. The third period, from the 1990s until the 2010s, discusses the stability and changes of housing finance policy in the context of globalization, financial liberalization, and economic

163 Jackson 2006, 13. 164 Kohl 2017. 165 Pierson 2003.

52 shocks, such as German reunification and the financial crisis of 2008-09. It is fruitful to explore housing finance policies in these three economic eras, as each period has distinct economic, social, and political characteristics that have affected most Western nations and led policymakers to adapt to shifting economic and political environments.166 And yet, the

United States and Germany have embarked on different policy trajectories despite some shared challenges posed by each era. Moreover, this approach allows us to take into account how policy decisions are influenced by previous policy periods.

To uncover the politics of housing finance policy, this dissertation analyzes within- case historical observations as part of its comparative, historical analysis of five carefully selected empirical case studies.167 Such an approach is key to explaining critical housing finance policy episodes, including their policy feedback effects over time,168 as it allows us to trace the preferences and capacities of political parties and interest groups in the policy-making process and to assess the causal claims and arguments presented in the dissertation.169 Specifically, the dissertation reconstructs the long-term trajectories of key housing finance policies and explains the politics of housing finance in the United States and Germany. Two chapters discuss the political evolution of tax breaks for homeowners in Germany (1949-2016) and the United States (1913-2016). Two additional chapters focus on the development of American (1930-2016) and German mortgage debt subsidies (1950-

2016). A final empirical chapter extends the empirical analysis by analyzing central bank support for housing finance by the Federal Reserve (1930-2016) as well as the German

166 Scholars in political economy have frequently used roughly similar periodization of economic eras. See Morgan (2006); Baccaro and Pontusson (2016); Blyth and Matthijs (2017). 167 Mahoney and Thelen 2015; Mahoney and Rueschemeyer 2003; Steinmo and Thelen 1992. 168 Fioretos, Falleti and Sheingate 2016; Morgan 2006. 169 Bennett and Checkel 2014; Collier 2011.

53 Bundesbank and the European Central Bank (1949-2016). The historical analysis relies on primary archival documents – government reports, speech drafts, memoranda, and correspondence with interest groups and other stakeholders – from the Ronald Reagan

Presidential Archive, the Federal Archives of Germany, the Archive of Social Democracy at the Friedrich Ebert Foundation, the Bundesbank Archive, the Bundestag Archive, and the Records of the Federal Reserve System. It also draws from the Congressional Record,

Bundestag Protocols, and other government publications, such as the Bundesbaublatt, a monthly government publication exploring trends in the German housing market since the

1950s. Finally, the analysis incorporates roughly 30 interviews with government officials, interest group representatives, and housing experts in both countries.

Plan of study

This study proceeds as follows. Chapter two investigates the political evolution of housing tax policy in Germany since WWII. It pays particular attention to the so-called homeowner allowance tax break, which grew to become the largest tax break in the country’s history before its surprising elimination in the mid-2000s. Chapter three explores housing tax policy in the United States since the adoption of the 1913 federal income tax. The chapter will especially highlight the political development of the mortgage interest deduction, the most important and expensive housing tax break in the United States, which has become a sacred cow in the U.S. tax code. Chapter four delves into mortgage debt policy in Germany.

The chapter focuses on how the country supported homeownership through the country’s social housing programs, which had been landmark social policies in the country’s postwar history, and why German policymakers eliminated this longstanding federal program.

54 Chapter five examines mortgage debt policy in the United States since the Great

Depression. Chapter six discusses how central banks have supported housing finance through unconventional monetary policy. The chapter is an extension of the theoretical framework and empirical material, explaining the differences in central bank stimulus for housing of the Federal Reserve, the Bundesbank, and the European Central Bank, drawing from historical and contemporary policy episodes, such as the recent financial crisis of

2008-09. The concluding chapter presents the theoretical and policy implications of this research.

55 Chapter 2: On the Chopping Block:

Homeownership Tax Policy in Germany, 1950s-2010s

Introduction

Scholarship on the American welfare state has prominently featured the “hidden” dimension of distributing social welfare through the tax code.170 Yet, much less is known about how European welfare states support social welfare through tax expenditures. Given the continent’s longstanding focus on the direct public provision of social welfare, scholars have turned a blind eye to the well-established practices of promoting social policy purposes through tax breaks in the housing and health care areas.171 Although the hidden welfare state in Germany is less extensive than in the United States,172 the country has offered significant tax expenditures with a social purpose -- particularly housing tax subsidies, which long were the country’s largest tax breaks.

Contrary to the widespread belief that the German state has not offered tax subsidies to homeowners, it has a long history of supporting homeownership through the tax code.

The origins of the country’s state-based homeownership tax model lie in the reconstruction of the country after WWII. The goal was to tackle the severe housing shortages after the war by attracting investments in the housing sector.173 To do so, the German state offered tax subsidies on the construction and financing costs of owner-occupied homes (i.e., the

170 Howard 1997; Titmuss 1958. 171 For a notable exception, see Morel et al. (2016). 172 The OECD (2010) reckons that Germany only spent 0.3% in tax expenditures as a share of GDP in 2006 (or 8.5% of total tax revenues), whereas the United States spent about 5% as a share of GDP in 2008 (or 34% of total tax revenues), including tax spending on health care, housing, education, pensions, business and industry, and the labor market. Tax expenditures with a social purpose constitute the largest share of tax expenditures in most advanced countries. 173 Diefendorf 1993.

56 homeownership tax allowance), property taxes, and savings contributions in building societies. These tax breaks complemented other policies to support homeownership in the mortgage area, such as the country’s landmark social housing programs, and rapidly became some of the largest items in the German tax code claimed by millions of households. The homeownership tax allowance, for instance, amounted to roughly

EUR11bn in 2004,174 benefitting 2.6 out of 38 million households between 1996 and 2000 alone.175 Yet, the country eliminated its homeowner tax breaks from the late 1980s until the mid-2000s -- and thereby switched to a market-based, investment-neutral homeownership tax model. This stands in stark contrast with the United States, where homeowner tax spending is considered the third rail of U.S. tax policy. Although it is true that German tax breaks for homeowners were less generous and widespread than their

American counterparts, they nonetheless enjoyed popularity among voters.176 Why did

German policymakers eliminate tax breaks for homeowners?

This chapter traces and explains the political evolution of the single most important tax break for homeowners in Germany -- the homeownership tax allowance -- from its origins in the early postwar years until its elimination in the mid-2000s. It shows that center-right governments (CDU-FDP, 1949-1966) adopted and expanded the tax allowance in order to rebuild the country with a special emphasis on homeownership in the early

174 The second largest tax subsidy -- tax exemptions for work at night-time, Sundays and holidays -- amounted to merely EUR2bn in the same year. 175 This number likely understates the number of recipients, as it only accounts for new recipients in that time period. 176 Opinion polls reckoned that 70-90 percent of the population expressed support for it. Please note that these polls were conducted by Emnid and TNS Infratest, but they were commissioned by the building societies. See, for example, Bundesgeschäftsstelle Landesbausparkassen (LBS), press release, “71-Prozent- Mehrheit für Beibehaltung der Eigenheimzulage Emnid-Umfrage: Sonst droht weiterer Einbruch bei Eigenheimbau,” (December 2, 2003).

57 postwar years. By the 1970s, the allowance was the largest tax break in the country and a major priority of center-right parties, building societies, and conservative social groups.

The subsidy would not go uncontested, as center-left parties, non-profit housing associations, and local communities had viewed the allowance as regressive and regionally damaging. Yet, even the social-liberal governments (SPD-FDP, 1969-1982) did little to retrench the tax break in the 1970s and 1980s, as the Social Democrats faced resistance from their own coalition partner, the Free Democrats (FDP), who were strong believers in the subsidy, and from the Christian Democrats in the opposition. Without difficulty, the subsidy survived the age of welfare retrenchment from the 1980s until the mid-1990s, given its special status within center-right governments (CDU-FDP, 1982-1998). When the center-left Schröder government (SPD-Greens, 1998-2005) assumed power in post- unification Germany, it started attacking the tax allowance -- attempts that were initially blocked by the center-right opposition. Yet, the Merkel grand coalition (CDU-SPD, 2005-

2009) eventually retrenched the tax allowance in 2005, when the Social Democrats -- supported by other left parties, federal states, and housing interest groups -- convinced their senior coalition partner to eliminate the tax break.

The impressive rise and retrenchment of the homeownership tax allowance stems from the struggles of political forces on the left and right in the context of the country’s export-oriented growth model. From its very beginning, the tax break, which tends to stimulate housing consumption, produced very few synergies with Germany’s postwar export-led growth model. This opened the door for conflicts between competing coalitions on political left and right. Unlike their American counterparts, German parties did not develop an overarching consensus of viewing the tax subsidy as a growth strategy to

58 stimulate consumption and demand. Instead, parties fought over the subsidy in pursuit of regional priorities, family values, and redistributive aspects. Where the center-right policy coalition of political parties and interest groups developed a strong preference in favor of the subsidy, given its conservative family values and preference for an ownership society, the center-left political bloc viewed the subsidy with skepticism, expressing redistributive and regional concerns. When policymaking power shifted from the political right to the left in the late 1990s, the subsidy came under attack. The key to understanding why these attacks were ultimately successful lies in the growing rift between the homeownership tax allowance and the export-led growth model. When exports gained even more importance relative to consumption in the German economy since the 1980s,177 this increased the subsidy’s vulnerability to reform, especially in the post-unification context of rising deficits, regional inequalities, rigid labor markets, and slow growth.178 Similarly, the policy’s weak track record of increasing homeownership made it vulnerable to reform.

Together, these developments persuaded the Christian Democrats, the once staunchest defenders of subsidy, to retrench the homeownership tax allowance as part of larger structural economic and austerity reforms to boost competitiveness and labor market mobility, with the goal of reinvigorating Germany’s export-oriented growth model.

Theoretical foundations of tax policy in the housing area

Tax policies have important economic, social, and political consequences. They often channel investments into certain economic sectors and benefit some social groups over

177 Baccaro and Pontusson 2016. 178 Germany was considered the sick man of Europe in the late 1990s and early 2000s. See Reisenbichler and Morgan 2012.

59 others.179 Time and again, policymakers clash over how to tax ordinary people, businesses, and capital.180 But what exactly is a tax break in the housing area? And what are state- based or market-based homeownership tax models?

The answer to these questions depends on whether the tax code defines owner- occupied housing as investment or consumer goods, a distinction between “property utilized primarily for purposes of enjoyment and property utilized for the securing of a money income.”181 Both definitions have been applied with various innovations and deviations across countries and over time. In economic theory, when owner-occupied housing is defined as an investment good for tax purposes, then homeowners are treated as if they are their own landlords. That means they ought to be taxed on their imputed rental income, a counterintuitive tax on the rent that homeowners would pay to themselves (i.e., the rental income one generates by living in one’s own home).182 At the same time, homeowners can deduct some business expenses from their income that are related to their homes, such as mortgage interest.183 In contrast, if owner-occupied housing is defined as a consumption good, then homeowners are not taxed on imputed rental income, but they also cannot deduct business expenses from their income, such as mortgage interest. Economists tend to agree that the investment good solution is theoretically superior, but that the consumer good solution is more practical, because measuring imputed rental income entails significant administrative difficulties.184 Both forms of taxation constitute market- based, investment-neutral homeownership tax models.

179 Steinmo 1996. 180 Morgan and Prasad 2009; Martin 2008; Mehrotra 2013. 181 Seligman 1914, 10. 182 Bourassa and Grigsby 2000. 183 Poterba 1984, 1992; Poterba and Sinai 2008; Hendershott and Slemrod 1982. 184 Bourassa and Grigsby 2000.

60 Yet, countries frequently deviate from these economic models and instead adopt state-based homeownership tax models. Many housing tax laws have deep histories that lie in the origins of national income tax laws in the 19th and early 20th centuries.185 The

United States, for instance, has privileged owner-occupied housing by offering a long list of tax breaks since the early 20th century, which defies the fundamentals of market-based taxation. Specifically, U.S. tax collectors have not taxed imputed rental income, but allowed homeowners to claim tax deductions on mortgage interest and property taxes, as well as tax exemptions on the capital gains from the sale of homes.186 In contrast, Germany experimented with both the investment and consumer good models of taxation in its postwar history. From the 1950s until the 1980s, German tax authorities considered owner- occupied housing an investment good, a system in which homeowners were taxed on imputed rental income but also allowed to deduct a limited amount of mortgage interest payments from their imputed rental income.187 Unlike in the United States, where the mortgage interest deduction is the largest tax break for homeowners, their German counterparts benefitted only marginally from the mortgage interest deduction.188 In the mid-1980s, Germany switched to the consumer good model, when the controversial tax on imputed rental income was eliminated and homeowners could no longer deduct mortgage interest payments. At first glance, this seems to be in line with economic theory.

185 In the German case, some housing tax laws, such as the taxation of imputed rental income, date back to Prussia’s first income tax law of 1808, in order to finance war debt. See Nieskens 1989. 186 Aaron 1970. 187 Importantly, Fecht (1983) notes that taxing imputed rent encountered administrative difficulties, such as the evaluation of property prices (the basis for calculating imputed rent). Tax authorities therefore adopted a lenient system that tended to undervalue property prices, which resulted in lower tax revenues for imputed rental income, a de facto tax break. 188 Homeowners could reduce their taxable imputed rental income for as long as they paid off mortgages on their homes by deducting the mortgage interest payments from their imputed rental income (note that the mortgage interest payments could not exceed the imputed rental income).

61 Upon closer examination, however, Germany also provided significant tax breaks for homeowners, but in a different way. In the late 1940s, the country adopted generous tax relief on the construction and financing costs of owner-occupied housing -- i.e., homeowners could deduct a certain percentage of the construction or financing costs of their homes for a limited amount of time, but only once in their lifetime. This tax break became one of the largest subsidies in the German tax code, lastly known as the

“homeownership tax allowance” (or Eigenheimzulage), which was co-financed by the federal government (42.5 percent), the federal states (42.5 percent), and local communities

(15 percent).189 While the tax break was tweaked and renamed multiple times, its core objective of subsidizing homeownership had been retained until the mid-2000s, when

German policymakers removed the tax subsidy.190

The German homeownership tax allowance also differed from U.S. housing tax breaks with respect to the distribution of benefits. At times, the German state provided more benefits to homeowners with children than those without children; to those building new homes as opposed to purchasing older homes; and to those building environmentally friendly homes. These factors have not been key considerations in the United States.

Moreover, while the mortgage interest deduction tends to benefit high-income households in the United States (e.g., 86 percent of the deduction went to people with incomes in the top 10 percent),191 the German tax subsidy became more equitable over time, targeting largely middle-income households.192 Since the mid-1990s, households with very high

189 Scholten 1999; Kofner 2004; Kühne-Büning, Nordalm, and Steveling 2004. 190 Voigtländer 2009. 191 Harris et al. 2014, 9. 192 Bericht zur Inanspruchnahme der Eigenheimzulage in den Jahren 1996-2000, Bundesamt für Bauwesen und Raumordnung (2002). For instance, between 1996-2000, the average income of beneficiaries was below the national average.

62 income had been excluded from the subsidy and beneficiaries received the same amount of tax subsidy independent of their income.

In sum, tax subsidies for homeowners take different forms across countries -- following market-based or state-based models -- and their paths are not ordained. Time and again, policymakers have faced important political and economic choices that shape the nature of homeowner tax breaks in advanced economies. The next section delves into the political origins and evolution of the German homeownership tax allowance from the postwar years until the early years of the new millennium.

The rise of homeownership tax breaks: From housing crisis to economic miracle,

1940s-1970193

This section examines the co-evolution of the country’s export-oriented growth model and housing tax breaks from the 1940s until 1970, with a particular focus on the homeownership tax allowance. After the war, the tax breaks for homeowners, along with other tax breaks for the rental sector, were adopted and cemented by strong center-right governments in order to increase the housing supply and rebuild the country as a nation of homeowners. Yet, since the 1950s, the country’s growth model was based on exports, savings, and restraining consumption. Policies to stimulate demand and consumption were therefore not essential parts of the country’s growth model, most notably not after the severe housing shortages had subsided by the 1960s. The absence of deeper macroeconomic linkages between the tax breaks and the country’s export-led growth model made the tax subsidy vulnerable in later policy episodes.

193 Please note that the author translated the historical material from German into English.

63 In the early postwar years, Germany’s growth model was characterized by strong exports, price stability, and restraining consumption.194 Contrary to the postwar growth models of other advanced economies, the German model was decidedly less focused on domestic consumption.195 The postwar Keynesian and Fordist economic models, in general, were characterized by high degrees of private and public consumption, such as wage-led growth and expansionary fiscal policy.196 While private and public consumption were undoubtedly important for the German postwar economy, the German model already deviated from the traditional Fordist model in that it privileged export-oriented growth.197

In one of the most authoritative studies on the German growth model of the 1950s, Henry

Wallich, then economist at Yale and later at the Fed, argued that Germany “vigorously” followed a strategy of production-oriented growth -- exporting goods with “extraordinary aggressiveness” -- as opposed to consumption-oriented growth.198 Instead of boosting consumption, “[w]ages were held down, social security and war damage payments were kept to a minimum … monetary and fiscal policy remained tight.”199 As one commentator in the American Economic Review put it in 1960 when comparing the growth models of the United Kingdom and Germany:

194 Manow and Seils 2000. 195 Wallich 1955; Kreile 1977; Piore and Sabel 1984; Herrigel 1996; Logemann 2012; Prasad 2012, 76-77. 196 Baccaro and Potnusson 2016; Blyth and Matthijs 2017. 197 Kreile 1977. The Adenauer government’s economic program intended to restrain consumption, restrict credit, and incentivize more production, with the goal of keeping inflation low, improving competitiveness, and boosting exports. Meeting protocols of the Christian Democratic Bundestag group reveal that party members, such as Maria Probst (CSU), demanded the “restriction of consumption, a strengthening of savings.” See CSU parliamentary group, meeting protocol (June 11 1956), in: Editionsprogramm Fraktionen im Deutschen Bundestag. 198 Wallich 1955, 30-31. Wallich argues that consumption-oriented economies are characterized by government action and stimulus, wage growth, low savings, and weak incentive structures, while production- oriented economies are characterized by anti-inflationary policies, high savings rates, low wage growth, and strong incentive structures. 199 Ibid., 33.

64 The crux of the matter comes when we examine the proportion of resources used

for private consumption in the two countries. Between 1950 and 1958 inclusive,

private consumption in West Germany amounted to 59.4 per cent of the GNP at

market prices. In the United Kingdom, it amounted to 67.2 per cent … The point is

simply that German consumption levels are very low by European standards … It

is this very low average propensity to consume which is clearly of supreme

importance in explaining the ability of the German economy to invest such a high

proportion of its resources, and consequently to grow at such a fast rate ... Between

1950 and 1958 inclusive, the share of wages and salaries, after the receipt of public

transfer payments and the payment of taxes on incomes and insurance

contributions, in the GNP at current prices averaged 58 per cent in the United

Kingdom, and just over 47 per cent in West Germany.200

Already in the 1950s, depressed consumption and a low wage share in the economy were considered important elements of the German growth model.

What were the key institutions of the German model? First, German policymakers emphasized savings over credit-led consumption in the early postwar years.201 As the country’s capital market was broken after the war, savings would contribute to rebuilding the country’s capital market, which was essential for financing investments in manufacturing and housing. As Logemann notes,

the goal of expanding private consumption was sidelined whenever other economic

goals -- such as the need for capital buildup or an overarching emphasis on

200 Opie 1960, 1023-24. 201 Mertens 2015.

65 strengthening German exports -- appeared to be threatened. Worries of inflation, in

particular, muted the ‘courage to consume’ rhetoric by the late 1950s.202

The focus on savings correspondingly limited consumption in the country. Second, the country’s collective bargaining system203 and the conservative and independent

Bundesbank kept wages and inflation under control.204 The effective sectoral wage bargaining system, the foundations of which had been established well before WWII,205 secured both repressed wages and social stability in the postwar period.206 In the postwar years, unions were remarkably cooperative in restraining wages in the interest of boosting productivity and investment, so as to stimulate exports and growth.207 In its own efforts to maintain price stability (over full employment), the Bundesbank applauded constraining consumption as a means of holding down prices and boosting exports. 208 It also engaged in practices that undervalued the Deutsche Mark to boost exports in the Bretton-Woods monetary framework with fixed exchange rates.209 These two institutional factors repressed wages and restricted the money supply in the German economy, contributing to price stability, repressed consumption, and exports. Finally, the third factor limiting an emphasis on domestic consumption was the country’s strong export-oriented industrial manufacturing sector, which was the engine of export-led growth.210 In the 1950s,

202 Logemann 2012, 38. 203 Thelen 1991; Martin and Swank 2012. 204 Hall and Franzese 1998. 205 Thelen 1991; Martin and Swank 2012. 206 Kreile 1977, 776. 207 Thelen 1991; Maier 1977; Eichengreen 2007. 208 See Bank Deutscher Länder, “Geschäftsbericht,” 1948-1956. One report (1950, 5), for example, reads: “… that exports started stimulating was undoubtedly the result of the aforementioned restraint of domestic demand.” 209 Kreile 1977, 793. 210 Streeck 1991, 1995; Herrigel 1996.

66 Germany increased its industrial production by 125 percent.211 These industries were not built from the scratch after WWII -- they had deeper historical roots in the 19th century -- and quickly recovered their industrial capacities after the war.212 The production of manufactured goods – machine tools, chemicals, capital goods, etc. -- by large and smaller firms (Mittelstand) was at the heart of the postwar German model,213 which would later be known as “diversified quality production.”214 The result was that Germany has produced trade surpluses for most years after WWII and continuously increased its export share as a percentage of GDP. Already in the 1950s, then, the essence of the German growth model was to keep “inflation rates down and domestic demand checked, so that the drive for export markets was doubly stimulate.”215 This postwar strategy worked very well in the context of opening world trade, European economic integration, Keynesianism in other

European countries, and a favorable international monetary regime of fixed exchange rates,216 all of which ensured stable consumer demand from abroad.217 But how did housing tax policies factor into this growth model?

The country’s state-based homeownership tax model fit the German growth model only partially. In the years following WWII, the country endured severe housing shortages and a broken capital market. Roughly half of the housing stock was destroyed or severely

211 British and American production levels only increased by 30 and 40 percent, respectively, during the same time period. Germany’s world share of exports increased from 3.6 percent in 1950 to 10 percent in 1959, an increase from DM8.4bn in 1950 to DM41.2bn. Similarly, the German trade surplus increased from DM0.7bn in 1952 to 5.9bn in 1958. See Alt and Schneider 1962, 49-50; also see Kreile 1978. 212 Wallich 1955; Alt and Schneider 1962. 213 Gourevitch 1986, 171; Herrigel 1996. 214 Streeck 1991. 215 Kreile 1977, 777. 216 Scharpf 2015, 92-93. The Bretton Woods monetary system benefited the German export-oriented model by undervaluing the effective exchange rate through restrictive monetary policy, holding wages down, and recycling trade surpluses to the rest of the world. 217 Herrigel 1996, 146.

67 damaged, producing a shortage of 4.5 million homes.218 Capital and financial markets, essential for financing export and housing industries, were battered. Overcoming these economic problems required large-scale private and public investments in the housing market. In those years, public policies aimed at increasing and stabilizing the housing supply. Housing tax policies, both for homeownership and rental markets, were designed to encourage private capital formation and investments in the housing sector, so as to increase the housing supply. Other housing tax breaks encouraged ordinary people to save in building societies and savings banks, building capital markets for the housing finance markets. However, these policies were most notably not adopted to stimulate demand or consumption, but instead to boost the housing supply and to build a capital market, so as to reconstruct the country and keep house and rental prices down.219 Wallich already questioned whether investment incentives for housing, such as tax breaks, were as productive as those in other areas of the production-oriented economy, as they “can hardly, however, have contributed as much as some other forms of investment … It is a matter of social viewpoint, therefore, whether housing, however urgently needed, is regarded as worth the sacrifice of an equivalent amount of more directly productive investment.”220

This is the crux of the issue -- housing tax breaks do not reinforce the German growth model and channel funds away from more productive areas, a factor that became especially prevalent once the housing shortages in the country were overcome.

Overcoming the housing crisis was one of the most important political issues in the

1950s, and the political debates centered around whether to reconstruct the country as a

218 Diefendorf 1993; Beyme 1999; Schulz 1994; Wullkopf 1982. 219 Wallich 1955, 171. 220 Ibid., 174.

68 nation of renters or one of homeowners. What became the most important tax break in

Germany, the homeownership tax allowance, started as an otherwise dull paragraph in the

German income tax code. In 1949, the Economic Council (Wirtschaftsrat) -- the predecessor to the country’s first elected postwar government -- included the so-called paragraph 7b (later known as “homeownership tax allowance”) in the tax code, allowing builders of residential homes to use tax write-offs for the cost of constructing and financing these homes.221 The goal of the tax break was to provide tax relief for ordinary people, in order to stimulate housing without lowering overall tax rates.222 However, the original measure was not designed to promote homeownership. It instead provided support for individuals building any type of new residential housing, including multi-family and owner-occupied homes.223 Given the severe housing shortages, the Economic Council intended to quickly increase the number of housing units in the country without specifying the form of tenure.

The urgency of overcoming the housing crisis is reflected in the first postwar government’s policy priorities. In 1950, the center-right Adenauer government (CDU-

FDP, 1949-1963) made housing the number one priority on the political agenda. In

Adenauer’s words:

Residential construction will be the most essential task for us in the coming next

years, in order to lead the German people to a political, economic, ethical and

cultural recovery.224

221 Kreikamp 1981. 222 Ibid. 223 Bundesregierung, Bericht der Bundesregierung über Möglichkeiten zur Umstellung des § 7 b EStG auf ein anderes Förderungssystem (8 February 1979). 224 1st German Bundestag, 41st und 42nd Session, Bonn (24 February 1950).

69 At the time, housing was crucial not only in the narrow sense of providing adequate shelter and increasing supply, but also in a wider sense of reintegrating local communities, resettling uprooted families, and redefining the country’s national identity after its Nazi past. There was widespread agreement across the political spectrum about providing public support for the housing area in order to tackle shortages and rebuild the country’s communities. This led the Adenauer government to adopt generous housing subsidies for both homeownership and rental markets in the 1950s, including large-scale tax breaks and social housing programs, in order to stimulate the housing market and overcome housing shortages.225

Yet, the political left and right differed on how to carry forward the housing policy agenda in the long term. Center-right political forces, such as the Christian and Free

Democrats, envisioned a nation of homeowners down the road. As Diefendorf notes, “the conservative parties understood [affordable rental housing] as a transitional stage that would give way to individual, private home ownership, once the economy recovered.”226

Single-family houses would be the ideal home for uprooted families, which would help them attain freedom and self-determination through property, an anti-collectivist ownership ideology in the postwar context.227 As Josef Brönner, the CDU’s leading housing expert at the time, put it:

We would like to see an emphasis on homeownership in residential construction.

The man who owns his home is a frugal, satisfied, and happy man; whose family

225 Diefendorf 1993; Beyme 1999. 226 Diefenforf 1993, 111. 227 See CDU, party programs, 1949, 1953, 1957, 1972. In the case of the FDP, the party had also promoted the construction of affordable multi-family housing projects in 1949, but started emphasizing private “property for all” in 1953; see FDP, party programs, 1953, 1957, 1976.

70 lives a completely different life from those who are crammed into apartments in

multi-family buildings … The more homeownership, the more satisfied the

population.228

Similarly, he remarked that:

We all are convinced that a man who owns his own home is in a better position

politically, economically and in his family life, and is much happier and much more

satisfied, than someone who rents for ever.229

In contrast, the Social Democrats privileged affordable housing for large parts of the population based on the principle of the common public interest, which could be best achieved through supporting multi-family rental housing.230 While the Social Democrats had not outright opposed the idea of homeownership, their core preference was, in the words of Erich Klabunde (SPD), to lead the country into a “century of social housing.”231

These preferences between the political left and right clashed several times and created intriguing policy dynamics when it comes to the politics of housing tax policy.

In the early 1950s, center-right political forces felt that housing finance policies, including the housing tax paragraph 7b (later known as the “homeownership tax allowance”), did not do enough to support homeowners. On one hand, the country’s social housing programs had overwhelmingly supported rental housing units, despite the programs’ guidelines of providing balanced support between homeownership and rental markets (see chapter four). On the other, housing tax breaks, such as paragraph 7b, often supported owner-occupied housing and rental markets at the same time, the latter of which

228 1st German Bundestag, 41st und 42nd Session, Bonn (24 February 1950). 229 1st German Bundestag, 53rd Session, Bonn (28 March 1950). 230 SPD, party programs, 1957, 1961; 1972, 1976. 231 Ibid.

71 left conservatives unhappy, as their goal of creating a nation of homeowners seemed to slip away. The center-right coalition of Christian Democrats, Free Democrats, and pro- homeownership interest groups, such as the conservative association of people’s homes

(Volksheimstättenwerk), was poised to shift the policy equilibrium in favor of homeowners.

The 7b tax break tied in with a set of other tax breaks for homeowners. First, the

Adenauer government adopted property tax reductions (i.e., Grundsteuervergünstigung) as part of the social housing programs in the 1950s, in order to revive and rebuild housing in the country. These tax subsidies could be used by both homeowners and landlords for ten years, if new property was built with social housing funds or if the property complied with specific guidelines, such as the size of the home. 232 The second additional tax break for homeowners was the deduction of individuals’ savings accounts contributions in building societies from their taxable income. It was created to channel funds into the capital and housing finance markets, which were battered in the postwar period. This tax break had the purpose of encouraging savings in building societies and accumulating the wealth of ordinary people as part of a wider web of policies inducing saving.233 But it did little to directly encourage homeownership, as subsidized savings in building societies did not necessarily have to be used for building or buying homes. Even so, the building society tax break was one of the largest housing tax breaks for homeowners from the 1950s until the late 1960s, amounting to DM1.2 billion in 1966 (see figure 2.1).

When the worst of the housing and economic crises subsided in the early 1950s, the Adenauer government expanded the 7b housing tax break (i.e., the homeownership tax allowance). In a little-noted policy episode in 1953, the Adenauer government changed

232 See The Second Housing Law of 1950, §88; §92-94. 233 See Mertens 2015; Logemann 2012.

72 paragraph 7b as part of its small tax reform,234 so as to allow individuals willing to purchase owner-occupied single-family houses or apartments to claim the tax break (previously, only those who built new houses could claim the tax break).235 Similarly, the Adenauer government increased the 7b subsidies in another reform in 1958, when it expanded the 7b subsidies to those purchasing two-family homes.236 According to a government report, the

7b expansions had the goal of supporting homeowners unable to build their own homes, but able to buy a new house with government support.237 More fundamentally, these extensions are important because they constitute the beginning of a larger shift from subsidizing multi-family to owner-occupied homes.238

The center-right government further expanded paragraph 7b in the 1960s, at a time when the housing crisis was over and the country considered an economic and export miracle.239 In 1964, the center-right Erhard government (CDU-FDP) established that, henceforth, the 7b tax break could only be used by homeowners (previously, individuals constructing multi-family homes could also claim the tax break).240 This was partly because the building industry for multi-family housing was humming, inducing fears of rising

234 See Gesetz zur Änderung steuerlicher Vorschriften und zur Sicherung der Haushaltsführung, 1953. 235 Leutner 1990; Bartholmai 2002a, 2002b; Bundesregierung 1979. 236 The 1958 reform expanded the 7b tax break to two-family homes, but it also added upper limits for the cost of these homes to 120,000DM. If the construction or financing costs exceeded these limits, owners could not claim paragraph 7b for the excess amount. In 1960, the coalition changed the deduction, allowing taxpayers to deduct from their income 7.5 percent of the construction and financing costs for a period of two years and then 4 percent for the eight following years. These limits were introduced to prevent the misuse of financing luxury homes with the subsidy. Also see Borgaes and Koopmann 1978. 237 Bundesregierung, Bericht der Bundesregierung über Möglichkeiten zur Umstellung des § 7 b EStG auf ein anderes Förderungssystem (8 February 1979). 238 Bartholmai 2002a, 2002b. 239 Abelshauser 2012. 240 See Gesetz zur Einschränkung des 7b des EStG; Gesetz zur Neuregelung der Absetzungen für Abnutzung bei Gebäuden, 1964. The paragraph 7b’s title changed from “Increased Tax Write Offs for Residential Buildings” to “Increased Tax Write Offs for Single-Family Homes, Two-Family Homes, and Condominiums.” Homeowners could use the tax break for the construction and financing costs of building or buying a new house or apartment (up to 5% of these costs for up to eight years). The limits were increased to 150,000DM for single-family homes and 200,000DM for two-family homes.

73 inflation and price instability,241 which led the Erhard government to tame consumption in an overheating rental housing market.242 At the same time, the center-right government wanted to shift housing policy support towards homeowners and the political economy toward homeownership finance, in order to inch closer to its goal of creating higher rates of homeownership.

Figure 2.1: Tax expenditures on homeownership in Germany, 1963-1975.243

2,500

2,000 Homeownership Tax Allowance 1,500 Property Tax Subsidy 1,000 Tax Subsidy on Savings in Building Societies Tax expenditure in million DM 500

Having outlived its original purpose of increasing the housing supply of all types of residential buildings -- the housing supply improved dramatically until the late 1960s --

241 It is important to note that the 7b tax breaks were temporarily increased to either stimulate the housing industry (i.e., by offering increased mortgage interest deductions with the 7b tax break) or suspended to balance the budget. For instance, the 7b tax break was suspended from 1963-65, and from 1973-74, and homeowners could use temporarily increased mortgage interest deductions from 1982-85 and 1992-94. 242 The finance committee pointed out that there was a mismatch between construction permits and the capacities of the housing industry, which led to an increase in construction costs of residential buildings (i.e., multi-family buildings). See 14th finance committee, Bonn (11 March 1963). 243 Source: Federal Ministry of Finance; GEWOS; own calculations.

74 center-right political forces incrementally transformed the 7b tax break into a tax subsidy with the specific purpose of subsidizing homeownership (i.e., the homeownership tax allowance). This transformation was part of larger policy efforts by center-right political forces to shift government support away from rental housing toward homeownership markets, including mortgage market subsidies as part of social housing programs and other tax breaks, such as on property taxes and savings accounts contributions in building societies.244 While the housing industry produced an impressive number of roughly

500,000 new homes per year between 1949 and 1964, most of these homes were rental units. Accordingly, and much to the dismay of conservatives, the country’s homeownership rate increased to only 36 percent by the mid-1960s – a number 25 percent lower than in the

United States at the time.245 This slow increase in homeownership, which can be considered a policy failure by center-right political forces, would be consequential in later policy episodes, when tax breaks for homeowners were attacked by center-left political forces.

Even more importantly, the improvement in housing supply and capital markets in the decades after WWII -- together with the slow increase in homeownership -- made the homeownership tax allowance vulnerable to reform in later policy episodes. As the postwar

German growth model emphasized export-oriented manufacturing, savings, and price stability, the economic incentives of boosting housing in times of perceived housing balances without major shortages waned. While it was important to overcome housing supply shortages in order to keep down the cost of living, it was much less important to stimulate housing activity with no major shortages left. Indeed, the homeownership tax

244 Another important, but temporary, tax break was the 7c tax break of the late 1940s and early 1950s -- a tax subsidy that allowed individuals, who loaned interest-free money to public agencies or non-profit housing associations for the purpose of social housing, to deduct the amount of that loan from their income. 245 Data retrieved from Statistisches Bundesamt; DIW.

75 allowance was even suspended in the early 1960s to tame the housing market and to slow down housing growth. By the end of the 1960s, the housing tax breaks for homeowners were better characterized as policies with the social purpose of increasing homeownership

(and private wealth), but they had lost their macroeconomic justification. Together, their waning economic significance and balanced housing markets within sight increased the political conflicts around these housing tax breaks in the following policy periods.

Homeowner tax breaks on the move: Liberalization and reform, 1970s-1980s

When the miracle years of economic growth and welfare state expansion came to an end, the German economy experienced slowly rising deficits and unemployment from the 1970s until the late 1980s (but much less so when compared with other advanced economies).246

During this period of welfare retrenchment, several social programs were scaled down, including the landmark social housing programs. One major exception was the homeownership tax allowance, which continued to grow at impressive rates and soon turned into the largest tax break of the country (see figure 2.2). According to political commentators at the time, the homeownership tax allowance had already earned the status of a sacred cow in the tax code.247 However, the mismatch between the German export-led growth model and housing tax policies started to reveal cracks and marked the beginning of intensifying battles around the homeownership tax allowance between the political blocs on the left and right. In this period, the center-left coalition pushed for reforms to make the tax break less regressive, which set the stage for more intense future political conflicts.

246 Streeck (1995, 5) mentioned that, in the late 1980s, Germany could be regarded as “the internationally most successful of the major economies.” 247 Stimpel 1991, 62

76 In this period, the German growth model specialized even more in export-oriented manufacturing. Where other countries witnessed inflation spiraling out of control, “the

Federal Republic looked like an island of stability,” largely avoiding the stagflation seen in other countries.248 The crisis of the Keynesian era of demand management and large welfare states resulted in declining government consumption and lower wage growth since the 1970s, including in Germany.249 Despite some growing economic problems in the

1980s, Germany largely maintained its macroeconomic focus on wage restraint, price stability, and exports in the post-Keynesian era.250 It adapted to these new macroeconomic realities by building on its existing strength in “diversified quality production,”251 the foundation of the German coordinated market economy.252 This adaptation came without greater difficulty, as the German economy had already lived by the principles that were now promoted in the post-Keynesian context – market discipline, price stability, wage restraint, austerity, and integration in world markets.253 In this period, the share of exports as a percentage of GDP increased from 15 percent in 1970 to 22 percent in 1989. At the same time, the country’s housing market was characterized by tremendous stability -- a perceived equilibrium of housing demand and supply -- without major housing shortages in the country. This further decoupled the growth model from homeownership tax breaks in times of balanced housing markets, as the policies’ previous focus on increasing housing supply became obsolete. If anything, in times of balanced housing markets, the homeownership tax breaks worked against the German growth model’s priorities of

248 Kreile 1977, 775; Gourevitch 1986, 205. 249 Baccaro and Pontusson 2016; Blyth and Matthijs 2017; Piore and Sabel 1984. 250 Gourevitch 1986. 251 Streeck 1991. 252 Hall and Soskice 2001. 253 See Blyth and Matthijs (2017, 210) for a contrast of Keynesian and post-Keynesian macroeconomic regimes.

77 restraining consumption, balancing the budget, and maintaining price stability. These macroeconomic frictions allowed for increasingly open contestation of the homeownership tax breaks, where discussions centered mainly around redistributive, family, and wealth priorities at the time.

Figure 2.2: Tax expenditures on homeownership in Germany, 1975-1998.254

18,000

16,000

14,000 Homeownership 12,000 Tax Allowance 10,000 Property Tax 8,000 Subsidy

6,000 Tax Subsidy on Savings in

Tax expenditure in million DM 4,000 Building 2,000 Societies

During the era of social-liberal governments (SPD-FDP, 1969-1982), the homeownership tax allowance expanded. This was because the tax break was politically locked in, as the Social Democratic coalition partner, the Free Democrats, were strong believers in homeownership allowance, while the Christian Democrats led the opposition in the country’s upper house. In committee, Franz Müntefering, a leading Social Democrat in the Bundestag, complained that the FDP had blocked attempts to reform the 7b tax break into a more equitable tax credit since the 1970s, a debate that should become more salient

254 Source: Federal Ministry of Finance.

78 in the 1980s and 1990s.255 Given this, the Social Democrats focused on making the tax break more equitable in different ways, such as by expanding the tax break to their core clientele in urban areas. In 1977, for instance, the Schmidt government extended the 7b tax break to include the purchase of older homes (previously, homeowners could only claim the tax break if they built or bought new homes), an initiative to appeal to urban constituents.256 Many people in urban areas had not benefited from the 7b tax break, because they could not afford building homes in metropolitan areas, where land is scarce and expensive, a factor that incentivized homeownership in suburban areas.257 The 7b extension was intended to enable ordinary people in urban areas to purchase homes, counter urban sprawl, and modernize urban areas.258

In 1981, the Schmidt government expanded the homeownership tax allowance by adding a family component to the allowance.259 The coalition felt that the tax allowance did not do enough for families with children, who often could not afford to buy or build houses.260 Under the new rules, homeowners with children were able to combine the

255 Bundestag committee on housing, construction, and urban development, 59th session, Bonn (26 February 1986). 256 Bundesregierung, Bericht der Bundesregierung über Möglichkeiten zur Umstellung des § 7 b EStG auf ein anderes Förderungssystem (8 February 1979). Also see Gesetz über steuerliche Vergünstigungen bei der Herstellung oder Anschaffung bestimmter Wohngebäude, 1974. The limit was set at 150,000DM for single- family homes or apartments and 200,000DM for two-family homes. 257 Wullkopf 1982; Görgmeier 1982; Borgaes and Koopmann 1978. 258 See remarks by Böhme (SPD), Gobrecht (SPD), Apel (SPD), Matthäus-Meier (FDP), in: 8th Bundestag, 23rd Session, Bonn (21 April 1977). The CDU proposed to include a component to increase the tax deduction for families with children, but the SPD-FDP rejected the proposal, arguing that it would mostly benefit high- income families. But the major parties agreed that more needed to be done to support families with children in future bills. 259 Homeowners received a tax credit of DM600 per child and year after the first child for as long as they could claim the 7b tax break. The CDU initially opposed the child allowance tax credit and instead wanted to increase the existing 7b tax deduction for families with children, but eventually agreed on the SPD-FDP proposal in the Bundesrat. The Schmidt government also increased the limits for single-family homes to DM200,000 and to 250,000 for two-family homes. See Zweites Gesetz zur Verbesserung der Haushaltsstruktur 1981. 260 See remarks by Haack (SPD), Schlatter (SPD), and Funke (FDP) in: 9th Bundestag, 55th Session, Bonn (1 October 1981).

79 regular 7b tax deduction with a new homeowner child tax credit, which resulted in higher tax benefits for many families.261 Together, the 7b tax break and the child allowance – the two components of the homeownership tax allowance -- became the largest subsidies in the country’s tax code by the early 1980s. Fundamentally, the child component was the first step in transforming the homeownership tax allowance from a status-oriented toward a more equitable subsidy. Beneficiaries of the child component were paid out a fixed amount of cash regardless of their income (a de facto tax credit), whereas the 7b tax deduction continued to benefit those with higher incomes disproportionately (a de facto tax deduction). This also shows that the Social Democrats, unable to adopt major homeownership tax reforms, resorted to making the tax break more equitable by expanding the homeownership tax allowance to their core constituents.262

In the mid-1980s, the center-right Kohl government (CDU-FDP, 1982-1998) passed a comprehensive housing reform, but did not fundamentally change the nature of the homeownership tax allowance. In 1986, the Kohl government specified that the taxation of owner-occupied homes should no longer follow the investment good model, which had taxed imputed rental income and allowed for limited mortgage interest deductions and the homeownership tax allowance. It should instead follow the consumption good model by eliminating the tax on imputed rental income and scrapping the mortgage interest deduction. Yet, the homeownership tax allowance survived the reform, just under a different label that is entirely modeled after the old paragraph 7b (i.e.,

261 The child allowance was also designed to turn around the sluggish performance of the construction sector and mitigate high mortgage rates of up to 12 percent at that time. 262 SPD, party programs, 1976, 1980.

80 it changed its name from 7b to 10e tax break).263 While the homeownership tax allowance had received a new label, its basic functions remained unchanged, when the country switched from the investment to the consumer good model of housing taxation.

However, the debates surrounding the 1986 housing reform revealed significant political differences between the center-right and center-left policy coalitions. Indeed, all major parties agreed that the consumption good model is preferable over the investment good solution, given the administrative difficulties of measuring imputed rental income and the associated practice of under-taxing imputed rent that had rendered the tax inefficient.264 They also viewed the tax on imputed rental income as punitive because it would place debt-free elderly homeowners under unnecessary financial pressure.265 Yet, the major point of disagreement was about the distributive consequences of the homeownership tax allowance. The center-right policy coalition wanted to preserve the tax subsidy’s status quo, including its regressive nature, following the mantra: those with higher income pay more taxes, so they ought to enjoy higher tax subsidies.266 In contrast, the center-left coalition criticized that the proposed reform would do little to change the status-oriented nature of the homeownership tax allowance. In the words of Bundestag member Gunter Huonker (SPD), “[t]he existing §7b is a perversion of justice. The principle of this perversion of justice is fully adopted in the draft bill of the federal government.”267

263 See Gesetz zur Neuregelung der steuerrechtlichen Förderung des selbstgenutzten Wohneigentums, 1986. The law also increased the upper limit of the costs of an object to 300,000DM and allowed homeowners to claim the child allowance for every one of their children (previously, they could only claim the child allowance for every child after the first child). Homeowners could continue to deduct 5 percent from these costs per year over a period of eight years, in order to stimulate the reeling construction industry. 264 Finanzauschuss, Beschlußempfehlung und Bericht (17 March 1986). 265 Hansjörg Häfele (CDU), 10th German Bundestag, “Schriftliche Fragen mit den in der Woche vom 9. April 1985 eingegangenen Antworten der Bundesregierung,” Bonn (12 April 1985). 266 Finanzauschuss, Beschlußempfehlung und Bericht (17 March 1986). 267 10th German Bundestag, 130rd Session, Bonn (29 March 1985).

81 In an earlier 1984 draft bill,268 the Social Democrats proposed reforming the homeownership tax allowance into a tax credit that would benefit all beneficiaries equally, but the proposal was met with resistance from the center-right bloc, arguing that that the

SPD proposal would be too costly, dis-incentivize people from buying homes, and be guided by envy.269 According to a former member of the Bundestag (SPD), the proposal failed because the Christian and Free Democrats wanted to preserve the tax benefits for their core constituents – middle and upper income families. 270 Eventually, the Kohl government realized its preference of policy stability of the homeownership tax allowance during the 1986 reform.

Yet, the conflict between the center-left and center-right policy blocs started to intensify. The center-right’s policy support for homeownership seemed unshakable at the time. They viewed supporting homeownership through tax policy as an essential element of the conservative welfare state that, in the words of Bundestag member Hansjörg Häfele

(CDU), would be the:

fourth pillar of retirement and life savings – next to the general pension schemes,

company pensions, and private savings – that increases the experience of owning

your home. At the same time, we want to strengthen families by focusing on

instruments that especially support families.271

268 SPD, Entwurf eines Gesetzes zur Neuregelung der steuerlichen Förderung selbstgenutzten Wohneigentums (22 November 1984). 269 Author interview (phone), Bundestag member III (SPD). May 14, 2015. Also see remarks by Jahn (CDU) in: Bundestag committee on housing, construction, and urban development, 56th session, Bonn (29 January 1986); also see remarks by Daniels (CDU), Jahn (CDU), and Gruenbeck (FDP) in: Bundestag committee on housing, construction, and urban development, 59th session, Bonn (26 February 1986). 270 Author interview (phone), Bundestag member III (SPD). May 14, 2015. 271 10th German Bundestag, 156th Session, Bonn (12 September 1985).

82 However, the Social Democrats have voiced increasing concern about not only the regressive nature of the homeownership tax allowance but also government support for homeownership in general. For instance, Franz Müntefering (SPD) cautioned that:

Property ownership is something nice, but it is not everything. In the interest of

families, especially children, one cannot prioritize the decision for homeownership

over all other decisions, such as training and education, such as health, such as

family peace. Those who elevate homeownership to an ideology do the people

affected by this a disservice.272

When it comes to the distribution of scarce resources, the center-left bloc increased their efforts of shifting government support for homeownership to other social areas.

Finally, other tax subsidies for homeownership and rental markets were eliminated under the Kohl government. First, it phased out the property tax break during a major tax reform that was intended to bring down tax rates and close some loopholes.273 The property tax exclusion had doubled in size from the late 1960s until the late 1980s, amounting to

DM1.2 billion in 1986, which made it the ninth-largest tax break in the country at that time.274 As most social housing programs -- policies to which the tax break was tied -- benefited the rental sector instead of homeowners, the center-right coalition did not view this tax subsidy as a major policy tool to support homeownership. Second, the Kohl government reduced the building society tax subsidy in successive steps before and after reunification, from DM840 million in 1986 to DM280 million in 1995. As the subsidy did little to encourage homeownership and instead subsidized the private wealth of households

272 10th German Bundestag, 208th Session, Bonn (21 March 1986). 273 See Steuerreformgesetz 1990. 274 Source: Federal Ministry of Finance.

83 (subsidized savings in building societies did not have to be used for building or buying homes), the center-right government cut back on these subsidies from DM840 million in

1986 to DM280 million in 1995, which rendered the subsidy insignificant.275 The only housing subsidy that seemed immune to reform was the homeownership tax allowance.

In sum, in this period of welfare state retrenchment, the homeownership tax allowance -- a transformed relic from the postwar period to overcome the housing crisis -- emerged as the most important housing policy in the country. Policymakers considered the housing question to be solved, with an affordable housing market lacking significant shortages. The tax break also did little to reinforce the German growth model, which became even more export-oriented by the late 1980s -- to the contrary, it diverted investments into housing that could go to the more productive export sector. While the tax breaks were sustained by strong center-right governments, these factors have enabled center-left political forces to make these tax breaks the subject of significant political discussion.

On the chopping block: The elimination of homeownership tax subsidies, 1990s-

2010s

The 1990s and early 2000s constituted a final break of the mismatch between housing finance policies and the larger growth model. It was in this period when the country doubled down on its export competitiveness, increasing its export share from 22 percent in

1990 to 46 percent of GDP in 2016, while the share of consumption dropped from 57 to 54 percent in the same period. Reunification was a shock to the German growth model. For

275 Gesetz zur Neuregelung der steuerlichen Wohneigentumsförderung 1995.

84 these and other reasons, Germany soon became the sick man of Europe in the late 1990s, with high unemployment, rigid labor markets, and high labor costs, all of which threatened

German export competitiveness.276 The homeownership tax break created at least three major macroeconomic tensions with the country’s post-unification economy. First, the tax break reinforced an existing trend of growing deficits and debt.277 The homeownership allowance had become the single most expensive subsidy in the tax code, while balancing the budget and reducing subsidies became a major policy priority, so as to eliminate market distortions. Second, it was said to contribute to significant housing market imbalances, including large-scale housing vacancies in the East. Stimulating demand in housing markets with large-scale housing surpluses would create further market instabilities. Third, given income and wealth differences between the old and new federal states -- where homeownership stood at just 27 percent278 -- the tax break was considered to be regressive.

As a result, center-left governments started attacking the homeownership tax breaks as part of structural economic and austerity reforms in order to increase labor market mobility and produce economic growth by eliminating market-distorting elements that channel investments away from the productive sector.

Inasmuch as reunification led to an initial increase in tax breaks for homeowners, including the homeownership tax allowance, it also destabilized the housing finance policy quo. In the early 1990s, the East German housing market was in bad shape when compared with its western counterpart. To stimulate investment and employment in the new federal states, the Kohl government (CDU-FDP, 1982-1998) provided generous tax incentives to

276 Reisenbichler and Morgan 2012. 277 Burda and Hunt 2001; Weishaupt 2010. 278 Data retrieved from Statistisches Bundesamt; DIW.

85 invest in the East German housing market, such as increasing the homeownership tax allowance. Until reunification, taxpayers could only use the homeownership tax allowance once in their lifetime, but the coalition allowed ordinary people from West Germany to use the tax break a second time if they bought a home in East Germany.279 The goal was to create a vibrant, privatized housing market and employment through these investments.280

However, these housing finance policies have contributed to overinvestments in East

German housing, which eventually resulted in declining house prices281 and large-scale vacancies of almost 13 percent of the entire East German housing stock – or one million homes -- by the late 1990s.282 These policies also did little to alleviate the growing housing shortages in the metropolitan areas of West Germany and contribute to urban sprawl,283 a situation that exacerbated because of population movements from East to West

Germany.284

Relatedly, the homeownership tax allowance did not benefit many East Germans, as their income was often too low to invest in the housing market. As a result, the Social

Democrats proposed making the homeownership tax allowance less regressive in the early

1990s. In particular, they suggested the introduction of a tax credit that would benefit all beneficiaries equally, referencing the party’s earlier 1984 proposal. The SPD argued that the proposal would be superior in creating homeownership and stimulating the construction

279 See Fördergebietsgesetz of 1991; Investititonszulagengesetz of 1991; Steueränderungsgesetz 1991, 1992. In particular, The CDU-FDP coalition introduced a temporary mortgage interest deduction of up to 12,000DM per year from 1992-1994. They also increased the child allowance tax credit to 1,000DM per child and raised the limits for homes to 330,000DM. 280 Ruprecht, Geiger, and Muellbauer 2016. 281 Ruprecht, Geiger and Muellbauer 2016; Lindenthal and Eichholtz 2012. 282 Glock and Häussermann 2004; Georgakis 2004b. 283 See remarks by Huonker (SPD) in: Bundestag finance committee, 8th session, Bonn (8 May 1991); also see Wullkopf 1982; Goergmeier 1982; Borgaes and Koopmann 1978. 284 Egner 2014; Wullkopf 1982; Görgmeier 1982; Heinelt and Egner 2006.

86 industry in the new federal states.285 As Otto Reschke (SPD), a former member of the

Bundestag, remarked:

Existing measures to support homeownership according to §10e do not show

efficacy in the five new states, because the income levels are so low that the

measure barely allows for tax savings.286

But the Christian and Free Democrats vehemently defended the status-oriented nature of homeownership allowance, rebutting the SPD proposal as too expensive.287 As a concession, the Kohl government agreed to introduce income limits, excluding high- income homeowners from the subsidy.288

Under mounting political pressure from the political left about the inequity of the homeownership tax allowance, the Kohl government transformed the homeownership tax allowance into a direct tax subsidy for homeowners in 1996.289 The new subsidy (named

Eigenheimzulage) no longer benefited high-income earners disproportionately, as every beneficiary received the same amount of cash, and the reform continued to limit the subsidy to middle- and low-income earners,290 which made the tax break less status-oriented and more egalitarian. The new subsidy also added an environmental component to the homeownership tax allowance. Homeowners building environmentally friendly homes

285 See remarks by Reschke (SPD) in: Bundestag committee on housing, construction, and urban development, 6th session, Bonn (17 April 1991). 286 12th German Bundestag, 25th Session, Bonn (14 May 1991). 287 See remarks by Faltlhäuser (CDU) in: Bundestag finance committee, 8th session, Bonn (8 May 1991). 288 These limits were set at 120,000DM for singles and 240,000DM for married couples in 1992 as part of an effort to reduce some federal subsidies to balance the budget. See Steueränderungsgesetz 1992. The SPD welcomed this move, but also made clear that it will continue to push for a tax credit instead of the existing 10e tax write-offs. See, for instance, 7th finance committee, Beschlußempfehlung und Bericht, Bonn (7 November 1991). 289 See Eigenheimzulagengesetz 1996. 290 The income limit was retained at 120,000DM for singles and 240,000DM for married couples. The tax subsidy was set at 5% of the construction and financing costs of up to 5,000DM for newly built houses per year (or 2,500DM for buying older homes) for eight years. The child allowance (tax credit) was set at 1,500DM per child.

87 received an additional tax credit as part of the allowance -- a component pushed by the

SPD and Greens.291 This policy outcome is surprising because the political right had opposed proposals advancing the idea of more equitable distributions of homeownership subsidies in recent decades. The reform even adopted longstanding ideas advanced by the

Social Democrats, who had long advocated a tax credit independent of homeowner income.

Despite the initial resistance from the Free Democrats against the reform,292 the Christian

Democrats convinced them to agree on a proposal that would not be blocked in the center- left upper house.293 As Reschke (SPD) stated in a Bundestag session,

In 1986, we had demanded in a draft bill that support [for homeowners] be

independent of income. … In our view, this resulted in misdirected subsidies that

have cost billions. For more than eight years we have been supporting the wrong

individuals. The rate of homeownership has not increased.294

The Social Democrats felt vindicated and celebrated the reform. Another Social Democrat in the Bundestag, Achim Grossmann (SPD), pointed out that the law:

… will benefit the new federal states. During the many attempted reforms of §10e

we have often pointed out that people in the new federal states could not make use

of this measure.295

In an interview, a member of the Bundestag (SPD) stated that the bill was also intended to help transfer ownership from former state-owned GDR housing into private hands.296

291 The “ecological component” allowed beneficiaries to receive an additional tax credit of 500DM as part of the homeownership allowance (Eigenheimzulage), in order to compensate for the cost of environmentally friendly construction or modernization, such as energy-saving measures. 292 Handelsblatt, “Liberale beharren auf Optionsmodell” (22 June 1995). 293 Handelsblatt, “FDP und Union einig über Bauzulage” (28 June 1995). 294 13th German Bundestag, 65th Session, Bonn (27 October 1995). 295 13th German Bundestag, 65th Session, Bonn (27 October 1995). 296 Author interview (phone), Bundestag member III (SPD). May 14, 2015.

88 Moreover, appealing to East German voters helps explain the CDU’s U-turn. As Bertold

Reinartz (CDU) noted, “the special situation in the new federal states with lower income than in the old federal states is decisive for the turn away from the regressive

[progressionsabhängigen] subsidy.”297 Similarly, Kurt Faltlhäuser (CSU) stated in the

Bundestag that:

This measure is good for the new federal states … Citizens, particularly in the new

federal states, will receive significantly more support than before just through the

switch toward a system that supports citizens independent of income, because the

income levels in the new states are still regrettably lower. It is a measure that is

tailored to the new states.298

Another Christian Democrat, Gerhard Schulz (CDU), concurred and acknowledged in a

Bundestag session that:

So far only few people in the new states could participate in the existing programs

according to §10e, because income and the tax bills are on average lower than in

the old federal states.299

When interviewed, a Bundestag member (CDU) stated that the core idea was to find a solution that did not legally privilege the new federal states with special measures, but still helped them in ways the pre-reform homeownership tax allowance could not have guaranteed.300 As a commentator in a major German newspaper put it, “[o]ne can be sure: this redistribution of [homeownership] subsidies from the top to the bottom would not exist

297 13th German Bundestag, 55th Session, Bonn (21 September 1995). 298 13th German Bundestag, 65th Session, Bonn (27 October 1995). 299 13th German Bundestag, 65th Session, Bonn (27 October 1995). 300 Author interview, Bundestag member I (CDU). Berlin, 22 June, 2015.

89 without the pressure from the new states.”301 Although the center-right Kohl government passed the reform, this was a victory for the political left that had long advanced the idea of making homeownership subsidies more equitable.302 Yet, the center-left political bloc had not stopped there.

In the late 1990s and early 2000s, when the country experienced its first center-left coalition between the Social Democrats and Greens, the Schröder government (SPD-

Green, 1998-2005) went after the homeownership tax allowance. These developments came at a time when Germany was considered the “sick man of the euro,” plagued by high unemployment, sluggish growth, and the costly fiscal consequences of reuniting the country.303 The fundamentals of the country’s export-led growth model were also crumbling, the roots of which The Economist saw in the country’s “byzantine and inefficient tax system, a bloated welfare system and excessive labour costs,”304 which made export-oriented firms less competitive. As a result, the Schröder government started several fiscal consolidation initiatives to decrease tax subsidies, including those for homeowners, as part of larger welfare state reforms to boost competitiveness and reinvigorate the country’s export-led growth model.305 In 2002, the center-left government, under the leadership of finance minister Hans Eichel (SPD), launched its first attack on the

301 Jürgen Forster, “Töpfer auf Harmoniekurs,” Süddeutsche Zeitung (28 June 1996). Also see Lindenthal and Eichholtz 2012. 302 Also see remarks by Grossman (SPD) and Reschke (SPD) in: Bundestag Committee for housing, construction and urban development, 18th session, Bonn (20 September 1995). Leading CDU politicians, such as housing minister Töpfer, Kansy, and Meister, conceded that the bill would do more to support middle- income families, especially in the new federal states. See Bundestag Committee for housing, construction and urban development, 18th session, Bonn (20 September 1995); also see Bundestag Committee for housing, construction and urban development, 20th session, Bonn (24 October 1995). 303 The Economist, “The sick man of the euro,” June 3, 1999. 304 Ibid. 305 In 1999, for instance, the coalition further reduced the upper-income limit of the subsidy to 80,000DM for singles and 160,000DM for married couples. For families with children, these income limits were higher (i.e., 30,000DM per child).

90 homeownership tax allowance in a proposal to reform the tax system.306 The proposal aimed at scaling down and limiting the tax allowance to homeowners with children only, but it did not pass the Bundesrat, where the CDU and FDP could block the bill.307 Still, the

Schröder government did manage to eliminate the environmental component of the homeownership allowance with an executive order on saving energy in the same year.308

In an interview, Eichel stated that the homeownership tax allowance would be “economic nonsense and misdirected spending,” especially because of overcapacities in the eastern housing markets.309 In contrast, Angela Merkel, then the chairwomen of the Christian

Democratic parliamentary group, responded to the plans to cut down the subsidy:

You do not at all comprehend what you are doing to the people! Do you know what

this means for a family who wants to build a house? … I am asking you here: What

are you actually doing with these plans for the construction industry in the East?310

At this time, the center-right opposition was still strong enough to prevent major reforms to the homeownership tax allowance, but the tax break appeared to be down for the count.

In a bipartisan, state-led effort, Peer Steinbrück (SPD) and Roland Koch (CDU), then the minister-presidents of the federal states, Lower Saxony and Hesse, proposed to

306 See Entwurf eines Steuervergünstigungsabbaugesetz. Also see Georgakis 2004a, 103. 307 Egner 2014; Heinelt and Egner 2006. 308 Verordnung über energiesparenden Wärmeschutz und energiesparende Anlagentechnik bei Gebäuden (Energieeinsparverordnung - EnEV), 2001. The environmental component of the homeownership tax allowance was tied to the preceding executive order of 1994. The new executive order required higher energy- saving standards across the board, which made the subsidy obsolete. 309 Der Spiegel, “Das tut immer weh” (28 October 2002). Also see remarks by Eichel (SPD), who pointed out that public funds are used for demolition in East Germany, where there are vacancies, but also for the creation of new housing; in: 15th Bundestag, 12th Session, Berlin (3 December 2002). Similarly, Groeneberg (SPD) argued that the overall housing market is in good shape, but that there are regional differences – shortages and urban sprawl in metropolitan areas and vacancies in East Germany, in: 15th Bundestag, 19th Session, Berlin (13 January 2003). 310 15th Bundestag, 4th Session, Berlin (29 October 2002). Other CDU and FDP members argued that the proposal would hurt the construction industry and the mission of creating homeownership, a basic need of the people. See remarks by Otto (FDP) and Minkel (CDU), in: 15th Bundestag, 19th Session, Berlin (13 January 2003).

91 cut all subsidies in the tax code by 12 percent, in order to balance the budget in 2003.311

The proposal was perceived as fair, because it targeted all subsidies equally in a larger effort to balance the budget, without singling out the homeownership tax allowance. As figure 2.3 shows, this marked a turning point in the history of the tax break, as it curbed and stabilized the previous expansion of the homeownership tax allowance.

Figure 2.3: Homeownership tax allowance, 1999-2015.312

12,000

10,000

8,000

6,000

4,000

Tax expenditure in million EUR millionin expenditureTax 2,000

Later in 2003, the Schröder government introduced a budget bill based on the bipartisan proposal, but the bill stirred anger among the center-right parties, as it included a provision to remove the homeownership tax allowance that deviated from the bipartisan proposal.313

While the conservative-led upper house correspondingly blocked the provision to eliminate

311 Roland Koch and Peer Steinbrück, “Subventionsabbau im Konsens,” (2003). 312 Source: Federal Ministry of Finance. 313 See Entwurf eines Haushaltbegleitgesetzes 2004. Again, Eichel (SPD) referred to vacancies and demolitions in East Germany and housing shortages in the metropolitan areas of West Germany, and that regional housing development should not be steered through the homeownership subsidy. See Bundesrat, 793rd Session, Berlin (26 September 2003).

92 the homeownership tax allowance, it agreed to reduce the allowance as originally specified in the bipartisan proposal.314

The center-left coalition launched another full-blown attack on the homeownership subsidy in 2004. In a draft bill, the center-left government again demanded the elimination of the homeownership allowance and suggested that these funds would be better spent on innovation, research, and education.315 In particular, the draft bill justified the elimination of the subsidy, as i) it would be the single largest subsidy in the tax code, ii) it outlived its original purpose of alleviating the housing crisis after WWII, iii) the dire demographic projections would reduce housing demand in the long run; iv) it benefited taxpayers, who do not actually need the subsidy; and v) it would do little to overcome vacancies in the East or alleviate shortages in the West.316 Moreover, finance minister Eichel criticized the subsidy’s house “price-inflating” tendencies,317 a factor that was also criticized in the draft bill.318 Bundestag sessions reveal the center-right irritation with the continued center-left efforts to dismantle the subsidy, provocatively asking the Christian Democrats whether public funds should be spent on: “bricks or education?”319 Angela Merkel (CDU) labeled

314 In particular, starting in 2004, the income limits were further reduced to 35,000EUR for singles and 140,000EUR for couples. The subsidy decreased to 1% of the construction and financing cost of owner- occupied homes for a period of eight years. Both types of housing – already existing and newly built homes – now received the same amount of 1,250EUR. The child allowance tax credit increased to 800EUR per child. See Haushaltsbegleitgesetz 2004. 315 See Entwurf eines Gesetzes zur finanziellen Unterstützung der Innovationsoffensive durch Abschaffung der Eigenheimzulage. 316 See remarks by Hilsberg (SPD), Andreae (Greens), Runde (SPD), and Tauss (SPD), in: 15th Bundestag, 133rd Session, Berlin (October 22, 2004) and 15th Bundestag, 129th Session, Berlin (September 30, 2004). 317 15th Bundestag, 129th Session, Berlin (30 September, 2004). Other members of the Bundestag made the same point during the session, such as Ortwin Runde (SPD). 318 Entwurf eines Gesetzes zur finanziellen Unterstützung der Innovationsoffensive durch Abschaffung der Eigenheimzulage. 319 See remarks by Andreae (Green) in: 15th Bundestag, 133rd Session, Berlin (October 22, 2004). Also see 15th Bundestag, 129th Session, Berlin (September 30, 2004). During the latter session, Seiffert (CDU) accused the SPD of not caring about homeownership. Thiele (FDP) argued that the subsidy is a success story in Germany. Michelbach (CDU) stated that homeowners would be a thorn in the Chancellor’s flesh. Minkel (CDU) associated homeownership with successfully parenting and educating children.

93 these attempts “poisoned.”320 She further stated that: “[f]or me it is not acceptable that the homeownership allowance be used to finance investment in something like education, but we wanted and still want tax reform.”321 Eventually, the measure passed the center-left

Bundestag, but was blocked by the CDU-led Bundesrat.322

One aspect criticized by the Social Democrats was that the country’s homeownership tax breaks had done little in raising the homeownership rate. From 1955 to 2005, the homeownership rate only climbed from 30 percent to 43 percent. Despite its policy support for homeownership, Germany still had one of the lowest rates of homeownership rates among advanced economies in the early 2000s. There are many reasons for why Germany’s homeownership rate is so low (see chapter four).323 But why has the homeownership tax allowance done little to increase homeownership in this context? First, surveying the vast literature in economics on housing tax breaks reveals that tax breaks for homeowners do very little to influence the decision of owning or renting.324

Instead, tax breaks incentivize households to take on larger amounts of debt, because tax breaks lower the cost of debt.325 In other words, tax breaks for homeowners mostly benefit those able to afford mortgages, but they do little to help households unable to afford mortgages. Homeowners require high down payments in the German mortgage market,

320 Süddeutsche Zeitung, “Union will am Zuschuss festhalten,” (March 29, 2004). 321 Handelsblatt, “Union: Es geht um die Anfangsphase der Bildung. Parteien streiten über Schulsystem” (15 September 2004). 322 See remarks by Teufel (CDU), in: Bundesrat, 803rd Session, Berlin (24 September 2004); also see Bundesrat, 806th Session, Berlin (26 November 2004). However, the state of Saarland (CDU-FDP) mentioned that in future it would be open to renegotiate the subsidy, in order to react to fiscal, demographic, regional development challenges. 323 Voigtländer (2009), for instance, rightly mentioned the strong and affordable rental markets, which provided a viable alternative to owning in the country. Also see Kofner 2014. 324 See Gruber, Jensen, and Kleven 2017; Glaeser and Shapiro 2003; Sommer and Sullivan (unpublished ms.); Hilber and Turner 2014. 325 See Capozza, Green, and Hendershott 1996; Poterba 1984; Dunsky and Follain 2000

94 which made homeownership unattainable for many households, as they were priced out of the homeownership market.326 This is especially the case for households living in the many metropolitan regions of the country.327 One effect of the low homeownership rate is that it resulted in lower levels of household wealth when compared with other European countries.328 Another effect was that the failure of achieving higher homeownership rates made the subsidy vulnerable to reform, given the policy’s weak track record and failure to produce a larger constituency of homeowners.

After the general elections in 2005, the Christian and Social Democrats entered negotiations to form a grand coalition, and the Social Democrats continued to rigorously oppose the homeownership tax allowance. The CDU initially wanted to preserve the homeownership tax allowance but then split over the issue. The party’s internal divide was driven by state governments, especially the new federal states, in the country’s upper house. The federal states were particularly open to reforming the homeownership allowance, because they financed 42.5 percent of the subsidy out of their own pockets and the subsidy often did not adequately fit their regional needs.329 The minister-president of

Saxony-Anhalt in East Germany, Wolfgang Böhmer (CDU), moved first in stating that the state would be open to the elimination of the homeownership tax allowance. This is unsurprising because the state is one of the poorest in the country, with the lowest rate of homeownership. In 2003, he stated that:

326 Deutsch and Tomann 1995; Kofner 2014; Voigtländer 2009; 2014. 327 Deutsch and Tomann 1995; Bentzien, Rottke, and Zietz 2012; Lerbst and Oberst 2014. 328 Recently, the European Central Bank’s Household Finance and Consumption Survey reckoned that Germany’s median household wealth was EUR51,000 (mean: EUR195,000), whereas the euro area median household wealth was EUR109,000 (mean: EUR230,000) in 2013. Source: ECB HFCS 2013. 329 Heinelt and Egner 2006.

95 I would not like to dispute what the homeownership allowance means for Baden-

Württemberg or some other states. For the new federal states, in part with vacancy

rates of up to 20 percent, we need different priorities. We would like to use that

money for urban planning and not only for supporting homeownership.330

He repeatedly made this point in interviews, stating that the state would be open to

“reducing the volume of the subsidy.”331 Similarly, Georg Milbradt (CDU), Saxony’s minister-president, stated that, “[w]e in Saxony do not need to support new residential construction … We have enough of that.”332 Moreover, he said that, “[i]n a situation in which city centers depopulate, there are vacancies, and the state in East Germany supports demolition, we can no longer afford new residential construction.”333 Other deficit-ridden,

CDU-governed Western states followed suit, including the Saarland,334 signaling openness to negotiate over the homeownership allowance. Interest groups representing German cities and local communities echoed that the tax subsidies were regionally damaging, as they neglected the local housing needs, contributing to urban sprawl, suburbanization, and vacancies in East German inner cities.335 Suburbanization, in turn, would also reinforce other tax breaks, such as the commuter’s tax break that had provided financial aid to commuters.336 In sum, the Social Democrats successfully managed to turn former veto

330 Deutschlandfunk, “Haushaltsituation der Länder” (22 May 2003); also see Deutschlandfunk, “Böhmer verlangt weitere Reformen” (17 December 2003). 331 Weiland, S. “Krisengipfel im Kanzleramt: Union sagt zur Eigenheimzulage leise Servus.” Spiegel Online (11 March 2005). 332 Damir Fras, Tom Levine, and Bettina Vestring, “Milbradt bricht CDU-Tabus: Sächsischer Ministerpräsident für Kürzung von Eigenheimzulage und Pendlerpauschale / Steuervorteile für Nachtarbeiter sollen fallen,” Berliner Zeitung (17 June 2003) 333 Die Welt, “Milbradt für spezielle Eigenheimzulage Ost” (27 November 2003). 334 See remarks by Müller (CDU), in: Bundesrat, 806th Session, Berlin (26 November 2004). Also see: Süddeutsche Zeitung, “CDU streitet über Eigenheim-Zulage” (13 March 2005); Handelsblatt, “Union wankt bei Eigenheimzulage: Front der CDU/CSU-regierten Länder gegen Abschaffung der Subvention für Häuslebauer bröckelt” (26 November 2004). 335 Author interview (phone), representative of Deutscher Städtetag I, December 11, 2015. 336 Author interview (phone), representative of Deutscher Städtetag II, December 11, 2015.

96 players -- i.e., conservative-led states in the upper house -- into allies in their efforts to remove the homeownership subsidy.337

The Merkel grand coalition (CDU-SPD, 2005-2009) eventually agreed to eliminate the homeownership tax allowance in 2005, when the Christian Democrats conceded defeat in the negotiations over tax break with the Social Democrats.338 The elimination of the subsidy was remarkable, because the center-right political bloc of Christian and Free

Democrats, supported by building societies, had a strong preference for maintaining the homeownership tax allowance, mainly because it has been a longstanding mainstay of

Christian Democracy, benefiting their core constituents of affluent middle-to-higher income households. The elimination therefore evoked nostalgic and mixed feelings among the Christian Democrats, which is reflected in Bundestag sessions.339 As Otto Bernhard

(CDU) expressed:

From where I stand I have defended the homeownership allowance at least a dozen

times. In committee, I have made clear that it was not easy for me to let go of the

subsidy… Given the financial situation, we unfortunately don’t have much room

for maneuver. That is why we have to cut back completely, in order to balance the

budget.340

337 Yet, not all new federal states supported the subsidy. The CDU-led state of Thuringia continued to support the subsidy. See remarks by Wucherpfennig (CDU), in: Bundesrat, 806th Session, Berlin (26 November 2004). 338 CDU-SPD, Gemeinsam für Deutschland--mit Mut und Menschlichkeit (11 November 2005). 339 See remarks by Georg Brunnhuber in: Bundestag Committee for Infrastructure, Construction, and Urban Development, 2nd session, Berlin (14 December 2005), who used the term Wehmut (“melancholy”) to describe his view on the elimination. Also see remarks by Steffen Kampeter (CDU) in: Bundestag Budget Committee, 4th Session, Berlin (14 December 2005), who stated that it was not easy for his party to agree on the elimination. 340 16th German Bundestag, 8th Session, Berlin (15 December 2005).

97 An interview with a high-ranking CDU Bundestag member involved in the coalition talks sheds further light on the political dynamics of its elimination. The member stated that the party accepted the elimination as part of a larger deal that included the reduction of corporate taxes and labor costs, while continuing moderate support for homeowners through pension schemes. The CDU member also remarked that the reform required a grand coalition, because the SPD and Greens would not have been strong enough on their own, while the CDU and FDP would not have gone against their own interest of promoting homeownership.341 Finally, the official stated that the CDU agreed with the SPD to fiscally consolidate, which was an important reason for agreeing to remove the homeownership tax allowance.

A large part of the housing lobby expressed its support for preserving the homeownership tax allowance and started the so-called “homeownership initiative” that included 18 housing interest groups. In a joint statement, they reckoned that the elimination of the tax break would, among other things, result in slower growth in construction and higher unemployment, citing 220,000 lost jobs as a result.342 First and foremost, the association of private building societies (Verband der Privaten Bausparkassen), founded in 1948, led the initiative to prevent the reform of the homeownership tax allowance, as it would go against their core interest of creating homeownership. They instead argued that subsidies for the social rental sector would be the “worst waste of money” in the housing area, leading to overinvestment in the affordable rental housing sector.343 Similarly, the conservative association of people’s homes (i.e., Volksheimstättenwerk) has, since 1946,

341 Author interview, Bundestag member I (CDU). Berlin, 22 June, 2015. 342 See Volksheimstättenwerk, “Initiative Wohneigentum: Eigenheimzulage muss uneingeschränkt erhalten bleiben!” Berlin, 18 April 2002. 343 Egner 2004.

98 supported the creation of single- or two-family homes. In their view, the homeownership tax allowance would be the main instrument to support their core mission of creating homeownership for middle and lower income families.344 The home and property association (Haus & Grund) was established in 1939 and has since represented the interests of property owners -- that is, homeowners and landlords. The interest group argued that reforming the subsidy would be one of the greatest setbacks for the creation of homeownership in the history of the Federal Republic. They instead advocated the reform of the “failed” social housing programs.345 These interest groups were supported by church- based interest groups (i.e., Katholischer Siedlungsdienst) representing traditional family values of marriage and family life in single-family homes, as well as the association of mortgage banks (Verband der Hypothekenbanken) and the construction lobby, the latter of which argued that the subsidy secures employment in the construction sector.346

On the opposite end of the housing debate, the center-left political bloc of Social

Democrats and other left political parties, supported by renters’ and non-profit housing associations, developed a preference for the policy retrenchment of the homeownership tax allowance. Interviews with high-ranking SPD members of the Bundestag shed light on why the Social Democrats favored policy retrenchment. Despite its widespread popularity of the homeownership tax allowance, the Social Democrats viewed the allowance as regionally damaging. For instance, Stephan Hilsberg (SPD) called the tax break

“pointless,” because:

344 Ibid. 345 Ibid. 346 Ibid.

99 It does not make any sense -- in some parts of Germany this is the daily practice --

to spend public money on reducing housing and simultaneously on the construction

of housing.347

He implicitly refers to the vacancies of the East German housing market, which required public funding to demolish housing units in inner cities.348 A member of the SPD

Bundestag faction echoed this view, noting that the tax break attracted people to move into the suburbs and did little to overcome housing vacancies in the East.349 Indeed, according to a government report, the tax break disproportionately benefited homeowners outside cities, contributing to urban sprawl.350 Another high-ranking member of the SPD’s

Bundestag faction stated that the problem in East Germany was an overheating market fueled by tax incentives, including the homeownership tax allowance, which resulted in an overblown construction sector and housing vacancies.351 Moreover, the elimination of the tax break tied in with the SPD’s larger structural economic and welfare reform program, such as the Hartz labor market reforms, in order to balance budgets, cut labor costs, and revive the German export-oriented growth model.352 According to a party official, the SPD felt uneasy about homeownership subsidies, because these subsidies would distort investments in the economy. The official continued that tax policy ought to be neutral, while homeownership would be a private matter and should not be subsidized. To the contrary, low rates of homeownership would be beneficial for creating labor market

347 16th German Bundestag, 5th Session, Berlin (1 December 2005). 348 In particular, he refers to the program “Stadtumbau Ost.” See Georgakis 2004b. 349 Author interview (phone), Bundestag member IV (SPD). September 25, 2015. 350 Bericht zur Inanspruchnahme der Eigenheimzulage in den Jahren 1996-2000, Bundesamt für Bauwesen und Raumordnung (2002). 351 Author interview (phone), Bundestag member V (SPD). May 7, 2015. 352 Author interview (phone), Bundestag member VI (SPD). October 27, 2015.

100 mobility.353 Another party official noted that the elimination freed up funds to set new impulses in areas, such as in education.354 Finally, a member of the SPD Bundestag group mentioned that the party felt pragmatic about homeownership, without strong ideological ties to the idea.355

Other political parties on the left -- Die Linke and the Greens, in particular – as well as several interest groups also expressed their support for the elimination of the tax break.

Die Linke and the Greens had long joined the Social Democrats in their efforts to eliminate the homeownership tax allowance -- either from the opposition bench or as a coalition partner. As Kerstin Andreae, a member of the Greens, pointed out in the Bundestag:

Of course we support the elimination of the homeownership allowance. We have

always said that. The elimination of the homeownership allowance is right. It leads

to distorted allocations in the housing market. When the subsidy was introduced,

there was a housing crisis. We don't have that situation any longer.356

This helped create additional pressure on the center-right political bloc. Similarly, interest groups representing renters, such as the powerful German renters’ association (Deutscher

Mieterbund), created in 1900, have long argued that the homeownership tax allowance would be inequitable and contribute to vacancies and urban sprawl. They instead advocated shifting housing funds towards the affordable rental sector with sensitivities to regional and local housing needs.357 As mentioned above, the association of German cities

(Deutscher Städtetag) also favored the reform of the subsidy on regional grounds.

353 Author interview (phone), Bundestag member V (SPD). May 7, 2015. 354 Author interview (phone), Bundestag member VI (SPD). October 27, 2015. 355 Author interview, Bundestag member II (SPD). Berlin, September 9, 2015. 356 16th German Bundestag, 8th Session, Berlin (15 December 2005). 357 Egner 2004.

101 Although the largest interest group representing (non-profit) housing associations

(Bundesverband deutscher Wohnungs- und Immobilienunternehmen, GdW) was part of the

“homeownership initiative,” they did not feel strongly about the reform of the homeownership tax allowance, given that most of its members and core constituents were not homeowners but rental housing associations and companies.358

Why were interest groups unable to prevent the retrenchment of the subsidy in

Germany? In the United States housing interest groups, representing the interests of homeowners, are considered to be among the most powerful in Washington.359 The first reason why their German counterparts were less powerful lies in the absence of strong complementarities between the economic interests of housing groups -- tax breaks stimulating the housing sector -- and the macroeconomic growth model. In Germany’s export-oriented growth model, economic arguments that suggest stimulating demand and consumption are inherently less powerful than in the American context. One housing interest group representative stressed that, while the German housing market is an important economic sector, it has few transmission effects to the wider economy:

There are grave macroeconomic consequences when house prices fall and loans

falter [in the United States]. Banks and financial markets are connected with that.

That is different in Germany because of the financing structure … It is rare to

finance with more than 80% … Even if we see house prices decline by 20%, then

this is buffered by equity, which will be reduced. But the lower value of the house

358 Author interview (phone), representative of GdW - Bundesverband deutscher Wohnungs- und Immobilienunternehmen, January 18, 2016. 359 Howard 1997; Birnbaum and Murray 1988; Hornstein 2005; McCabe 2016, ch. 6.

102 would still cover the mortgage loan on the house, so that banks do not have to be

concerned about this at all. 360

Even if the retrenchment of housing tax breaks were to result in falling home prices, it would be unlikely to result in negative transmission effect to the wider economy. These economic realities tremendously limit the influence of housing interest groups, as the elimination of subsidies would not produce strong and negative ripple effects for the economy.

The second reason why German housing groups were unable to defend the homeownership tax allowance lies in the structure of the country’s political economy of housing. While the American political economy of housing is based overwhelmingly on owner-occupied housing -- realtors benefit from increasing transactions, mortgage banks from extending credit, and homebuilders from construction -- the German political economy of housing offers a balance between homeownership and rental markets.361 With fewer transactions in a low-homeownership context, paired with conservative mortgage markets and strong rental economies, the German housing lobby is much more fragmented and, correspondingly, weaker than in the United States.362 In Germany, housing groups do not speak with a single voice, which compromised their influence during the reform process. In sum, interest groups do not always get their way, especially if they do not have the powerful economic arguments of reinforcing the country’s national growth model. To the contrary, retrenching the tax subsidy was seen as a way to reinvigorate the country’s export model through structural economic reforms.

360 Author interview (phone), representative of Haus & Grund (H+G), January 14, 2016. My translation. 361 The German mortgage banks (Pfandbriefbanken) and savings banks (Sparkassen), for instance, are not necessarily specialized in owner-occupied financing, but have traditionally financed rental housing. 362 See Egner 2004.

103 In general, the macroeconomic frictions between the German export-led growth model and homeownership tax breaks to stimulate consumption allowed for political battles around the tax break that, unlike in the United States, were most notably not about macroeconomic demand and consumption.363 Instead, policymakers debated and reformed the tax break in pursuit of their preferences with regard to regional, redistributive, and familial views. As a CDU Bundestag member stated with regard to the homeownership tax allowance:

In Germany, we don’t have demand-side orientation in economic policy. Instead,

we emphasize the supply-side … That’s why I don’t share the American view of

stimulating the economy as a cure for an itch.364

Homeownership tax breaks had many functions and goals, but stimulating the economy was not one of them. To the contrary, the center-left criticized its price-inflating effects on the overall housing market. Unlike in the United States, rising house prices are not celebrated across the political spectrum, given the macroeconomic differences of consumption-led and export-oriented economies. The tax break was then eliminated as part of structural economic, supply-side reforms to enhance efficiency in the wider economy.

The elimination of the subsidy was a significant political blow for the center-right policy coalition, which has not been able to reinstate tax subsidies for homeowners in subsequent policy episodes. While the grand coalition (CDU-SPD, 2005-2009) adopted a subsidized homeownership pension savings scheme in 2008, as agreed upon in the coalition contract with the SPD, the measure is moderate in size, amounting to merely EUR880

363 In interviews with five members of the Bundestag (CDU and SPD) involved in the negotiations, none of them considered macroeconomic concerns, such as housing demand and consumption, as important elements of the discussion. 364 Author interview, Bundestag member I (CDU). Berlin, 22 June, 2015.

104 million per year.365 The subsidy is integrated in the country’s government-supported private pension scheme (i.e., Riester Rente), which now includes certified savings schemes in building societies that have to be used to finance an owner-occupied home. 366 The number of beneficiaries has since increased to 1.7 million individuals in 2016 (out of 16 million total Riester beneficiaries) and is expected to amount to EUR900m per year once the program is rolled out completely. The subsidy scheme is rather complicated -- it includes an annual direct subsidy of EUR154 (more for savers with children) on their savings scheme and a moderate tax deduction of EUR2,100.367 While the instrument is related to homeownership, it is, strictly speaking, not a housing policy tool, but instead one to build pensions and wealth.

The second Merkel government (CDU-FDP, 2009-2013) discussed the reintroduction of homeownership tax breaks in a lighter, “calibrated form” in 2013 just before the federal elections that year. Yet, the Christian Democrats also acknowledged that the elimination of the homeownership tax allowance had left significant “skid marks” that would make it very difficult to pass legislation against center-left political forces in the

Bundesrat and fiscally conservative Christian Democrats who had prioritized balancing the budget in recent years. Moreover, re-introducing homeownership subsidies was especially difficult in the context of unfolding housing crises in the United States and Europe, when

Germany’s housing market was admired for its stability.368 The third Merkel government

365 See Gesetz zur verbesserten Einbeziehung der selbstgenutzten Wohnimmobilie in die geförderte Altersvorsorge (Eigenheimrentengesetz), 2008. 366 Kofner 2013; Mertens 2015. 367 While the Riester savings contributions and subsidies remain untaxed until the saver’s pension age, tax authorities collect taxes on the savings scheme when the saver is retired, a form of taxing imputed rental income of the saver’s home. 368 Frankfurter Allgemeine Zeitung, “Ramsauer will Eigenheimzulage wieder einführen,” (26 Feburary 2013).

105 (CDU-SPD, 2013-2017), again, discussed the adoption of homeownership tax breaks for families with children and for those in increasingly expensive urban areas just prior to the

Bundestag election of 2017.369 While none of these discussions materialized in formal legislative procedures -- they were dismissed at the party-level and might therefore be best characterized as campaign talk -- it also shows that the preferences of the competing policy coalitions continue to clash in political debates.

In sum, the growing rift between the country’s export-oriented growth model and the homeownership tax allowance made the tax break vulnerable to reform. Center-right political forces initially expanded government support for the housing sector as a response to the housing challenges posed by reunification. Yet, the homeownership tax allowance came under intense fire from reinvigorated center-left political forces opposing the tax break, as it reinforced housing imbalances between East and West Germany (i.e., vacancies in the East and shortages in the West), strained the country’s budget, widened wealth differences between the old and new federal states, and contributed to urban sprawl. The reform of homeownership subsidies was then part of larger structural economic reforms to eliminate tax distortions from the German economy, promote labor market mobility, and revive the export-oriented growth model. With the retrenchment of the homeownership tax allowance, Germany adopted a market-based homeownership tax model.370

369 Süddeutsche Zeitung, “Union will Eigenheimzulage in Teilen aufleben lassen” (31 October 2016). 370 Please note that German homeowners are exempt from paying a tax on the gains on the sale of homes if they have owned their homes for at least three years before selling them. However, there are no official statistics available for this tax subsidy. It is fair to assume that, given stagnant house prices in recent decades and fewer transactions than in the United States, the tax break would not have been a major item in the tax code.

106 Conclusion

This chapter has investigated the politics of the single largest tax subsidy in postwar

Germany -- the homeownership tax allowance. The political rise of the state-based homeownership tax model from the 1940s until 1970 can be explained by the dominance of the center-right political bloc and its drive of creating a nation of homeowners. Yet, the growing mismatch between the German export-oriented growth model and homeownership tax breaks made the latter vulnerable to reform down the road. As political parties across the spectrum agreed that these policies are ill-suited strategies to promote economic growth, they instead prioritized family, wealth, regional, or redistributive aspects when debating the homeownership tax breaks. When policymaking power shifted towards the left after reunification, the subsidy came under intense fire for its inequity, costliness, and regional effects. In the early 2000s, their efforts were rewarded with the removal of the tax allowance -- which created a market-based homeownership tax model -- as part of larger structural economic reforms and austerity measures to boost labor mobility and export competitiveness.

This chapter makes two contributions to the comparative political economy literature -- one empirical and another theoretical. First, the common wisdom is that

German policymakers have predominantly provided government support for the rental market, while neglecting homeownership markets.371 Contrary to this popular belief, however, homeowners in Germany did receive sizable tax breaks from the late 1940s until the 2000s. For decades, conservative policymakers have tried to create a nation of homeowners -- but have struggled to do so. The empirical contribution is to demystify these

371 Kofner 2014; Voigtländer 2009.

107 notions about the German political economy and housing market by tracing the political evolution of the homeownership tax allowance. Second, while Germany is not necessarily known for its hidden welfare state, some of the country’s largest social programs were extended through the tax code. In Germany’s nation of renters, the homeownership tax allowance has been the largest subsidy in tax code. By delving into the politics of the homeownership tax allowance, the chapter contributes to an emerging body of work on the fiscal welfare state in Europe that goes beyond traditional social expenditure programs.

Tax expenditure for homeowners supports private housing markets in providing human welfare, an important but understudied topic in the political economy literature.

108 Chapter 3: Third-Rail Politics: Homeownership Tax Policy in the United States,

1910s-2010s

Introduction

Tax breaks for homeowners are some of the largest and most “sacred” items in the U.S. tax code. The most prominent of these housing tax breaks is the mortgage interest deduction

(MID), one of the oldest national housing programs in the country that dodged virtually every major tax reform in the past one hundred years. While it started as an “accidental” deduction in the early twentieth century372 -- not purposefully designed to subsidize mortgages -- it has grown into the fifth-largest tax break in the United States, amounting to USD59bn in 2016.373 “The sun will go away before it does” noted then House

Representative Barney Frank (D-MA) in reference to the persistence of the MID.374 How could an accidental tax break become one of the largest social programs in the United

States, a third-rail that policymakers are afraid to touch?

Together with Social Security and Medicare, tax spending on homeowners has become a key pillar of the holy trinity of the American welfare state.375 Yet, unlike

Medicare or Social Security, tax relief on homeowners is spent through the U.S. Treasury

Department’s Internal Revenue Service. The mortgage interest deduction is an itemized deduction in the U.S. tax code that allows homeowners to deduct the interest payments on their mortgages from their income (for mortgages up to one million dollars), which results

372 See Ventry (2010) for an excellent and detailed discussion of the MID’s history. 373 Source: Joint Committee on Taxation. 374 Quoted in: Jon Prior, “Barney Frank Says Mortgage Interest Tax Deduction Is Safe,” Housing Wire (March 31, 2011). 375 Howard 1997, 93.

109 in a lower tax bill376 -- a fiscal welfare program that significantly lowers the cost of mortgage debt. Unlike the German homeownership tax allowance (1949-2007), American homeowners can use the MID multiple times in their lifetimes and the deduction is not restricted to any number of years. In addition, homeowners may even use the deduction on interest paid on home equity loans taken out against their homes.377 In 2016, 40 million

U.S. households have claimed the MID, a share of roughly 20 percent of all households.378

It should come as no surprise, then, that the MID is popular among voters.379 As Glaeser and Shapiro note: “[t]o its supporters, the home mortgage interest deduction is the cornerstone of American society.”380 In other words, the subsidy represents the American

Dream of homeownership.

Yet, this narrative about the MID requires nuance, given the subsidy’s unequal distributional consequences and questionable effects on homeownership. First, the MID overwhelmingly benefits affluent over poor households. This is not only because renters, who tend to be poorer than homeowners, cannot claim the deduction. Even among homeowners, the MID disproportionately benefits the well-to-do. For instance, in 2016, two-thirds of U.S. households with more than USD125,000 in annual income claimed the

376 U.S. taxpayers have the option of either claiming the standard deduction (USD12,600 for a married couple in 2016) or itemize individual deductions, such as for mortgage interest payments. For most households, especially for low and moderate income households, the standard deduction is more sizable than itemizing deductions. Accordingly, roughly two-thirds of U.S. households use the standard deduction and only one- third itemizes deductions (i.e., 75 percent of those who itemize claim the mortgage interest deduction). In other words, high-income homeowners with sizable mortgages will have higher mortgage payments, allowing them to deduct an amount that exceeds the standard deduction, whereas lower income homeowners with smaller mortgages may be better off with the standard deduction. Also see Lu and Toder 2016. 377 Homeowners may deduct the interest paid on mortgages not exceeding USD1m and home equity loans not exceeding USD100,000. 378 Source: Tax Policy Center. 379 For example, a recent Gallup poll reckoned that roughly 60 percent of Americans are against the elimination of the deduction (if it served to reduce the federal deficit or lower overall tax rates). See Jeffrey Jones, “Americans Oppose Eliminating Income Tax Deductions,” Gallup.com (April 15, 2011). 380 Glaeser and Shapiro 2003, 38.

110 MID. But only 25 percent of households earning between USD50,000 and USD125,000 claimed the deduction, while 2.4 percent of household with less than USD50,000 did so.381

In expenditure terms, in 2012, households earning more than USD100,000 received

USD52.6bn in MID expenditure, while those earning less than USD100,000 received only

USD15.6bn.382 Similarly, the benefit is distributed unequally among regions, benefiting regions with high house prices, such as the metropolitan regions along the east and west coast.383 Second, tax breaks, such as the MID, violate the principle of tax neutrality and channel investments in some sectors over others -- a practice we should not expect in the

American liberal market economy.384 Were policymakers willing to accept these market- distorting effects as the price to pay for the social objective of increasing homeownership?

Economic research suggests that there is little evidence demonstrating a robust and positive association between the MID and homeownership.385 What economists found instead is a relatively robust relationship between the MID and higher amounts of household indebtedness and house prices.386 While increasing or retaining the MID tends to increase house prices and debt, its elimination would likely have the opposite effect. In sum, the subsidy does little to promote homeownership and overwhelmingly benefits the well-to- do.

381 Lu and Toder 2016, 21. 382 Fischer and Huang 2013, 3. Households with less than USD50,000 received only USD2.1bn. 383 Sinai and Gyourku 2004. 384 Hall and Soskice 2001; Poterba and Sinai 2008. 385 For the most prominent study that finds a positive correlation between tax policy and homeownership, see Rosen and Rosen (1980). Yet, Gruber, Jensen, and Kleven (2017) suggest that there is a robust zero effect of receiving the deduction on the choice of homeownership in Denmark. Most other research on the topic concurs with the latter camp: see Glaeser and Shapiro 2003; Sommer and Sullivan (unpublished ms.); Hilber and Turner 2014. 386 Gruber, Jensen, and Kleven 2017; Capozza, Green, and Hendershott 1996; Poterba 1984; Dunsky and Follain 2000; Sommer and Sullivan (unpublished ms.).

111 The comprehensive tax reforms of the past one hundred years have left the MID largely untouched. Scholars agree that the absence of reform has to do with the political dynamics surrounding the tax break, privileging the influence of strong constituencies, including interest groups,387 or cultural values.388 Yet, studies in political science have rarely dedicated a lengthy analysis on the MID.389 One notable exception is Christopher

Howard, who offers the most prominent explanation for the growth and persistence of the

MID, an account that emphasizes the very nature of the tax break.390 He argues that, until the mid-twentieth century, the slow growth of the accidental MID went largely unnoticed as part of the hidden welfare state,391 as the MID had automatically expanded as a result of increasing the tax base and the number of homeowners. Before policymakers knew it, the

MID had grown into a large social program that benefited millions of households by the

1960s. Only then did powerful housing interest groups start focusing on preventing retrenchment and maintaining the policy status quo. The growth of the tax break, along with growing lobby support, then made it more difficult for policymakers to reform the tax break over time.

While Howard’s account is persuasive in explaining the initial and little-noticed growth of the MID until the late 1950s, it is weaker in explaining its subsequent persistence.392 Specifically, Howard neglects the macroeconomic context in which the

387 McLure and Zodrow 1987; Birnbaum and Murray 1988; Hornstein 2005; McCabe 2016, ch. 6; Ventry 2010; Howard 1997. 388 Dreier and A. Schwartz 2014; Jackson 1985. 389 Outside political science, Ventry (2010) and Frederick (2013) offer very good descriptive accounts on how the MID evolved over time. 390 Howard 1997. 391 Until the 1960s, the U.S. Treasury had not officially reported the cost of the mortgage interest deduction, which, according to Howard, “reflected the invisibility of the program.” See Howard 1997, 95. 392 As Jake Haselswerdt (2014) convincingly shows, tax breaks are not immune to reform in the United States. To the contrary, he demonstrates that tax breaks with a narrow reach are often more vulnerable to reform than direct spending programs with a broader reach.

112 MID evolved. It is questionable whether the MID was still part of the hidden welfare state in the 1960s, when the U.S. Treasury started publishing the cost of the tax break in its annual reports and budgets. Howard is certainly correct in stressing the strong support from housing interest groups, which “are among the most powerful in Washington and cut across party lines.”393 But this begs the question as to what made these interest groups so powerful in the first place and why policymakers from both major parties developed a strong preference in favor of the MID. This chapter concurs with Howard’s focus on path dependence, but offers a different mechanism that produces it -- the tax break’s link to the wider economy. The meat of this chapter is therefore in the sections that detail the persistence of the MID since the early 1960s, especially the Tax Reform Act of 1986.

This chapter argues that the U.S. consumption-led growth model is central to explaining the policy stability of the mortgage interest deduction. When the deduction started to grow in size after WWII -- due to a broadened tax base and growing numbers of homeowners -- it blended in seamlessly with depression-era (i.e., FHA programs) and war- related mortgage guarantee programs (i.e., VA programs) that had already created deep interlinkages with the consumption-led growth model. These macroeconomic linkages between the MID and the larger growth model helped shape a policy consensus among policymakers of all stripes, promoting the MID as a core policy tool to stimulate housing credit, house prices, and consumption. Concomitantly, these macroeconomic features empowered interest groups in pressuring policymakers who deviated from the consensus.

The result is that the MID has survived every major tax reform in the past one hundred

393 Howard 1997, 93.

113 years -- most notably, the last comprehensive tax reform in 1986.394 Neither the tax break’s inequitable and inefficient effects nor the recent housing crash of 2008-09 budged policymakers toward serious reform. The political history of the MID is an example par excellence of how deliberate policy inaction in an evolving tax and economic environment created one of the largest social programs in the United States.

This chapter traces the rise of the mortgage interest deduction as part of the country’s state-based homeownership model from the early twentieth century to the present. The tax break has its origins in the country’s first national income tax code of

1913. At that time, the MID was not a stand-alone provision designed to promote homeownership, but instead part of broader tax relief on any kind of indebtedness. For decades, until WWII, tax relief on mortgage interest remained insignificant, as the majority of Americans paid no income taxes and rented their homes. It was only in the late 1940s that the MID started to grow in size and importance on the heels of two key developments

-- broadening the tax base to finance war and increasing homeownership and mortgage debt. From the 1940s until the 1960s, the rise of the MID then blended in perfectly with existing housing programs that had stimulated the American growth model of consumption. It was since the early 1960s that policymakers of both parties, together with housing interest groups, discovered and supported the mortgage interest deduction as an important element of the country’s national growth model -- with the notable exception of a vocal group of technocrats at the U.S. Treasury, who viewed the tax break as inefficient and market-distorting. From the 1970s until the late 1980s, the U.S. Treasury pushed for

394 It should be noted that the MID is influenced by adjusting the amount of the standard deduction in the U.S. tax code, which can incentivize homebuyers to claim the standard deduction instead of the itemized mortgage deduction. The value of the MID is also influenced by general tax rates.

114 MID reform, but policymakers and interest groups ensured that the MID remained untouched during the Tax Reform Act of 1986. Policymakers feared the potential effects of falling house prices on mortgage liquidity, housing wealth, and consumption as well as the related public outrage and voter backlash.

The failure to reform the MID cemented the tax break’s status as the third rail of

U.S. politics in subsequent policy periods.395 Presidential administrations of all stripes then embraced the deduction as part of their respective ownership society programs to stimulate housing credit, asset-based welfare, and economic growth. After the 2008-09 housing crash, policymakers left the MID in place, trying to avoid hurting the vulnerable housing market and economy, painfully aware of the economic and political constraints imposed by the growth model.

The origins of the mortgage interest deduction, 1913-1940

Unlike other U.S. housing programs, the mortgage interest deduction was not designed to benefit homeowners or the home finance market. At the time of its establishment, in 1913, it was included in the tax code as part a provision that allowed taxpayers to deduct interest payments on “indebtedness.” The historical record demonstrates that boosting homeownership, mortgage credit, or house prices was neither a priority among policymakers nor interest groups. In the early twentieth century, the United States was still a nation of renters, with a homeownership rate of 46 percent in 1910.396 Concomitantly, the vast majority of ordinary people did not pay income tax. At the time, the progressive federal income tax code was primarily designed as a class tax on the rich, who had reaped

395 Bartlett 1996. 396 Source: U.S. Census Bureau.

115 the fruits of industrialization, and exempted middle-class households.397 In addition, the

U.S. housing finance market was still characterized by fragmented, short-term mortgage lending and slow growth in mortgage debt.398 Given this, tax relief on mortgage interest did very little to promote homeownership or housing at that time.

The Revenue Act of 1913, which established the federal income tax code, included a provision on deducting interest paid on “indebtedness.” The act specified that taxpayers may deduct “all interest paid within the year by a taxable person on indebtedness.”399 This provision included interest paid on mortgage debt, which was later known as the mortgage interest deduction. Yet, contrary to policy periods in the second half of the twentieth century, the Congressional Record does not indicate that policymakers intended to boost homeownership or housing when creating the tax break.400 Similarly, Congressional hearings do not reveal any interest group pressure on including the tax break and its mortgage component.401 This is not surprising, given that the tax code only subjected roughly two percent of all U.S. households to income taxes.402 As Dennis Ventry argues,

“the better interpretation for why legislators included the deduction in the original Revenue

Act is that it was extraordinarily difficult, both practically and administratively, to differentiate between the personal and profit-seeking expenses of family-run farms, small

397 Morgan and Prasad 2009. 398 In 1913, outstanding (non-farm) residential mortgage debt was only around USD5bn, while that number skyrocketed to USD27bn by 1929. Source: Historical Statistics of the United States (1970). 399 See Tariff of 1913. Also see Green and Wachter 2005. 400 Also see Ventry 2010; Frederick 2013. 401 Influential housing groups, such as the National Association of Real Estate Boards (NAREB), did not prepare testimonies before Congress. The historical archives of the Washington Post and New York Times also do not indicate any significant discussion about tax relief on mortgage interest or indebtedness more generally. 402 Morgan and Prasad 2009. In 1916, the number of taxable individual income returns was only around 300,000, with a top tax rate of 15 percent for the richest Americans and 2 percent for the lowest-income households (see figure 3.1). Sources: Historical Statistics of the United States (1970).

116 businesses, and individual proprietors.”403 In other words, those subject to income taxes could claim interest paid on indebtedness as a business expense. In sum, there is little evidence that the mortgage interest deduction was purposefully designed to support homeownership.

In the three decades following its creation, the tax and economic environment around the MID started to change, but the MID itself remained irrelevant. First, the First

World War was an important event that cemented the progressive nature of the U.S. tax code, which led to increasing tax rates and broadening the tax base in order to finance the war.404 Yet, the wartime tax code was still a “class tax” on the rich that exempted many middle-income households.405 Moreover, as the war ended, policymakers brought tax rates down again in the 1920s.406 The mortgage interest deduction could still only be claimed by a small portion of the population. While the U.S. tax code had not yet been reformed into a “mass tax,” this early policy episode laid the foundation for future wartime taxation during the Second World War, when the class tax was transformed into a mass tax. The second development was the rise of the housing market and housing finance in the 1920s.407

The U.S. housing market boomed in the 1920s, with strong construction, rising property values by 38 percent, and a mortgage credit volume that tripled from USD9bn to

403 Ventry 2010, 241; Kahn 1960. However, others have countered that business expenses, including interest payment on debt, could have been deducted even without these broad provisions. See Frederick 2013, 48-49. 404 Kahn 1960; Morgan and Prasad 2009. The Congressional discussions around the Revenue Acts of 1916 and 1918 neither mentioned the mortgage interest deduction nor included housing interest groups in the testimonies. 405 At the end of the war, in 1920, the top tax rate climbed to 73% (and 4% for the lowest income bracket), while the number of income tax returns increased to roughly 6 million. Sources: Historical Statistics of the United States (1970). 406 For instance, housing interest groups have lobbied for the exemption of capital gains on the sale of homes from income taxation during discussions on the Revenue Act of 1924, without mentioning the mortgage interest deduction in their testimonies before Congress. See, for instance, Frederick Shipman, “Brief of the National Association of Real Estate Boards: To the honorable Chairman and Members of the Finance Committee of the United States Senate,” Hearings, Senate Finance Committee, March 7 -April 8, 1924 407 White, Snowden, and Fishback 2014

117 USD30bn.408 Yet, despite the growth in mortgage credit, tax rates were still relatively low and few ordinary people paid taxes in the 1920s, which rendered the MID insignificant.409

The Great Depression then laid the foundation for national housing programs that established a strong national political economy of home finance,410 which would go on to influence the mortgage interest deduction in later policy periods.411 The depression initially ended the housing boom of the 1920s and produced a massive decline in home values and construction, which led to foreclosure waves.412 The Hoover administration increased tax rates again as part of the Revenue Act of 1932 (i.e., top rate of 64 percent) in order to counter the dramatic losses in government revenue on the heels of plummeting economic activity and wages (see figure 3.1).413

408 Snowden 2010; White 2014; Field 2014. The construction boom reached its peak in 1925, with almost one million new housing units produced that year. 409 The top tax rate dropped again to 25% in 1925 (see figure 3.1). 410 Green and Wachter 2005. 411 Howard 1997; Ventry 2010; Frederick 2013. 412 Hornstein 2005. 413 Congressional debates on housing have predominantly focused on property taxes and the taxation of real estate transactions. See, for instance, L.T. Stevenson, President, National Real Estate Boards, Hearing, U.S. Senate Finance Committee, April 6-21, 1932.

118 Figure 3.1: U.S. individual income tax rates, 1913-2015.414

100 90 80 70 60 50 40 30 20 10 0 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013

higher bound lower bound

Yet, these tax measures did not do much to revive the economy and even resulted in further declining tax revenues, as they squeezed most ordinary people in hard times.415 More fundamentally, the Hoover and Roosevelt administrations adopted large-scale housing programs to stimulate mortgage credit, demand, and consumption in the larger economy

(see chapter five). These policies created standardized long-term, fixed-rate, amortizing mortgages and established a national political economy of homeownership finance.416 In the 1930s, these housing finance policies contributed to reviving the U.S. housing market and economy from the Great Depression and laid the foundation for an economic boom starting in the 1940s.

414 Sources: U.S. Treasury; Internal Revenue Service; Federal Reserve. 415 The number of taxable income tax returns fell again to 1.7 million in 1933 and income tax revenues declined from USD1bn in 1929 to only USD370m in 1933. Source: Historical Statistics of the United States (1970). 416 Green and Wachter 2005.

119 In the early twentieth century, the MID remained an insignificant provision in the

U.S. tax code. While the majority of ordinary people did not pay income taxes, the political economy of housing finance was crippled by the Great Depression. Yet, attempts to both broaden the tax base and create a strong, national political economy of housing were already underway and laid the foundation for the tax break’s subsequent rise as a core social policy tool in the latter half of the century.

Growth and entrenchment, 1940s-1960s

From the 1940s until the 1960s, the mortgage interest deduction not only transformed into an important item in the tax code but also developed strong ties with the country’s growth model. While the MID was still hardly mentioned by policymakers and interest groups at that time -- preoccupied with other housing tax breaks, such as the capital gains exemption

-- Treasury officials started to cast the spotlight on the tax break by the late 1950s. One key development in bringing about the slow growth of the MID was increasing tax rates and the number of taxpaying households during WWII. The second development was the booming U.S. economy and surging housing markets after the tumultuous 1930s, which entailed rising homeownership and mortgage debt from the 1940s until the late 1960s. As the depression-era and war-related housing finance policies (i.e., FHA and VA programs) helped create a strong national political economy of housing and deep interlinkages with the booming U.S. consumption-led growth model, the homeownership rate skyrocketed from 44 percent in 1940 to 62 percent in 1960.417 The corresponding rise of the MID in postwar America -- given the increasing numbers of mortgaged households subject to

417 Source: U.S. Census Bureau.

120 income taxes – seamlessly tied in with the pre-existing set of housing finance policies in reinforcing the American growth model of consumption. As subsidizing homeownership finance had already been an explicit policy goal with strong bipartisan support since the

1930s -- itself shaped by the fresh memory of the housing crash during the Great

Depression -- the rise of the MID offered the best of all worlds for policymakers: it did not require any policy action,418 and more importantly, supported housing growth and consumption. This section shows that it was in the early 1960s that policymakers and interest groups discovered the mortgage interest deduction as an important element of the country’s national growth model.

The two decades after the Great Depression were characterized by some key developments that enabled the growth of the mortgage interest deduction: wartime taxation, economic growth, and a booming housing market. The first development was increasing the tax rate in order to finance WWII (see figure 3.1). It is widely known that the Roosevelt administration increased tax rates and broadened the tax base to help finance

WWII, a transformation from “class” to “mass tax.” At the same time, the Roosevelt administration introduced the standard deduction, so as to reduce the administrative burden of processing income tax returns and alleviate some of the tax burden. In Howard’s words,

“no home owner would pay more taxes and most would pay less, so cutting the program in this way did not seem to penalize home owners.”419 Yet, in contrast to itemized deductions, which had no fixed limit on interest deductions, the standard deduction was fixed and not inflation-adjusted. It was hence unable to stop the growth of itemized deductions. Once the war ended, tax rates were reduced again, but the mass-based nature of the tax code

418 Howard 1997. 419 Howard 1997, 99.

121 remained.420 This transformation was a necessary condition for the growth of the MID, simply because more households were able to itemize deductions.

The second and related development was the booming U.S. economy and housing markets in the 1940s and 1950s. Economic historians concur that war-time production stimulated economic growth in the country and that “World War II got the economy out of the Great Depression.”421 Relatedly, the housing market grew dramatically in these decades. While the homeownership rate rose from 44 percent in 1940 to 62 percent in 1960, the volume of mortgage debt grew sevenfold from USD23bn in 1940 to USD161bn in

1960.422 Where earlier housing finance policies, especially FHA-insurance, have helped revitalize the U.S. economy, the GI bill’s housing finance programs contributed to housing growth in postwar America after the war-time economy ended.423 Together, these developments led to an increase in mortgaged households from 4.8 million in 1940 to 15.8 million in 1960, many of whom claimed the MID.424 The growth of the MID then seamlessly blended in with pre-existing housing finance policies in lowering the cost of mortgage debt, as homeowners could now benefit from multiple, reinforcing programs at the same time, all of which tended to stimulate housing credit, prices, and consumption.

Yet, until the early 1960s, the MID had still not become a major topic of political debate. Instead, policymakers and interest groups were concerned with the taxation of capital gains on the sale of homes. Housing groups viewed the capital gains tax on the sale

420 Ventry 2010. 421 Higgs 1992, 58. 422 Source: Historical Statistics of the United States (1970). 423 Fetter 2013; Mettler 2002. 424 Unfortunately, there are no precise estimates as to how many households have received the MID and how much it cost the U.S. Treasury. In 1964, 27 million households itemized deductions – a share of more than 40 percent of households -- which amounted to USD12bn in tax expenditure that year. Source: Historical Statistics of the United States (1970).

122 of homes as an unfair burden on homeowners, which would limit mobility in the labor market.425 There was widespread public support for this view. In an editorial, the

Washington Post endorsed the exemption of capital gains, which “would be in the public interest.”426 In 1951, NAREB’s decades-long call for exempting the capital gains on the sale of homes bore fruit, as the Revenue Act of 1951 excluded these capital gains from taxation if they were reinvested in a new home.427 From then on, the capital gains exclusion would develop into another major tax break supporting home finance next to the MID and the property tax deduction.

Given the growth of mortgage debt -- and the associated itemized deductions -- the

U.S. Treasury started criticizing the increasing number of households itemizing deductions, while those claiming the standard deduction decreased.428 Itemized deductions already cost the U.S. Treasury USD10bn in 1950 and USD35.3bn in 1960.429 Treasury officials also viewed the mortgage interest deduction as a violation of tax neutrality in the housing area, given the absence of taxing imputed rental income.430 Stanley Surrey,

President Kennedy’s assistant secretary for tax policy, was the most vocal critic of these tax breaks.431 Yet, when it comes to housing tax policy, the Treasury did not find many allies in Congress.

In the early 1960s, the U.S. Treasury launched its first small-scale attack on itemized deductions, including the MID. Without directly targeting the MID, the Kennedy

425 Herbert Nelsen, NAREB, “Hearing on Proposed Revisions of the Internal Revenue Code,” House Ways and Means Committee, July 1947. Also see, Calvin Snyder, NAREB, “Hearing on H.R. 4473,” U.S. Senate Finance Committee, July 1951. 426 Washington Post, “Relief for Home Buyers,” June 25, 1951. 427 Revenue Act of 1951. 428 Kahn 1960. 429 Source: IRS, Statistics of Income. 430 Kahn 1960. 431 Howard 1997; Ventry 2010.

123 Treasury developed a tax reform plan to limit the growth of itemized deductions.432 The

Treasury estimated that, in 1960, consumer interest deductions amounted to USD8bn.433

This was the first time that the future of the MID was seriously debated in Congress. The reform proposal intended to allow taxpayers to itemize deductions only if they exceeded five percent of their household income. The goal was to broaden the tax base by incentivizing households to claim the standard deduction and to bring down war-time tax rates, which would “hold[] back consumer demand, initiative, and investment” and constitute “the largest single barrier to full employment of our manpower and resources and to a higher rate of economic growth is the unrealistically heavy drag of Federal income taxes on private purchasing power, initiative and incentive.”434 Despite its willingness to limit the deduction, the administration still viewed homeownership support as a “desirable” policy goal.435

The reform plans regarding curbing the mortgage interest deduction were met with the opposition of housing interest groups and policymakers in Congress. In 1963, there was the first substantial discussion about the future of the mortgage interest deduction. In a

Congressional hearing, NAREB clearly articulated their policy preferences of maintaining the status quo:

MR. POLLAK. … As a real estate broker for approximately 37 years, I want to

assure the committee that the full deductibility of mortgage interest and the full

deductibility of real estate taxes are of major consideration to the purchaser of a

432 Tax Foundation, “Tax Reduction and Reform: A Summary of the President’s Tax Proposals,” February 11, 1963. 433 Douglas Dillon, Secretary of the Treasury, Hearing, House Ways and Means Committee, “President’s 1953 Tax Message,” January 1963. 434 John F. Kennedy, “Special Message to the Congress on Tax Reduction and Reform.” January 24, 1963. 435 Ibid.

124 home … We are fearful that any change in the tax laws which provides less than

full deductions will have an adverse effect on home-ownership … [Reform] will

absolutely slow the purchase of homes. When you slow the purchase of homes,

certainly you slow the construction of homes.436

Policymakers in Congress did not need much convincing and pointed to the proposal’s potential “injurious effect upon continued building of homes and buying of homes,” as pointed out by Representative Howard Baker (R-TN).437 The agreement on the issue could not have been any stronger, as evidenced by this short exchange between Baker and a realtor:

MR. BAKER. Don’t all of you gentlemen feel that this, in effect, non-deductibility

of interest on home mortgages … presents a very serious problem to continued

homeownership and home construction in this country?

[…]

MR. SHEEHAN [NAREB]. I think as you have so well put it, that this tax reduction

could be so far reaching that it could affect our economy not only within our

business, but in many other businesses, including the construction business and all

of the allied businesses that fit into construction.438

This demonstrates that, by the early 1960s, policymakers and interest groups viewed the mortgage interest deduction as an instrument to stimulate housing consumption, which would have transmission effects on the wider economy. Congress successfully blocked this

436 Daniel Sheehan, Maurice Pollak, and Edwin Kahn, NAREB, Hearing, House Ways and Means Committee, “The Tax Recommendations of the President Contained in His Message Transmitted to Congress,” January- February, 1963. 437 Hearing, House Ways and Means Committee, “The Tax Recommendations of the President Contained in His Message Transmitted to Congress,” January-February, 1963. 438 Ibid.

125 part of the Treasury proposal, which left the mortgage interest deduction in place.

Similarly, the Tax Reform Act of 1969, signed by President Nixon, did not touch the mortgage interest deduction, but it increased the standard deduction as proposed by the

U.S. Treasury.439

This was not (yet) the last word on reforming the mortgage interest deduction, as the Treasury continued its tax reform efforts. One way of attacking tax breaks, such as the mortgage interest deduction, was to calculate and publicize the precise amount of tax expenditures in government reports.440 The Treasury’s goal was to convince policymakers to treat tax expenditure similar to direct public expenditure. These efforts helped move the

MID from the “hidden” to the “visible” territory of the welfare state. Another way of attacking the MID -- albeit indirectly -- was to increase the standard deduction, which would incentivize fewer households to claim itemized deductions, simplify the tax code, and offer tax relief for the middle class. Yet, increasing the standard deduction is an imperfect solution for limiting itemized deductions. As the historical record demonstrates, the mortgage interest deduction has continued to grow despite increases in the standard deduction.

In sum, by the late 1960s, the MID had not only grown in size (i.e., USD2bn in

1968) -- visible to everyone in the Treasury’s tax expenditure reports441 -- but also found staunch supporters in Congress and housing interest groups. This is because policymakers discovered the MID as a major policy tool to stimulate the consumption-led economy,

439 The Congressional Record also does not reveal much discussion on the MID, with the notable exception of academic economists in Congressional hearings. 440 Howard 1997; Ventry 2010. 441 U.S. Treasury, Annual Report of the Secretary of the Treasury on the State of the Finances for the Fiscal Year Ended June 30, 1968 (Washington, D.C., Government Printing Office, 1969).

126 including the economic and political constraints of reforming the tax break. In addition, policymakers established the capital gains exclusion on the sale of homes, another far- reaching housing tax break. These early and failed attempts to reform the tax break set the stage for future tax reform efforts.

On the chopping block? The politics of tax reform, 1970s-1990s

The mortgage interest deduction faced its toughest tests during the comprehensive tax reform efforts during the 1970s and 1980s. In the 1970s, the calls for reforming the housing tax breaks increased among tax economists and the U.S. Treasury. These calls found some short-lived, high-level political support, such as then presidential candidate Jimmy Carter.

Yet, when suggesting MID reform as part of broader tax reform, Carter earned heavy criticism from across the political spectrum and, soon thereafter, declared the deduction safe. More fundamentally, the 1986 Tax Reform Act was the most important window of opportunity for reforming the deduction, as the reform’s main goal was to bring down tax rates in exchange for closing a number of loopholes.442 Just prior to the reform, President

Reagan announced that all tax deductions were up for discussion and tasked the U.S.

Treasury -- the strongest opponent to the MID in the U.S. political system -- to draft a report evaluating options for tax reform. Yet, while the Reagan administration and

Congress eliminated many tax deductions, such as those on interest paid on car loans or credit cards, they left in place all housing finance tax breaks, such as the MID, the property tax deduction, and the capital gains exclusion. Contrary to accounts that emphasize the role of interest groups,443 this sections shows that the deep interlinkages between the

442 Birnbaum and Murray 1988. 443 McLure and Zodrow, 1987; McLure 1986; Ventry 2010.

127 consumption-led growth model and the MID led the Reagan administration and Congress to keep the deduction. While public expenditure for public housing was slashed, the decision to retain the MID cemented the status of the MID as a third-rail issue in U.S. politics.

Tax reform remained an important topic of discussion in the 1970s, when U.S.

Treasury officials and tax economists kept targeting the MID. 444 These proposals found some prominent political support in then presidential candidate Jimmy Carter, who, at a

Boston presidential debate in February 1976, mentioned that: “in general, I would say, along with the elimination of other tax incentives, those [the MID and property tax deductions] would be among those that I would like to do away with.”445 As the elimination of these tax breaks would help bring down tax rates for middle class Americans, homeowners would still come out ahead. Carter’s remarks caused a storm of criticism across the political spectrum. Other Democratic presidential candidates, such as Senator

Henry Jackson (D-WA), attacked the proposal during the primaries, stating that this would constitute the “destruction of the working and middle-class American family.”446 Similarly,

President Ford attacked Carter’s plans in campaign events, stating that “[i]t is not an act of compassion to prevent a young couple from buying a home.”447 Carter’s remarks were an easy political target, as he deviated from the broad-based policy consensus that the MID promotes housing, growth, and middle class wealth.448 As a result, the Carter campaign

444 Surrey 1973. 445 William Chapman, “3 Rivals Attack Carter,” Washington Post, February 26, 1976. 446 Ibid. 447 Gerald Ford, “Remarks at the ‘Days of the Verdugos’ Festival in Glendale, California.,” October 8, 1976. 448 Newspapers at the time reported that presidential candidates attacked Carter, as the elimination of the MID would hurt the housing industry and the wealth of homeowners. See Tom Wicker, “Now It’s ‘Stop Carter,’” New York Times (March 5, 1976); Peter Milius, “Don’t Tax You, Don't Tax Me, Tax the Fellow Behind the Tree,” Washington Post (March 15, 1976).

128 quickly toned down its MID reform plans and, when sworn in as President in 1977, he declared the MID safe. In the words of Carter’s assistant secretary of the Treasury,

Lawrence Woodworth: “Don’t expect to see us remove the mortgage interest deduction.”449

Accordingly, Senator Edward Kennedy’s (D-MA) proposal to replace the mortgage interest deduction with a tax credit for homeowners -- a more equitable tax break than the

MID that had aided “the richest families” 450 -- did not receive the backing of the White

House.451 During his time in office, Carter did not pursue major tax reforms and the smaller revenue acts did not include changes to the MID.452

The economic problems of the late 1970s and early 1980s contributed to rising deficits and debt, which elevated the issue of comprehensive tax reform on top of the political agenda. When President Reagan started his reelection campaign in 1984, he tasked the Treasury to come up with a proposal to reform the tax code. In his State of the Union address that year, he called for an “historic reform” that would reduce tax rates, close loopholes, broaden the tax base, and bring down the growing deficit.453 During the speech, he tasked the U.S. Treasury with drafting a report to be released just after the election.

According to a former Treasury official, the Treasury itself considered the report to be a campaign strategy:

So you have this request from the President to do the study. But it was largely a

request -- despite what people say ex post -- to do just another study. Well, we will

449 Washington Post, “Mortgage Tax Break Said Safe,” March 25, 1977. 450 Edward Kennedy, “The Path to Fundamental Tax Reform,” July 1, 1977. 451 In a memorandum to the President, White House staffers noted that it would “[p]robably be better to encourage people to move away from itemizing altogether” by proposing a “floor for all itemized deductions.” See White House, “Memorandum for the President: Assessment of Senator Kenney’s Tax Reform Package (prepared at you request),” July 14, 1977. 452 Ventry 2010. 453 Ronald Reagan. “Address Before a Joint Session of the Congress on the State of the Union,” January 25, 1984.

129 go study it! So a lot of people internally said: ‘let’s just not do much or give him a

three page summary.’ But I was flattered and said that this was an opportunity to

put on paper some really comprehensive thinking about what’s going on … So to a

large extent, the story was that, essentially, the study was a way to defer the tax

issue until after the election. No one necessarily expects anything to come out of

the study … The President and the White House decided that they didn’t really

want to know what was going on in the Treasury, because they didn’t want to be in

a state of denial. This is a campaign, so part of the reason for pushing it in the State

of the Union was to take the tax issue out of the presidential race.454

Accordingly, the Treasury started drafting a report -- known as Treasury I – which would become 700-page, two-volume tax reform plan.455

However, Reagan’s strategy to defer the issue until after the election failed and created rumors. Interest groups grew increasingly concerned about the future of the mortgage interest deduction. At a roundtable event with the housing industry in Texas, a panelist asked President Reagan whether “increased taxation on homeownership is being considered, such as doing away with interest deductibility on home mortgages.” Reagan responded -- indirectly and vaguely -- that under some circumstances even the mortgage- interest deduction could be reformed:

Some of the things in the tax that you're talking about -- deduction of interest on

home mortgages and all -- I have told them I want them to look in the area of

simplification at everything, but study everything that can be done. Now, would

there be any harm if -- and this is theoretical; I don't know anything that so far has

454 Author interview, former Treasury official. Washington, D.C., July 9, 2014. 455 U.S. Treasury, Tax Reform for Fairness, Simplicity and Economic Growth, November 1984.

130 -- that we’re engaged in in the study -- but if we could have a tax simplification that

was so constructed that you could then actually reduce the individual’s rates

because of the simplification of the tax structure, and if that included such things

as eliminating some things that today are deductibles, would that not resolve the

problem, if we had an entirely different type of tax structure with a quite low rate?456

Yet, soon thereafter, he felt the need to clarify his stance on the mortgage interest deduction in front of the National Association of Realtors (NAR). He stated that:

I know some of you’ve heard questions raised about whether there might be

some plan to do away with the home mortgage interest deduction, which has

played such an important role in helping Americans fulfill their dream of

homeownership. I'm afraid that story was just another example of someone

trying to read into my remarks things that weren't there. At that time, I was

trying to emphasize that the Treasury Department’s study of ways to simplify

and reform the tax code, which I consider a real priority, is supposed to look

at every aspect of the tax structure. However, in saying that, I also stressed

that I strongly agreed with the home mortgage interest deduction, which is so

vital to millions of hard-working Americans. And in case there's still any

doubt, I want you to know we will preserve that part of the American dream.

I could’ve said that first and saved you listening to a lot of speech, couldn’t I?

[Laughter]457

456 Ronald Reagan, “Remarks During a Roundtable Discussion with Housing Industry Representatives,” Arlington, Texas, April 12, 1984. 457 Ronald Reagan, “Remarks at the Midyear Meeting of the National Association of Realtors,” May 10, 1984. Interestingly, the archival record shows that this passage on the mortgage interest deduction was not part of Reagan’s original speech, but only inserted later. A person familiar with the speech draft mentioned that the NAR convention was a good platform to clarify Reagan’s tax policy preference on the mortgage

131 With this remark, Reagan effectively eliminated the discussion on the MID during the reform process.458 It is also notable that policymakers and interest groups often invoke the powerful narrative of the American dream together with emphasizing the MID’s economic importance, which further strengthens their case for supporting the MID.459 The remark upset Treasury officials, whom Reagan tasked with designing a technocratic reform proposal that was neutral in terms of revenue, investment, and distribution.460 As Charles

McLure, a key Treasury official at that time, and George Zodrow lamented: “[t]his promise guaranteed that the so-called ‘playing field’ would not be level.”461 Much to the dismay of the U.S. Treasury, which had developed plans to cut the MID, it was forced to retain the deduction as part of its Treasury I proposal.462 Reagan’s own tax reform plan of 1985, partly based on Treasury I, then retained the MID.463

Was it the power of housing interest groups that led Reagan to declare the mortgage interest deduction off limits? This might be a reasonable assumption given that Reagan clarified his stance of the deduction during a speech in front of the realtors.464 It is also true that these interest groups exerted pressure on Reagan. Yet, there is little evidence -- in the

Congressional Record, archival presidential files, or interviews with White House officials

-- that the Reagan administration planned on eliminating or significantly reducing the MID,

interest deduction. See White House, speech draft, “Presidential Remarks: Address National Association of Realtors Convention,” May 9, 1984. 458 A White House memorandum said that the purpose of the speech was to “share Your [the President’s] views on economic recovery and to recognize the contributions of the real estate industry… to it.” See White House, “Meeting With National Association of Realtors,” May 9, 1984. 459 Jackson 1985, 1980. 460 Birnbaum and Murray 1988, 246. 461 McLure and Zodrow 1987, 46. 462 The report reads: “The home mortgage interest deduction is retained for a taxpayer’s principal residence.” See U.S. Treasury, Tax Reform for Fairness, Simplicity and Economic Growth, November 1984. 463 When presenting the tax plan, Treasury Secretary James Baker noted that “[w]e propose retaining deductions for home mortgage interest.” See James Baker, Hearing, House Ways and Means Committee, May 30, 1985. 464 Birnbaum and Murray 1988; McLure and Zodrow, 1987; McLure 1986; Ventry 2010.

132 as suggested or feared by housing groups. Instead, Reagan had already formed a strong preference in favor of housing finance policy before the discussions on tax reform.

That Reagan declared the MID to be sacrosanct was instead due to deeper structural forces -- the MID’s linkage with the growth model. The historical evidence shows that the

Reagan administration viewed the MID as an effective way of stimulating the national economy and housing wealth. What is more, the housing market in the early 1980s had already been very unstable, plagued with illiquidity in mortgage markets, low housing starts, high interest rates (see figure 3.2), and declining residential investment.465

Figure 3.2: Effective federal funds rate and 30-year mortgage rates, 1954-2017.466

0 1954 1957 1959 1962 1964 1967 1970 1972 1975 1977 1980 1982 1985 1988 1990 1993 1995 1998 2001 2003 2006 2008 2011 2013 2016

FEDFUNDS MORTGAGE30US

From the very beginning, the administration’s housing agenda aimed at alleviating these housing problems -- not only in terms of taxation but also in the mortgage market. In 1982,

465 Green and Wachter 2005. 466 Sources: Federal Reserve; Freddie Mac.

133 Reagan’s housing commission already recommended “continuing the current tax deduction for mortgage interest and property taxes.” 467 Similarly, a White House memorandum stated that the administration explored “ways to achieve an effective ‘countercyclical stimulant’ for the economy: a program to get housing production going and create jobs.”468 The memorandum not only highlighted that the administration viewed housing as a stimulant for the wider economy, but also that reducing the cost of mortgage debt is key in producing economic growth. The memorandum reads further: “When rates fall, people start buying houses, which ‘stimulates’ the economy -- thus suggesting the ‘lead role’ of housing in a recovery.”469 For the mortgage interest deduction lowers the cost of mortgage debt, it was in line with these economic priorities. So why did Reagan say that everything in the tax code is subject to discussion? In the words of a senior Reagan White House official, “it was his sense that it [MID] would be discussed … But that didn’t mean that he would necessarily give in on something like that.”470 The broader Reagan kept the tax reform discussions, without a priori explicating sacred cows, the better his chances of avoiding

“that other interest groups might use the pressure of the election campaign to get the president to declare their tax breaks off limits.”471 The counterfactual might help underline this point. Even without interest group pressure, it is very likely that the MID would still have been declared off limits by the Reagan White House. In short, Reagan considered housing finance policy as an effective way to stimulate economic growth.

467 White House, Memorandum, “Report of the President’s Commission on Housing,” June 1, 1982. 468 White House, Memorandum, “HELP for Housing,” February 16, 1982. 469 Ibid. 470 Author interview, former White House official I. Washington, D.C., September 3, 2014. 471 Birnbaum and Murray 1988, 247.

134 Interviews with senior White House officials reveal that Reagan used the platform to clarify his policy preference on the matter. In an interview, a senior former White House official and close advisor to President Reagan underlines the deep interlinkages between the MID and the American economy:

We were in the process of just coming out of one of the worst economic crises that

the nation had faced up to that time. Part of this was the fact that home building and

home purchasing was an important part of the economic growth … And a part of

that economic growth had to do with something that is pretty fundamental to

conservative principles -- and that is allowing people to own their own homes, to

own their own property. So it was a dual purpose: one, out of fairness to the middle

class and, secondly, to preserve this idea of homeownership as a part of economic

growth.472

For the Reagan White House, and many other conservatives, the MID was no tax break like any other, but a powerful symbol that represented the national interest of promoting economic growth and conservative values of property ownership.473 The official also mentioned that the decision to retain the MID had little to do with interest group pressure:

The main driver was that the President wanted to protect something that was

important economically and for the middle class … With Ronald Reagan, I don’t

think the lobbyists had the final say. I think it was his own concepts of what was

the right thing to do.474

Another White House official at the time echoed this view and stated that:

472 Author interview, former White House official I. Washington, D.C., September 3, 2014. 473 See Béland and Wadden (2007) for a study on the nexus between American conservatism, social policy, and ownership. 474 Ibid.

135 There are certain deductions that are so central to the economy and, of course, to

people across the spectrum, so that we want to make sure to maintain them. I think

the mortgage deduction was considered one of those.475

This official added that:

You can’t throw out something like that [the MID] -- they didn't want to mess

around with the economy. The economy was so bad in 1982 and we worked really

hard to get this expansion moving. We didn’t want to do anything that would

unsettle people or destroy confidence, create instability in the market place and

uncertainty.476

The Reagan White House viewed the MID as part of the growth model and the direct influence of interest groups was limited, as they promoted what the administration wanted to promote in any event -- a strong housing market.

Similarly, Reagan was well aware that a broad-based coalition of policymakers of both parties in Congress strongly favored the mortgage interest deduction. Congressional hearings on the mortgage-interest deduction in the run-up to the Tax Reform Act of 1986 reveal the key economic and political concern for Congress -- falling house prices and housing wealth in individual districts and its effects on the wider economy -- when discussing potential ways of reforming the MID. Before Reagan declared the deduction off limits, several economists, and the U.S. Treasury indeed characterized the mortgage- interest deduction as expensive, ineffective, and inequitable.477 At the same time, however,

475 Author interview (phone), former White House official II. August 8, 2014. 476 Ibid. 477 In hearings before Congress, Martin Feldstein and Henry Aaron both made the case for reforming the MID. See House Ways and Means Committee, Hearings on “The President’s Tax Proposals to the Congress for Fairness, Growth, and Simplicity.” May-July, 1985.

136 most experts also noted that eliminating the deduction could lead to falling house prices, at least in the short term. In 1982, for instance, Robert Hall and Alvin Rabushka, two economists known for advocating a flat tax system, stated that eliminating the MID “would tend to draw wealth out of housing and into plant and equipment, which might reduce housing values temporarily.”478 That is not a very convincing argument before Congress, where short-term interests are often more important than long-term outcomes given tight electoral cycles. In addition, the lines of questioning by policymakers reveal a deep concern with boosting housing activity rather than neutral tax policy, such as Senator Baucus’ (D-

MO) questions for Robert Hall:

SENATOR BAUCUS. Let’s assume two different situations. Under one, we have

a flat tax … with no deductions. In the second case we have the same flat tax with

the home mortgage interest deduction like we have today. My question is under

which of those two alternatives would there be more housing?

MR. HALL. Under the second proposal you would be introducing a special break

for housing so that that would stimulate housing relative to the flat taxes … in a

quite inappropriate way. […]

SENATOR BAUCUS. Let’s take the proposal introduced by Senator Bradley. Let’s

take it as it is. An alternative proposal would be as is without the home mortgage

interest deduction. The question is, again, under which of the two alternatives

would there be more housing? […]

MR. HALL. The answer to that question is very straightforward. Namely, that the

housing industry would be in better shape in a system such as Senator Bradley is

478 Senate Finance Committee, Hearing on Flat-Rate Tax, September 30, 1982.

137 proposing where the deductibility of interest is retained as opposed to one where it

is eliminated just for mortgages.479

Technicalities aside, this exchange reflects the wish for a proposal that would -- at a very minimum -- not hurt the housing market and preferably lead to “more housing.” A report by the Joint Committee on Taxation to the Senate Finance Committee in 1982 warned that

“[e]liminating the deduction for mortgage interest would significantly increase the tax liability of most homeowners as well as reduce the market value of most homes.”480 This would not be popular among voters, because, in the words of a former Treasury official,

“you are going to do something to these homeowners. It’s identifying losers.”481 This is precisely what unites Congressional Republicans and Democrats on the issue: a shared interest in promoting house prices, wealth, and economic growth in their districts. In an interview, a former Republican member of the House of Representatives stated that there were very few incentives to reform the MID. This is because the deduction made buying homes cheaper, made your constituents happy, and is very important to the U.S. economy.482 The economic dimension of reforming the MID is key to understanding its persistence.

Unsurprisingly, the housing lobby supported the preservation of the MID.483 The

National Association of Home Builders, for instance, repeatedly stated that “[a]ny modification of the homeowner’s mortgage interest deduction would have a devastating

479 Senate Finance Committee, Hearing on Flat-Rate Tax, September 30, 1982. 480 Joint Committee on Taxation, “Analysis of Proposals Relating to Broadening the Base and Lowering the Rates of the Income Tax,” September 28-29, 1982. 481 Author interview, former Treasury official. Washington, D.C., July 9, 2014. 482 Author interview, former member of the House of Representatives (R). Berlin, August 6, 2015. 483 There were some low-income and multi-family housing groups, such as the National Multi Housing Council, which did not outright oppose the MID, but pointed toward its effects that would place multi-family rental housing at a competitive disadvantage.

138 effect on both the housing market and the economy. We believe very strongly that this provision of the tax code should remain.”484 A representative of the American Bankers

Association echoed that “[t]he tax code can be a useful mechanism for stimulating economic growth. This is clearly seen in the positive effects of the mortgage interest deduction.”485 But it is fair to say that the White House and Congress did not need much convincing. As the senior White House official stated, “the mortgage bankers, the realtors

… they all had, I think, good arguments and that’s why those arguments prevailed.”486 In other words, both policymakers and interest groups pursued the same objective -- a strong housing market that would promote growth in the wider economy.

The result was that the Tax Reform Act of 1986, which reduced tax rates and broadened the tax base, left in place the MID (including the deductibility of interest on home equity loans),487 the property tax deduction, and the capital gains exclusion. In the words of Representative Dick Gephart (D-MO), there was no “critical political mass” that could move proposals suggesting the elimination of the MID through Congress.488 Most policymakers in Congress, such as Senator Howard Heflin (D-AL), viewed the mortgage interest deduction as “important not only to those who cling to the American dream of owning their own homes but also to the real estate and homebuilding industries whose

484 Peter Herder, President, National Association of Home Builders, Hearing, Senate Finance Committee, August 7-9, 1984. 485 Gordon Martin, American Bankers Association, Hearing, House Banking, Finance, and Urban Affairs Committee, March-June, 1985. 486 Author interview, former White House official I. Washington, D.C., September 3, 2014. 487 While interest deductions on consumer loans were eliminated, homeowners could continue to take out home equity loans against their homes to finance consumer goods, such as cars and boats. The purpose of keeping this provision was intended to allow homeowners to finance education, medical expenses or home improvement. In 1987, Congress therefore limited the amount of eligible loans to USD100,000 under the Omnibus Budgetary Reconciliation Act, so as to prevent the financing of luxury goods (as well as limited the MID to mortgages up to one million dollars). 488 House Ways and Means Committee, Hearings on Fundamental Tax Reform, February-March, 1985.

139 success is vital to a healthy economy.”489 In other words, what is good for housing is good for the U.S. economy. This also sent a strong signal for future tax reformers -- that the MID is a third-rail issue in American politics. While the tax reform eliminated other interest deductions on credit cards and car loans, the MID stood its ground.

In sum, contrary to those who emphasize strong interest group pressure in explaining the entrenchment of the MID, this section has argued that the MID has become an integral part of the U.S. growth model. Policymakers of all stripes believed that the MID would stimulate house prices and housing wealth, mortgage consumption, and economic growth in their individual districts and the national economy, which led them to favor the preservation of the MID. While interest groups exerted pressure on policymakers, most politicians did not need much convincing to begin with. It should also be noted that the

Treasury Department celebrated its own victory in that the standard deduction was increased quite significantly.490 While the increase in the standard deduction indirectly limited the mortgage interest deduction, the success was short-lived and could not stop the

MID’s subsequent growth to one of the largest tax breaks and social programs in the United

States (see figure 3.3).

489 Congressional Record, Senate, June 10, 1986. 490 The standard deduction increased from USD3,760 in 1987 to USD5,000 in 1988 for married couples.

140 Figure 3.3: Estimated tax expenditure on mortgage interest deduction (in billion USD),

1974-2015.491

100 90 80 70 60 50 40 30 20 10 0

The third rail of U.S. politics, 1990s-2010s

After the Tax Reform Act of 1986, there was very little debate about reforming the mortgage interest deduction. On one hand, there simply has not been another comprehensive tax reform since 1986. On the other, the 1986 act has demonstrated that the

MID has become a third-rail issue in U.S. politics. More importantly, the MID’s perceived importance for the wider economy and the wealth of ordinary people has cemented policymakers’ preferences in favor of the MID and strengthened the voice of the housing lobby. The subsequent decades after the 1986 tax reform were characterized by an overwhelming policy consensus in favor of retaining the MID, with very few proposals to change the deduction. While tax experts, academics, low-income housing advocates, and

491 Sources: U.S. Treasury; Joint Committee on Taxation; own calculations.

141 Treasury officials continued to voice their concerns about the subsidy, policymakers of both parties and the housing interest groups defended the MID.492 The devastating 2008-

09 housing crisis entailed some discussions on how to reform the housing finance system, including the future of the MID. Yet, the crisis did little to break the belief that the MID stimulates housing, credit, and the wider economy.

While debated in Congress, the MID experienced very little legal changes in the

1990s. It is true that there were efforts to limit itemized deductions more generally in order to reduce the growing deficit. Yet, these measures were ineffective in taming the rise of the

MID. As Howard points out, the Omnibus Budget Reconciliation Act of 1990, for instance, included a little-noted and little-debated provision that limited all itemized deductions for high-income households, with the goal of consolidating the budget.493 Yet, this was a minor measure that neither altered the nature of the MID nor stopped its subsequent the growth of the MID as a result of growing mortgage debt and low interest rates (see figures 3.2, 3.3, and 3.4).

492 There were certainly some exceptions on both sides, such as deficit hawks or low-income housing advocates, but these were rather marginal voices. 493 Howard 1997, 111. Specifically, the bill reads that, for households exceeding USD100,000, the amount of the itemized deduction will be reduced by “3 percent of the excess of adjusted gross income over the applicable amount [100,000USD].”

142 Figure 3.4: U.S. mortgage debt outstanding (in million USD), 1984-2017.494

16,000,000

14,000,000

12,000,000

10,000,000

8,000,000

6,000,000

4,000,000

2,000,000

1984 1985 1986 1987 1989 1990 1991 1992 1994 1995 1996 1997 1999 2000 2001 2002 2004 2005 2006 2007 2009 2010 2011 2012 2014 2015 2016

A few years later, in the mid 1990s, reforming the MID was discussed as part of flat tax reform proposals -- without success. As supporting homeownership was one of the main policy priorities for the Clinton administration, the MID had little to fear. Presidential hopefuls, such as Steven Forbes (R), and some policymakers in the Republican-led

Congress revived the idea of a flat tax, simplified to the extent that all itemized deductions would be eliminated.495 Others suggested a less “pure” flat tax that would retain the MID and other key deductions, such as for charitable contributions.496 Yet, these proposals were quickly dismissed in Congress and opposed by President Clinton, who argued that they would “increase the deficit and increase taxes on all Americans with incomes of under

$200,000 a year.”497 Republicans in key Congressional positions also did not support the

494 Source: Federal Reserve. 495 Richard Armey’s (R-TX) proposal would have eliminated the MID. 496 Representatives Mark Souder (R-IN), Newt Gingrich (R-GA) as well as Senators Sam Nunn, (D-GA), Pete Domenici (R-NM), and Robert Dole (R-KA) proposed flat tax systems that would have retained the MID. 497 Bill Clinton, “The President’s News Conference,” April 18, 1995.

143 flat tax, such as Bill Archer (R-TX), the chair of the House Ways and Means Committee, and Bob Packwood (R-OR),498 the chair of the Senate Finance Committee.499 Policymakers in Congress were particularly concerned about the effect of a flat tax (without the MID) on housing values and economic activity. In the words of Representative Michael Patrick

Flanagan (R-IL):

Real estate and housing comprise the engine that drives America’s economy …

Eliminating, or further limiting, within the current Federal Tax Code, the home

mortgage interest deduction will create a likelihood of a regional or national

housing recession.500

Similarly, the housing lobby went on the barricades and labeled flat-tax reformers, such as

Forbes, “Famous American Homewreckers,” 501 as these reforms would lead to falling housing demand and prices and, consequently, plummeting economic activity.502 A representative of the building industry stated that the trade’s core concern was that

“[e]liminating the mortgage interest deduction would be devastating to property values and a homeowner’s equity in his or her home.”503 This broad-based coalition of policymakers and interest groups accordingly opposed the reform of the MID. The resulting Tax Relief

Act of 1997 not only left in place the MID but even expanded the limits of the capital gains

498 Packwood suggested capping the MID at USD250,000. 499 Maryann Haggerty, “A Battle Over Mortgage Interest Deduction,” New York Times, February 17, 1996. 500 Congressional Record, May 15, 1995. 501 Ibid. 502 The realtors commissioned a study, which reckoned that house prices would decrease by 15% as a result of a flat tax without the MID. See Sandra Brothers, realty representative, Hearing, House Committee on Small Business, February-April, 1996. 503 Bill Sherman, building industry representative, Hearing, House Committee on Small Business, February- April, 1996.

144 exclusion on the sale of homes.504 Tax support for homeowners was increased during the

Clinton years.

Much like the Clinton administration, President George W. Bush developed his own home ownership society program, which made large-scale attacks on the mortgage interest deduction unlikely. While the early Bush years were characterized by lowering tax rates (2001-2003), he made overhauling the tax system and social security key priorities for his second term. In 2005, he commissioned an advisory panel on federal tax reform to simplify the tax code and promote economic growth, “while recognizing the importance of homeownership and charity in American society.”505 But when the panel released its recommendations,506 it created a splash. Surprisingly, the panel criticized the MID and recommended its replacement with a tax credit amounting to 15 percent of mortgage interest paid on the primary residency.507 In principle, this could have been a more effective way of boosting homeownership, given that this tax credit was more equitable than the

MID. Yet, a member of the President’s panel, James Poterba, a well-known Harvard tax economist, acknowledged that the proposal, if implemented, would lead to a “downward effect on prices.”508 The housing groups immediately responded with their usual concerns about declining housing activity and prices.509 Congressional leaders, similarly, opposed the report. Katherine Harris (R-FL), for instance, stated that limiting the mortgage interest deduction would “discourage home ownership and stifle economic growth.”510 President

504 Avramenko and Boyd 2013. 505 George W. Bush, Executive Order 13369, January 7, 2005. 506 The President’s Advisory Panel on Federal Tax Reform, “Simple, Fair, and Pro-Growth,” November 2005. 507 Ibid. 508 Quoted in: Eduardo Porter and David Leonhardt, “Goodbye, My Sweet Deduction,” New York Times, November 3, 2005. 509 Ibid. 510 Quoted in: Ventry 2010, 277.

145 Bush himself declared the mortgage interest deduction safe a few weeks later during a question-and-answer session: “I don't think you have to worry about the mortgage deduction not being a part of the income tax law.”511 Subsequently, the MID was not subject of any meaningful tax discussions and contributed to further expanding mortgage debt during the housing boom of the early and mid-2000s (see figure 3.4).

Did the housing crash of 2008-09 provide an opening for reform? Some scholars have assigned partial blame to federal housing policies in causing the financial crisis.512 It is therefore not unreasonable to expect political debates about the future of one of the largest housing programs in the country -- the MID. Yet, the Obama administration, for the most part, retained the housing finance policy status quo, eschewing significant housing finance and tax reform. It considered limiting the mortgage-interest deduction in order to reduce the deficit, but only half-heartedly. In most of its annual budgets, the Obama administration included provisions that would curb the MID for the wealthiest households

(USD250,000 and up), but it did not use much political capital to push the matter.513 Interest groups, such as the Mortgage Bankers Association, stood ready to defend the MID, arguing that: “We need the housing market to recover -- particularly the home purchase market -- to recover for the broader U.S. economy to get back on track.”514 In an interview, a low- income housing advocate expanded that these interest groups “object to any changes

511 George W. Bush, “Remarks on the War on Terror and a Question-and-Answer Session in Tampa, Florida,” February 17, 2006. 512 Wallison 2015; Calomiris and Haber 2014. 513 The Obama administration appointed a commission to look into ways of reforming the tax code, which then recommended limiting the MID (e.g., capping mortgage amount to USD500,000 to principal residences only; eliminating interest deductions on home equity loans and second homes). See National Commission on Fiscal Responsibility and Reform, “The Moment of Truth,” December 2010. 514 Kerri Ann Panchuk, “MBA ready to defend mortgage interest deduction,” Housing Wire (October 10, 2012).

146 whatsoever, because they see any changes as slippery slopes to changing it altogether.”515

Suzanne Mettler argues that this is precisely what would explain the stability of the MID during the Obama years, given “the political power possessed by the organized groups that benefit from such provisions, starting with the real estate lobby.”516 At first glance, again, interest groups seem to be the driving force in explaining the stability of the MID.

Yet, once again, interest groups and a broad-based coalition in Congress were already part of the same alliance favoring the preservation of the MID. Congressional leaders across the political spectrum argued that limiting the deduction could hurt an already reeling housing market and did not need much convincing. Senator Ron Wyden

(D-OR), for instance, noted that taking away the deduction from the “housing sector [that] is so fragile” could result in serious economic harm.517 Only few policymakers in Congress were serious about curbing the MID,518 which stopped the Obama administration from pressing the issue any further.519 Shaun Donovan, then Secretary of Housing and Urban

Development, conceded that “[a]nything that would change the system substantially now

[could create] a real risk of stopping the momentum that we have in the housing market.”520

The MID was therefore not in any real danger of being eliminated or reformed during the

Obama years.521 Policymakers in Congress and housing groups were bound together by the

515 Author interview, NLIHC representative. Washington, D.C. August 5, 2014. 516 Mettler 2010, 811. 517 Quoted in: Benson and Tomkin 2010. 518 For instance, Representatives Keith Alison (D-MN) and Dave Camp (R-MI) proposed bills that included limiting the MID, while prominent politicians, such as Representative Nancy Pelosi (D-CA) and Senator Charles Schumer (D-NY), favored the MID. 519 The administration was already heavily criticized by economists across the political spectrum for not doing enough to reduce the mortgage debt of homeowners. See Mian and Sufi (2014). Also see Martin Feldstein “How to Stop the Drop in Home Value,” New York Times (October 12, 2011). 520 Brady Dennis, “Hands off homeowners’ tax break, HUD chief says,” Washington Post (September 28, 2012). 521 It remains to be seen whether reforming the mortgage interest deduction will be part of President Trump’s planned tax reform.

147 strong belief that supporting housing finance is a core policy tool for producing economic growth.

Conclusion

This chapter has traced the growth and persistence of the mortgage interest deduction -- a key pillar of America’s state-based homeownership model -- from the early twentieth century to the present. The common wisdom is that cultural values, interest groups, and constituency politics explain the rise and persistence of the MID. While illuminating, these views miss a key development in explaining the growth of the MID -- that the consumption- led growth model entrenched the MID. Policymakers have done little to curb the mortgage interest deduction -- and thereby promoted its rise by policy inaction -- as they viewed the

MID as a major policy tool to stimulate house prices, mortgage credit, and consumption in the larger economy. While the deduction was not originally created to support housing markets in the early twentieth century, a broad-based coalition of policymakers and interest groups soon discovered its economic potential of stimulating credit, house prices and wealth, and consumption. This broad-based coalition ensured that the mortgage interest deduction survived recent tax reforms, such as the Tax Reform Act of 1986, and the financial reforms after the housing crash of 2008-09. The cumulative result of these policy actions is the entrenchment of the MID as part of the national growth model.

This chapter offers important contributions to the comparative political economy literature. First, this chapter calls into question the often-held view that liberal market economies are governed by market relations without significant government intervention.522 This chapter has shown that government intervention in liberal market

522 Hall and Soskice 2001, 27-33.

148 economies can be constitutive elements in promoting economic growth. The primary insight is not that the U.S. government intervenes more frequently in the economy than we often assume, but that liberal market economies rely on government support in some of their key economic sectors producing economic growth. If one accepts the view that housing has been an important element of America’s postwar economic success, then it is also imperative to acknowledge the role of the U.S. government in promoting economic growth, as the private housing market and public policies are virtually inseparable. In short, the U.S. housing market, a core sector of the economy, is governed by a fusion of public and private mechanisms.

The second implication is that subsidizing mortgage debt through tax policy reinforces wealth inequality. The chapter has shown that tax relief on mortgage interest benefits predominantly affluent households with large mortgages, while households of modest means receive little in MID tax expenditure. Moreover, as tax benefits tend to increase house prices, the American dream of homeownership slips away for poorer households, facing unattainable mortgages and unaffordable rents in times of rising home prices, growing student debt, and stagnant wages. The homeownership gap between white and minority households -- who are, on average, less affluent than white households -- is still around 30 percent.523 Almost ten years after the onset of the housing crash in 2007, the homeownership rate dropped to 63 percent -- its lowest rate since the mid-1960s -- as middle- and working-class families continue to struggle to climb the property ladder. The mortgage interest deduction does little to either promote homeownership for these families

523 Source: U.S. Census Bureau.

149 or close existing wealth gaps. Instead, it is a program that should be considered “public housing for the rich.”524

524 Desmond, Matthew. “How Homeownership Became the Engine of American Inequality,” New York Times Magazine (May 9, 2017).

150 Chapter 4: Subsidizing Homeowners or Renters?

Social Housing Programs in Germany, 1950s-2010s

Introduction

When it comes to social housing in the United States, the story often told is one of utter failure. While the images of poor design, mismanagement, crime, and deterioration are often overdrawn, the public perception about low-income housing projects in the country is not flattering. 525 The common wisdom is that government-operated housing programs are inferior to private solutions of homeownership and renting, as the high cost of housing investments would be better managed by the private market. For these reasons, together with weak bases of political support, scholars of the welfare state have argued that social housing is the “wobbly” pillar of the welfare state vulnerable to policy retrenchment.526

While the German experience with social housing also ends with policy retrenchment, its journey could not be more different. The country’s social housing programs were landmark social policies that helped rebuild the country after WWII, producing around nine million affordable, high-quality homes until the end of the twentieth century, roughly one-third of all new homes during that time. A number of features set the

German experience apart from that of the United States. One factor is that, unlike in the

United States, the German programs were not limited to the poor, but also included the middle class.527 Another is that, from the very beginning, the programs were designed to create affordable rental housing and homeownership under one policy framework. Given

525 Goetz 2013. 526 Pierson 1994; Harloe 1995; Torgerson 1987. 527 Kemeny 1995.

151 that social housing is often associated with the rental sector, the focus on homeownership as part of social housing is particularly intriguing in the context of the German renter nation. Finally, the role of the German state in the provision of social housing was relatively limited when compared with its American counterpart, relying to a much greater degree on private entities.

Much like housing tax expenditure, social housing programs were key elements of

Germany’s state-based homeownership model. A defining feature of the country’s social housing programs was that they offered government support -- subsidized housing loans or interest-rate subsidies on loans -- for the private housing market to create affordable rental and owner-occupied housing. To no small extent, the German state delegated the task of providing affordable rental and owner-occupied housing to the private and non-profit sectors, such as private companies, housing associations, and ordinary people.528 At the same time, the German state preserved its influence over the housing area by setting the standards -- affordability and size, for instance -- that private actors had to follow. The public-private social housing model -- particularly the focus on homeownership as part of this model -- very well reflects the character of the country’s postwar Christian Democratic welfare state, where “privately governed, but publicly financed welfare state arrangements are the ideal,”529 with a preference for private solutions and ownership, self-responsibility, restoring status and wealth, and conservative family life.530

This chapter argues that the export-oriented growth model is key to explaining the rise and eventual fall of social housing policy. In the 1950s, the Adenauer government

528 Hacker 2002; Morgan and Campbell 2011. 529 van Kersbergen 1995, 190. 530 Kalyvas and van Kersbergen 2010; van Kersbergen 1995.

152 (CDU-FDP, 1949-1966) adopted social housing programs to overcome the large-scale housing shortages of 4.5 million homes, subsidizing rental and owner-occupied housing.

Initially, social housing policies produced temporary synergies with Germany’s postwar export-led growth model.531 While these policies were not considered growth strategies to stimulate demand and consumption, their goal was to increase the supply of housing in times of shortages, so as to keep down house prices and living costs and to avoid a wage- cost spiral that could threaten the country’s export-oriented growth model.532 There was agreement across the political spectrum that housing supply should be increased, but the political left and right disagreed over whether to prioritize funding for homeownership or rental housing.533 Much to the dismay of conservatives, the federal states -- tasked by the federal government to distribute social housing funds -- decided to predominantly subsidize rental markets, a strategy they considered superior in overcoming the severe postwar shortages (mostly found in cities) and providing affordable housing. The result was that, by 1970, the social housing programs supported an astonishing number of 5.8 million new homes (out of 11.4 million total new homes), but only one-quarter of these 5.8 million homes were owner-occupied. These developments cemented the country’s status as a nation of renters with low rates of homeownership.

Without major housing shortages to tackle, social housing policies decoupled from the country’s export-led growth model since the 1970s. In times of balanced housing markets, large-scale social housing policies tend to produce unwanted housing momentum

531 Wallich 1955. 532 Wertheimer 1958. For general evidence in economics on how higher house prices exert upward pressures on wages, see Bover, Muellbauer, and Murphy 1989; Muellbauer 1991. 533 Although the Social Democrats were not part of the federal government until the 1960s, they significantly shaped social housing legislation in the Bundestag in the 1950s. Many aspects included in the First and Second Housing Laws were based on Social Democratic proposals.

153 in the country’s export-led growth model that benefits from stability in the housing market.

These factors contributed to the slow erosion of these policies in the post-Keynesian era of welfare state retrenchment, when the country further increased its reliance on exports as a growth strategy.534 Within the parameters of policy retrenchment, the political struggles about subsidizing homeowners or renters continued. Yet, increasingly, the policies were seen as marginal tools to increase homeownership by the center-right, whereas the political left celebrated balanced housing markets within sight. While the reunification of the country led to a short-lived comeback of social housing, national housing supply shortages were soon considered a thing of the past, given broadly available affordable housing in the country in the late 1990s and early 2000s. The elimination of social housing policies by the grand coalition of Christian and Social Democrats in 2006 was then part of the country’s federalism reform and structural economic reform agenda, with the goal of reducing distortions in the economy, such as channeling investments into housing that could go to the productive export sector.

The fundamentals of social housing policy in Germany

For almost half a century, social housing had been an essential pillar of Germany’s postwar

Christian Democratic welfare state. The landmark Second Housing Law of 1956 had provided the legal foundation for housing policy until the turn of the twenty-first century.

A distinguishing feature of the German social housing programs was that they offered housing finance support to private entities -- companies, (non-profit) housing associations, and families -- in order to build affordable rental or owner-occupied housing. Through a

534 Baccaro and Pontusson 2016.

154 complicated web of programs, they offered subsidized loans or interest-rate subsidies on loans and, to a lesser degree, government guarantees on mortgages, so as to lower the cost of construction and mortgage debt financing.535 In return, beneficiaries had to comply with certain standards – the size of homes or affordability guidelines -- for as long as they received benefits. Private entities had to apply for funding but without a guarantee of receiving subsidies, even if they met the programs’ criteria.

Another important feature of social housing policy was that the federal states

(Länder) were responsible for administering and implementing social housing programs.

In the German federal system, the Länder often implement and co-finance federal government programs.536 In the case of social housing, federal state and local authorities were tasked with managing and approving funding applications for social housing.537

Moreover, although federal government spending on social housing programs had roughly matched that of the federal states in the early postwar years, the Länder’s funding started to exceed federal funds since the late 1950s.538 In 1964, for instance, the federal government provided only DM1bn in social housing funding, whereas the Länder provided the lion’s share of DM2.5bn.539 As Katzenstein observes, “the federal government is so dependent on the information and technical expertise provided by the states that it has

535 They also included the subsidized the sale of land and tax subsidies in order to assist private markets in creating new housing. While the programs were originally intended to create new housing, later on they also supported the modernization of existing homes. 536 Katzenstein 1987. 537 Scharpf et al. 1976. 538 In 1956, the federal government spent roughly DM700m on social housing, while the federal states contributed DM900m in the same year. Please note that federal spending includes the traditional social housing programs and special housing programs, such as for refugees from the Soviet Occupation Zone. Source: Bundesbaublatt. 539 There is tremendous variation, both between states and over time, as to how much individual states have spent on social housing. In 1998, for instance, some states merely matched the funding they received from the federal government, such as Saarland and Saxony-Anhalt; others spent fifty times the amount they received in federal funding that year, such as Hamburg. Source: Bundesbaublatt.

155 virtually no control over lower levels of government.”540 This made the federal states powerful actors in the social housing area.

As figure 4.1 demonstrates, the number of supported social housing units corresponded closely with developments in the larger housing market. In times of balanced housing markets -- a perceived equilibrium between housing demand and supply -- federal and state policymakers decreased the number of subsidized units; and, in times of housing shortages, the number of supported units increased. For instance, construction was booming in the early postwar years, with 3.5 million new homes from 1950 until 1956, roughly 70 percent of which received social housing subsidies. Because of strong population and economic growth, construction levels remained high until the mid-1970s

(roughly 500,000 to 700,000 units per year), but the share of subsidized units declined steadily to about one-third of total new units once the housing crisis was over, the private capital market recovered, and policymakers started celebrating a balanced housing market.

While reunification led to an initial increase of social housing activity in the country to modernize the East German housing market and to stimulate West German housing to cope with newcomers from the eastern parts, these programs also fueled an overheated eastern housing market. As a result, housing activity in the country leveled off at the turn of the century. In 2003, the social housing programs subsidized merely 32,000 homes (down from

162,000 in 1994), a share of 12 percent of all new homes.

540 Katzenstein 1987, 20.

156 Figure 4.1: Total construction and social housing units in Germany, 1950s-2000s.541

800,000

700,000

600,000

500,000

400,000

300,000 Housing units Housing

200,000

100,000

0 1950* 1955* 1960 1965 1970 1975 1980 1985 1990 1995 2000

Total construction Social hosuing units owner-occupied SH

541 Sources: own calculations; Bundesbaublatt; Statistisches Bundesamt. Note that the numbers for social housing are newly approved units per year. Data from 1950 until 1955 is based on Bundesbaublatt.

157 Figure 4.2: Share of subsidized owner-occupied homes as part of social housing

programs in Germany, 1950s-2000s.542

50 occupied units occupied - 40

20 % share of owner of share % 10

0 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003

Although the social housing programs prescribed funding priorities for homeowners since the mid-1950s, they disproportionately supported rental housing. Figure

4.2 shows that, with appropriate caveats about some differences between federal states, there were only three brief periods from 1950 until 2005, during which more social housing funds were distributed to homeowners than renters (from 1976 to 1981, from 1984 to 1988, and from 1999-2004).543 In these periods, the share of subsidized owner-occupied housing climbed above 50 percent, peaking at 73 percent in 2003, but overall social housing numbers were low during these years. The result of these funding decisions was that,

542 Sources: own calculations; Bundesbaublatt; Statistisches Bundesamt. 543 Some notable regional variation exists in that states, such as Baden-Württemberg and Rhineland- Palatinate, offered more subsidies to homeowners than other states.

158 between 1956 and 2000, social housing programs supported 4.5 million rental and only 2.5 million owner-occupied homes.544

The rise of social housing policy in postwar Germany, 1950-1970

This section traces the co-evolution of the German growth model and social housing policy from the 1950s to the present. On the national level, in the 1950s, the center-right Adenauer government adopted the country’s social housing programs to overcome the postwar housing supply shortages of 4.5 million homes. Despite the hegemonic power position of the Christian Democrats, social housing legislation combined the center-right policy preference of subsidizing homeowners with the center-left preference of subsidizing renters. The Adenauer government considered an exclusive focus on homeownership unfeasible in the context of severe housing shortages, so it instead specified funding priorities for homeowners in the allocation of social housing funds. However, on the subnational level, the federal states, in charge of distributing the social housing funds, disproportionately favored rental over owner-occupied units. For them, supporting rental housing proved more effective in offering affordable housing for large parts of the population, especially in the metropolitan regions of the country. The federal states also had longstanding ties with the local political economies of housing that were mostly specialized in building multi-family homes. In this period, the social housing programs helped build affordable housing markets that kept down the cost of living and thereby temporarily supported the German growth model in restraining wages and price developments in the wider economy. Yet, the policies were not themselves growth

544 Own calculations based on data retrieved from: Federal Statistics Office Germany; Bundesbaublatt.

159 strategies, as they did little to directly reinforce the export-oriented growth model. The absence of deeper macroeconomic linkages between the growth model and social housing policies then made these policies vulnerable to reform in later policy episodes, when the housing market stabilized and shortages were overcome.

Social housing programs produced temporary synergies with the early German export-led growth model. As discussed in chapter two, the postwar German growth model was based on exports, price stability, wage restraint, and restraining consumption.545 While social housing policies were not growth strategies to stimulate the economy, they were instead designed to increase the country’s housing supply and channel investment into the housing market. As Wertheimer argues, “[t]o the small extent that houses could be built without government aid, rentals greatly exceeded the paying-power of the average wage earner.”546 Yet, stable and low-cost housing was important for the success of the German growth model, as it would help alleviate pressures for higher wages and counter inflation.

In the words of Wertheimer, the social housing programs were effective in achieving price stability in the larger housing market:

... low-cost rents within the paying capacity of most wage earners became

extremely helpful in the fight against inflation … Low-cost rental housing became

a major factor in keeping down the cost of living and consequently pressures for

wage increases leading to the familiar wage-cost spirals.547

Yet, others have already cautioned that investments in housing do not reinforce the growth model in the long-term and would divert money away from more productive sectors of the

545 Wallich 1955; Kreile 1977; Herrigel 1996; Manow and Seils 2000. 546 Wertheimer 1958, 344. 547 Ibid., 341-344.

160 economy.548 The extra-ordinary circumstances of housing shortages made the social housing policies temporarily viable in the context of the export-oriented growth model.

While there was widespread agreement among the major political blocs that private and public investment was needed to overcome the severe housing shortages, they disagreed over the kind of housing supply -- rental units favored by the political left or owner-occupied units privileged by the right.549 The stakes were high, as these decisions would go on to shape the country’s housing market long into the future. While these political struggles between the left and right were important, the country’s federal states -- tasked with distributing social housing funds -- had significant autonomy in making funding decisions within the confines of social housing legislation. The remainder of this section delves into (i) the national, legislative battles between the political left and right and (ii) the conflicts of policy implementation between the federal government and the federal states.

The Adenauer government’s First Housing Law of 1950, the country’s first national social housing program, constituted a temporary compromise between the competing housing visions of the political left and right. The Law offered subsidies to private and public entities, such as housing associations, building companies, and ordinary people, in order to create or rebuild 1.8 million residential homes until 1956, including both rental and owner-occupied homes. The programs offered cheap or interest-free loans, government guarantees in the mortgage market,550 and the subsidized sale of land, all of which came with strings attached: landlords and homeowners had to comply with certain

548 Wallich 1955, 171. 549 Diefendorf 1993; Schulz 1994. 550 The government guarantees were set at DM100m.

161 housing standards in terms of size, affordability, and income requirements.551 In principle, funding applications for owner-occupied or multi-family homes received equal treatment.552 The Law was a compromise between the political left and right, because the

Adenauer government acknowledged that, despite its strong preference for homeownership, the severe housing crisis made an exclusive focus on homeownership unfeasible at that time. Struggling to put together its own proposal for the First Housing

Law, the center-right government borrowed elements of an earlier proposal by the Social

Democrats. The center-left proposal strongly emphasized the creation of affordable rental homes to overcome the housing crisis and was itself influenced by non-profit housing associations.553 The Social Democrats acknowledged that “we must by all means prevent that this guaranteed stimulus [Konjunkturguarantie] does not lead to inflating prices.”554

For the time being, the Adenauer government viewed that supporting both homeownership and renting on an equal footing would be the most pragmatic solution until the worst of the housing crisis was over.555 The Bundestag passed the First Housing Law unanimously, given that the bill represented the broad-based consensus of supporting both homeownership and rental markets.

551 While landlords had to offer below-market rent to tenants, homeowners needed to meet certain income criteria to be eligible for social housing funds. 552 See paragraph 16 of this law. 553 The SPD viewed creating homeownership as a secondary preference to their first preference of creating affordable rental housing; also see SPD, Entwurf eines Gesetzes über den Sozialen Wohnungsbau, 1949. 554 Erich Klabunde (SPD), 1st Bundestag, 53rd session, March 28, 1950. 555 In its capital market reform of 1952, the Adenauer government included provisions to increase the funding sources for the social housing programs. Specifically, it temporarily (until 1954) exempted the profits made from covered bonds as well as debt obligations issued by local communities – which would otherwise be subject to the capital gains tax -- if these bonds and obligations served the purpose of financing social housing. These measures were introduced to channel money into the country’s capital and housing finance market. The subsidy was eliminated in 1954, so as to pave the way for an “organic development” of the capital market and its interest rates. See Kapitalmarktförderungsgesetz 1952; Gesetz zur Neuordnung von Steuern 1954.

162 Very shortly thereafter, the Adenauer government was unnerved that the vast majority of social housing funding went to the rental sector, so it reformed the First

Housing Law in 1953.556 While the First Housing Law should have treated homeowner and rental applications equally, the share of homeowner funding was only around 16 percent in 1952.557 In a report, the Christian Democrats expressed grave concern about the First

Housing Law’s failure of boosting homeownership:

Basic elements of our political Weltanschauung were firmly established; however,

a number of demands remain open, which could not be incorporated into this law

… The CDU’s core demand of creating property for the population through

residential construction, with the goal of allowing uprooted people to become

settled again and providing them with the opportunity to own their home, could not

be realized in a way that would be desirable. The goal of housing politics must be

to create property for these uprooted people.558

This became all the more important in the context of the Cold War, when Christian

Democrats thought that “human dignity and existence are highly threatened by the collectivist tendencies of our time,” against which homeownership would be a bastion.559

The Adenauer government consequently reformed the First Housing Law in 1953, establishing social housing funding priorities for owner-occupied homes.560 While the

Adenauer government convinced the country’s upper house (Bundesrat), representing the

556 Gesetz zur Änderung und Ergänzung des Ersten Wohnungsbaugesetzes, 1953. 557 Source: Bundesbaublatt. 558 Brönner, J. Überblick über das Erste Wohnungsbaugesetz (date unknown, source: Bundestag Archive). Also see remarks by Lücke (CDU), who said that the First Housing law has failed in that it did not offer enough funding for homeowners. 1st German Bundestag, 45th Session, Bonn (21 January 1953). 559 The CDU’s 1953 party manifesto reads: “human dignity and existence are highly threatened by the collectivist tendencies of our time ... Therefore, we demand homeownership. We demand, where possible, the construction of owner-occupied homes.” Also see CDU, party program, 1965. 560 It also increased the social housing target of creating 1.8 homes to two million new homes by 1956.

163 federal states, to prioritize homeowners with an “appropriate” amount of funding, it was still up to the federal states to decide what exactly that entailed.561 In its original reform proposal, the Adenauer government had pushed for quotas to ensure that the majority of social housing funding would go to homeowners.562 Much to the dismay of the Adenauer government, the upper house opposed the provision,563 as the federal states wanted to preserve their autonomy in implementing housing programs without fixed quotas set by the federal government.564 They argued that city-states, such as Hamburg and Berlin, would naturally have different needs than states with abundant land.565 This was a setback for the political right in that they could only inch the policy equilibrium toward homeowners, struggling to “make the [single] family home the norm of social housing.”566

The Adenauer government then attempted to cement its priority for subsidizing homeownership in the Second Housing Law of 1956.567 The core idea of the law was to generate affordable housing for large segments of the population, with a particular focus on homeowners and low-income households. Wherever possible, social housing funding should be given to homeowners. Where single-family homes were unfeasible, funding

561 Paragraph 16 of the updated First Housing Law read: “Subsidies for the construction of new homes should prioritize single-family homes … An appropriate amount of social housing funds should be used to subsidize single-family homes.” The federal government offered DM500m in funding per year from 1953-56. 562 CDU, Entwurf eines Gesetzes zur Schaffung von Familienheimen, 1952. 563 As Neumayer (FDP) noted: “I especially regret that the Bundesrat opposed the provisions that promote the idea of ownership.” See 1st German Bundestag, 45th Session, Bonn (21 January 1953). 564 The SPD also opposed the idea of quotas, as it would disregard local and regional housing needs. See remarks by Jacobi (SPD); 1st German Bundestag, 45th Session, Bonn (21 January 1953). 565 Pergande 1952a, 1952b. 566 See remarks by then housing minister, Neumayer (FDP), 1st German Bundestag, 45th Session, Bonn (21 January 1953). 567 The social housing programs were not the only programs subsidizing homeownership at the time. In 1952, the Adenauer government also started subsidizing savings accounts in building societies (Wohnungsbauprämie). The goal of the subsidy was to kill two birds with one stone -- creating property ownership for ordinary people and rebuilding the country’s capital market by encouraging private savings instead of consumption, in order to finance the housing and economic recoveries. See Mertens 2015.

164 should be distributed for the purpose of creating affordable multi-family rental homes. 568

This would ensure affordable housing for large parts of the population and low-income households in need of affordable housing, a target of building 1.8 million homes until

1962.569 The social housing finance toolkit -- direct loans, government guarantees in the mortgage market,570 and the subsidized sale of land -- was expanded. And the use of the toolkit shifted from providing direct government loans to interest-rate and annuity subsidies, when the capital market recovered.571 Similarly, the federal government increased its funding to DM700 million in 1957, but also specified a tapering of DM70 million per year. The Adenauer government included the tapering provision, because it still viewed the social housing programs as temporary programs that would give way to the private market once the capital and mortgage markets fully recovered and the housing crisis was over. Public funds for the housing sector were essential sources of housing finance at the time, constituting a share of 30 to 40 percent of the housing finance market in the 1950s, while that number decreased to less than 10 percent by the late 1960s as the capital market took over that role.572

While the Second Housing Law established a funding priority for homeowners, it still left the federal states with room for maneuver to interpret and implement the law in

568 Fischer-Dieskau 1956. 569 Paragraphs 1 & 26 of the 1956 Second Housing Law specified these priorities. Paragraph 26, for instance, states unmistakably: “building single-family homes has priority over other forms of housing.” 570 The Second Housing Law increased the volume of federal government guarantees to DM500m. But the guidelines for the federal states to make use of these government guarantees left them considerable autonomy, which led housing experts to complain that they did too little to support homeowners; see Simon (1957). Until 1961, the federal government guaranteed DM3.77m in mortgage debt. 571 For example, in 1958, 86 percent of new social housing units that year received subsidized public housing loans, while that number decreased to only 13 percent in 1962. At the same time, in 1962, 72 percent of new social housing units received interest-rate or annuity subsidies, which have become more important over the years. Source: Bundesbaublatt. 572 Source: Bundesbaublatt.

165 their own regional interests. In the run-up to the reform, the Christian Democrats called distributing the lion’s share of social housing funding to the rental sector “disturbing.”573

Yet, they were unable to adopt clear, quantifiable funding standards of supporting homeownership as part of the Second Housing Law. First, they failed to establish a

“homeowner first” provision that would guarantee special status and treatment to homeowner applications if they met the criteria for social housing (without a funding guarantee).574 Second, they failed to create specific quotas that would assign the majority of social housing funds to homeowners.575 Third, they also failed to establish a right for homeowner funding if they met the income criteria for social housing and had a down payment of 30 percent.576 The upper house made clear that it would not pass such provisions. Instead, the Länder argued that they needed to retain the ability to subsidize housing units as they saw fit. The Free Democrats, otherwise staunch advocates of homeownership, sided with the federal states, arguing that quotas were too dirigiste in that the federal government should not force housing tenure choices upon the states, ordinary people, or markets.577 The result was that, without such quantifiable standards, the federal states interpreted the vague and buried funding priorities of the law -- that “building single- family homes has priority over other forms of housing”578 -- in ways preferable to them.579

The former housing minister, Victor-Emanuel Preusker (FDP), had foresight and cautioned that:

573 See remarks by Lücke (CDU). 2nd German Bundestag, 9th Session, Bonn (14 January 1954). 574 Schubert 1955. Also see Bundesregierung, Wohnungsbau- und Familienheimgesetz, 1954. 575 Dieskau 1956, in: Bundesbaublatt. Lücke 1958a. Also see CDU, Entwurf eines Gesetzes zur Schaffung von Familienheimen, 1952. 576 See remarks by Brönner (CDU), 2nd German Bundestag, 143rd Session, Bonn (3 May 1956). Also see Bundesregierung, Wohnungsbau und Familienheimgesetz, 1954. 577 See remarks by Preusker (FDP), 2nd German Bundestag, 6rd Session, Bonn (26 June 1954). 578 See paragraph 26 of the Second Housing Law of 1956. 579 Leutner 1990.

166 local authorities did not implement the First Housing Law in the way it was

unanimously approved in the Bundestag. I may therefore, in an attempt to restore

the unconditional trust between all executive branches in the entire Federal

Republic, express my wish that this law will be implemented to the fullest degree

of loyalty.580

Where the center-right government struggled to adopt tangible measures for homeowners against the federal states, the Social Democrats were unable to convince the Christian

Democrats to include specific measures for low-income households (as suggested in the

SPD’s own draft bill).581 But the federal states settled the matter by distributing the majority of social housing funds to the rental sector, not to homeowners, until the end of the decade, which was in some ways against the spirit of the Second Housing Law.

When the housing crisis was considered to be over in the 1960s, the social housing programs were scaled back, but policymakers again launched reform efforts to tip the social housing scale in favor of homeowners. As the private capital market recovered, and the country experienced its first full-blown recession, the number of new subsidized social housing units halved between 1960 and 1975 -- from 300,000 to 150,000 per year.

Similarly, federal funding for the social housing programs decreased from its peak of

DM1.6bn in 1959 to less than one billion in the late 1960s.582 Yet, until the mid-1970s, the housing market in the country was still not yet balanced, in part because of the continued influx of East Germans as well as guest workers from abroad. While policymakers across

580 See remarks by Preusker (FDP), 2nd German Bundestag, 143rd Session, Bonn (4 May 1956). 581 SPD, Entwurf eines Zweiten Wohnungsbaugesetzes, 1954. 582 This does not include state and local social housing spending, which, in most years, matched or exceeded federal spending.

167 the political spectrum continued to express their general support for social housing programs, the political right wanted to see social housing support go to homeowners.

The Erhard government (CDU-FDP, 1963-66) continued Adenauer’s mission of boosting homeownership by reforming the Second Housing Law in 1965.583 The idea was to introduce a ranking of housing units that needed to be consulted before distributing social housing funds, an attempt to impose stricter guidelines on the Länder from which they could not easily deviate.584 Single-family homes (and condominiums) were at the top of the ranking when it came to social housing funding. Moreover, the federal government introduced a new program specifically for middle and higher income families to receive homeownership benefits as part of social housing programs (the so-called “second way” of social housing).585 The coalition wanted to incentivize families, who previously exceeded the income limits for social housing, to attain homeownership, so as to open up rental units for those in need of affordable housing.586 The center-right government initially won these battles, even though the Bundesrat argued that it would prefer more flexibility in the distribution of funds. Yet, this success was short-lived, as soon thereafter, in 1967, the

Länder negotiated to suspend the funding rankings until 1971 (and, then again, until 1976).

The Länder pressured the Kiesinger government (CDU-SPD, 1966-1969) to relax these

583 See Gesetz zur verstärkten Eigentumsbildung im Wohnungsbau und zur Sicherung der Zweckbestimmung von Sozialwohnungen (Wohnungsbauänderungsgesetz 1965 — WoBauÄndG 1965). 584 See the newly inserted paragraphs 26 & 30 of the Second Housing Law. 585 See inserted paragraph 88 of the Second Housing Law. The second way of subsidies focused on middle and higher income homeowners, allowing them to exceed the income limits of social housing programs and to receive annuity subsidies to help them meet their monthly mortgage and interest payments. The paragraph specified that these homeowners may exceed social housing income limits by 30%. 586 Häußermann and Siebel 1996.

168 guidelines with the help of the Social Democrats, granting them elasticity to respond to pressing housing problems in their regions.587

That the Länder supported social rental housing over homeownership was not a mere accident of history, but instead the result of their own regional interests and deep ties to their local political economies specialized in multi-family rental housing. First, supporting multi-family homes offered a pragmatic solution to alleviate the acute housing shortages after the war and the prolonged shortages in metropolitan regions, with sensitivity to the country’s pre-existing urban structure. As a technocrat in the housing ministry noted in 1958:

Housing shortages … are increasingly found in big cities and industrial,

metropolitan areas. However, building single-family homes cannot meet the

housing needs there because of a lack of land … Better conditions for that are

usually found in rural areas and in small towns. Land can be developed without

difficulty there, and the possibilities of self-help and receiving help from family

members are more likely than in big cities.588

Relatedly, the pre-existing urban structures of the country, which had consisted of compact cities with multi-family buildings since at least the late 19th century, influenced their proclivity to support multi-family housing.589 This was especially true of federal states with large metropolitan regions, where land is scarce and construction expensive. As figure 4.3 shows, between 1956 and 1988, the city-states -- West Berlin (BE), Hamburg (HH) and

587Gesetz zur Verwirklichung der mehrjährigen Finanzplanung des Bundes, II. Teil (Finanzänderungsgesetz), 1967. 588 Fischer-Dieskau 1958. 589 Also see Kohl 2016.

169 Bremen (HB) --590 subsidized homeownership the least, with support for owner-occupied units ranging from only 10 to 30 percent as a share of total social housing units, numbers much lower than the West German average of 34.3 percent. North-Rhine Westphalia

(NRW), home to the largest metropolitan regions in the country, also had a below-average share of 31 percent.591 In these metropolitan regions, where housing shortages were most acute, ordinary people were priced out by increasing land and construction prices,592 a factor that induced these states to provide the majority of funding for the rental sector.593

Such a strategy also allowed them to contain urban sprawl and suburbanization, including the costs associated with it, for which they would have been on the hook when it comes to financing new infrastructure and development. The association of German cities

(Deutscher Städtetag), representing many of these metropolitan areas, hence called the

Christian Democratic efforts of boosting homeownership “artificially bloated.”594 In contrast, states with abundant land -- Saarland (SL), Baden-Württemberg (BW),

Rhineland-Palatinate (RP) and, in some years, Lower Saxony (NI) --595 subsidized owner- occupied units with a share higher than 50 percent.596 The larger point is that the Länder

590 The three city-states have very strong Social Demoratic traditions and were mostly led by center-left governments in the postwar period. 591 The state also has strong Social Democratic traditions, especially since the mid-1960s, but it was led by center-right governments from 1946-56 and from 1958 to 1966. 592 For instance, according to the Bundesbaublatt, construction prices rose by 34% from 1954 (=100) to 1960; 43% from 1962 (=100) to 1970; 42% from 1970 (=100) to 1976; 43% from 1976 (=100) to 1981; and 26% from 1980 (=100) to 1989. Similarly, land prices increased from DM25.71 to DM140 per square meter between 1967 and 1994. The data collected by Knoll, Schularick and Steger confirm that trend, showing that house prices in Germany increased by about four percent per year between the 1960s and the 1980s. See Knoll, Schularick, and Steger 2017. 593 Kujath 1988; Becker 1988; Lüning 2006. 594 Klett 1955. 595 Throughout the postwar period, BW, SL, and RP had very storng center-right governments, whereas NI was governed by center-left governments from the late 1940s until the mid-1970s. 596 In the case of Baden-Württemberg, the so-called land of homebuilders, industries were scattered throughout the state, allowing for more homeownership than in regions with dense economic centers. In Lower Saxony, this was because of a higher savings rate, abundant land, and less economic dominance of non-profit associations specialized in rental housing in those areas. See Lüning (2005); Fey (1958).

170 were not ordained to distribute the lion’s share of funding to the rental market, but they made these funding decisions grounded in their local contexts and needs based on demographic, economic, and urban development considerations.597

Figure 4.3: Approved social housing units in the German Länder between 1957 and

1988.598

2,000,000

1,800,000

1,600,000

1,400,000

1,200,000

1,000,000

800,000

600,000

400,000 Approved Social Housing Units Housing Social Approved 200,000

0 SH HH NI HB NRW HE RP BW BY SL* BE all social housing owner occupied

Second, local authorities were often embedded in local political economies specialized in multi-family housing, which induced them to approve social housing funding for the rental sector. These authorities frequently had longstanding ties with non-profit housing association, mortgage banks, and semi-public savings banks, all of which had long specialized in financing and building affordable, multi-family rental housing. The non-

597 Also see Ostrom (1990) for an argument that takes into account how local knowledge can provide an alternative to top-down state-led resource management or private market solutions. 598 Source: own calculations; Bundesbaublatt; Statistisches Bundesamt. Due to data limitations, the time series for Saarland (SL) starts in 1962.

171 profit associations (Gemeinnützige Wohnungsunternehmen) and housing cooperatives

(Baugenossenschaften) had specialized in building multi-family homes since the mid-19th century.599 Similarly, mortgage banks (Hypothekenbanken) -- initially established to provide credit for the cash-poor and land-rich Junker class in Prussia due to the Seven

Years’ War in the late 18th century600 -- did not primarily extend credit to individual homeowners, but instead to (non-profit) housing associations for the creation multi-family housing in urban areas.601 The semi-public savings banks (Sparkassen), locally embedded and operating in the public interest, also were a major funding source of mortgage lending for (non-profit) housing associations building multi-family homes.602 This led the German association of people’s homes (Deutsches Volksheimstättenwerk), a conservative interest group promoting the provision of cheap land and homeownership, to bemoan that:

… soon we had to make the surprising experience, almost inconceivable experience

from a lawyer’s perspective, that laws alone are not sufficient to guarantee the

priority of owner-occupied housing in the production of social housing … It is not

understandable that, against the will of legislative authorities and against the wish

of the majority of those looking for housing, housing needs were not adequately

met … None of the parties involved in the production of housing are actually

interested in building owner-occupied homes, except homeowners themselves.

Urban planners fear … urban sprawl. To underline their concern, they refer to the

negative examples of large American cities. Local communities shy away from

what they believe is an inevitably higher usage of land and higher cost of land

599 Kohl 2015; Simon 1964; von Beyme 1999; Kujath 1988; Leutner 1990. 600 Wandschneider 2015. 601 Goedecke et al. 1997; Biber 1953. 602 Kohl 2015; Baumann and Falkenstein 1976.

172 development. For architects, the planning and designing of multi-family homes is

less time-consuming and much more lucrative than dealing with individual

homeowners and their extra wishes, whose properties are often scattered. For

banks, processing a mortgage of DM500,000 for a multi-family home is hardly

more work than the DM10,000 to DM15,000 mortgages of single-family homes. It

makes the local government employee’s hair stand on end, when he processes

incomplete and flawed applications of homeowners … Who can blame him to pick

the application of a housing association, which he has known all too well for

providing complete and flawless applications? The fact that the municipality might

have a stake in this very housing associations does not make his decision any

harder.603

This lengthy quote is worth citing in full, as it demonstrates the dense networks of local authorities and organizations specialized in building multi-family homes. The deep interlinkages between these actors can also be seen in the financing structures of social housing programs. In the 1950s, non-profit housing associations helped build between 40-

50 percent of all social housing units and even more than 50 percent in the 1960s.604 They were mainly financed by the Hypothekenbanken and Sparkassen, providing close to 40 percent of their funds, and the German state (i.e., social housing programs), providing an additional 30 percent of funding for the non-profits in the 1960s.605 In contrast, the building

603 Simon 1964. Emphasis added. 604 Source: Bundesbaublatt. In 1958, federal housing minister, Paul Lücke, called on the housing cooperations to produce more single-family homes. See Lücke 1958b. 605 Source: Bundesbaublatt. The building societies, Bausparkassen, only financed 1.6 percent of the non- profit housing associations’ building activities.

173 societies (Bausparkassen) -- the most important financial institutions specialized in financing private homeownership -- were marginal actors in financing social housing.606

These deep interlinkages of local authorities and key housing players are representative of the country’s larger mortgage market that has historically specialized in financing multi-family homes. Since the late 18th century, mortgage banks had mainly financed rental properties instead of individual home properties by using covered bonds

(Pfandbrief) to (re-)finance their activities.607 They preferred financing rental buildings because, in their view, rental units would bring in profits and likely secure repayment, whereas non-standardized single-family homes would be riskier.608 It is therefore not surprising that mortgage banks developed deep ties with non-profit housing associations that had long specialized in building multi-family homes. Similarly, the German savings banks (Sparkassen), established in the late 18th century, had not specialized in homeownership lending -- such as the savings and loans in the United States established in the mid-19th century -- but instead financed rental housing given their public mission.

German building societies (Bausparkassen) were only established in the 1920s and, despite their fast-moving success in postwar Germany, had not yet built the same dense networks as the rental finance sector.

606 Source: Bundesbaublatt. The major sources of social housing funds were provided directly by the German state (1955: 38.1%; 1960: 32.1%; late 1960s: 15.5%), the mortgage banks (1955: 10.4 %; 1960: 6.4%; late 1960s: 20%); insurance providers (1955: 3.3%; 1960: 3.8%; late 1960s: 7.2%), the savings banks, Sparkassen (1955: 10.2%; 1960: 14.5%; late 1960s: 27.7%), and the building societies (1955: 1.6%; 1960: 3.8 %; late 1960s: 2-3%. 607 Kohl 2015, 2016; Wandschneider 2015. Covered bonds are securities pooling together mortgage loans. Covered bonds are more conservative than mortgage-backed securities, because they cover only up to 60 per cent of home values to absorb losses and to protect investors in the case of declining property prices. 608 See Löhr 1912. In postwar America, the process of building single-family homes in suburban areas was much more standardized following a mass-production model, such as the famous “Levittown” projects. See Jackson 1985.

174 The country’s postwar housing finance structure is then a testament to these historical, institutional legacies. While housing finance was very much dependent on the

German state in the early 1950s, the private capital market gradually became the most important source of housing finance by the late 1960s. The mortgage banks increased their funding share of the country’s housing finance market from 15 percent in the early 1950s to almost 20 percent in 1962. The funding share of Sparkassen climbed from around 10 percent in the 1950s to 19 percent in 1968. The building societies, the key housing finance source for homeowners, increased their funding share from around 10-15 percent in the

1950s to 30 percent in 1968. While the building societies have increased their market share

-- which is in part the result of a retreating state and tax incentives to induce savings in building societies -- their share was still smaller than that of Sparkassen, the mortgage banks, and insurance companies, all of which tended to fund the rental sector.609

Finally, is it possible that there were not enough potential homeowners applying for social housing funding? A closer look reveals that more than 100,000 homeownership applications per year remained unprocessed in the late 1950s and 1960s.610

Administratively, the local authorities had few incentives to process the applications from thousands of individual homeowners, which were often incomplete and required extensive correspondence. Housing minister, Paul Lücke (CDU), urged the federal states to process these applications with priority, as specified in the Second Housing Law, but to no avail.611

It is therefore fair to say that, if the federal states had been willing to process and approve these applications, it would have resulted in higher homeownership.

609 The share of the German state as a housing finance source decreased from around 40% in the early 1950s to 13.1% in 1968. 610 Source: Bundesbaublatt. 611 Lücke 1958a.

175 In sum, the social housing programs successfully helped rebuild the country’s housing market and eliminate the large-scale housing shortages from the 1950s until the late 1960s. On the national level, political parties on the left and right realized their respective preferences of social housing programs for homeownership and rental markets

(but with a priority for homeowners specified by the center-right Adenauer government).

On the subnational level, however, the federal states used their autonomy to distribute the majority of social housing funds to the rental sector. If the federal states had distributed the lion’s share of funding to homeowners, then the country’s homeownership rate would have been significantly higher. This might have also created a stronger constituency of homeowners able and ready to defend these subsidies in later policy periods. The social housing programs did, however, create affordable housing markets that helped the macroeconomic regime in keeping down the cost of living, which is beneficial for an economy privileging wage restraint and price stability.612 Yet, these synergies with the growth model were short-lived. The social housing programs were scaled down in later policy periods, as their supply-side functions were much less important in times of re- balancing housing markets.

Social housing in free fall, 1970-1990

In the 1970s and 1980s, social housing policies decoupled from the export-oriented growth model. When the Keynesian period of demand management and welfare expansion came to an end in the mid-1970s, the German growth model specialized even more in export- oriented manufacturing and built on its strength in “diversified quality production.”613 In

612 Wertheimer 1958. 613 Streeck 1991.

176 the post-Keynesian period of slower growth, higher unemployment, and rising debt,

Germany’s export share as a percentage of GDP increased from 15 percent in 1970 to 22 percent in 1989. Social housing programs helped keep down house prices and the cost of living in the early postwar decades, which tends to exert downward pressure on wages. 614

Yet, in times of balanced housing markets without major shortages, continuing (large- scale) social housing programs would have generated unwanted momentum and demand in the housing market. As Muellbauer notes, in general, “increased housing demand has inflationary consequences.”615 While inflationary consequences might be the price to pay for stimulating housing, consumption, and economic growth in the United States, it works against the German export- and production-oriented growth model. The absence of deep macroeconomic linkages between social housing policies and the German growth model then made these policies subject to retrenchment.

As a result of re-balancing housing markets, the number of newly subsidized social housing units steadily declined until the late 1980s, from almost 200,000 units in 1970 to only 40,000 units in 1988, especially under the center-right Kohl government. Within these parameters of retrenchment, policymakers across the political spectrum tried to shift social housing funding priorities from renters to homeowners in their appeals to attract middle- class constituents. Even the Social Democrats promoted subsidizing homeowners in this period, as their primary goal of achieving affordable housing for large parts of the population was within sight. For the first time in the country’s postwar history, and despite some resistance by the federal states, homeowners received a larger share of social housing

614 Wertheimer 1958; Bover, Muellbauer, and Murphy 1989, 128. 615 Muellbauer 1992, 547-8.

177 benefits than the rental sector (i.e., between 1975-1981 and 1984-1989). However, the miniscule size of social housing in these periods did little to increase homeownership.

The first social-liberal coalition under Willy Brandt (SPD-FDP, 1969-1974) initially revived the social housing programs on the heels of housing shortages in the metropolitan regions of the country in the early 1970s,616 partly due to the influx of guest workers and migration movements within the country.617 In addition to the already existing social housing programs, the Brandt government adopted a long-term housing plan, consisting of social, regional, and modernization components, for which the federal government granted the Länder significant funding and autonomy.618 While the regional component provided additional funding for economically depressed regions with housing shortages, the social program aimed at low-income households, the elderly, and families with children.619 The modernization program provided funding for renovating the existing housing stock.620 The overall goal was to increase the number of subsidized social housing to above 200,000 units per year.621 While homeowners were eligible for many of these new

616 Lauritzen (SPD), then housing minister, noted that: “in the cities and metropolitan regions … there is always the need for new housing because of internal migration and the immigration of foreign workers, which needs to be met.” 6th German Bundestag 18th Session, Bonn (5 May 1971). 617 Scharpf, et al. 1976. Also see Wohnungsbauänderungsgesetz 1971. 618 See Lauritzen 1971. 619 The social program included DM150m per year in federal funding per year to complement existing social housing programs and an additional DM250m per year to secure affordable rental housing for low-income households. The regional program offered federal funding for housing developments in economically depressed regions, countering housing shortages in metropolitan regions, and urban development projects, especially for households who would not qualify for social housing, but also cannot afford to rent or buy in the private market. The Brandt government increased the social housing income limit for these programs by 40 percent. 620 The federal government offered DM30m for the renovation or modernization of the existing housing stock. 621 The Brandt government also adopted the “housing assistance program” (Wohngeld) in the early 1970s, which offered direct financial assistance to low-income renters and homeowners struggling to pay their rent or mortgage payments. The program is regarded as valuable across the political spectrum because of its social targeting. Total government spending on the housing assistance program eventually ranged from EUR2-5bn annually in the 2000s, benefitting between 1-3 million individuals in that period. However, the homeowner component (Lastenzuschuss) of the program is relatively marginal, ranging only from 4-11 percent of all beneficiaries. The component serves as a social security net against the risk of losing one’s home. Source: Wohngeldstatistik.

178 programs, especially the regional program, the federal states continued to distribute most social housing funds to the rental sector. Homeownership as part of social housing programs was not a priority for Brandt government.

When the economic volatility of the mid-1970s led to rising deficits and cooling off housing markets, including the first postwar housing vacancies, the Schmidt government (SPD-FDP, 1974-1982) scaled back the social housing programs and re- centered the focus on homeownership.622 In 1976, the social-liberal government reformed the social housing programs to increase the share of homeowner funding by building on the two-decades-old Christian Democratic demand to assign at least 50 percent of social housing funding to homeowners.623 As their primary preference of establishing an affordable rental market was within sight, the Social Democrats focused on their secondary preference of boosting private homeownership and wealth.624 As Bundestag member Ernst

Waltemathe (SPD) remarked:

If only 1.5 million out of 5.8 million social housing units were owner-occupied,

then this is not due to the malevolence of the federal, state, or local governments.

It shows clearly, on one hand, what the housing needs were in past years and

decades, and, on the other hand, the difference between theory and practice.625

But given that the housing and economic context has shifted – the acute housing shortages were over and the population became richer -- a focus on homeownership became more viable than in earlier decades. As Horst Krockert (SPD), another member of the Bundestag,

622 Ravens 1974. 623 Gesetz zur Förderung von Wohnungseigentum und Wohnbesitz im sozialen Wohnungsbau, 1976. The reform also lowered the down payment requirement for homeowners to 10 percent. 624 The longstanding Social Democratic ally, the German association of renters (Deutscher Mieterbund), opposed the reform’s focus on homeownership and instead demanded higher levels of social rental housing. 625 7th German Bundestag. 162nd Session, Bonn (10 April 1975).

179 expressed, the SPD focused on homeownership at that time, because large parts of the population would desire to become homeowners and “not because homeowners would be ideal-type citizens.”626 The Christian Democrats in the Bundestag were quick to declare victory. In the words of Friedrich-Adolf Jahn (CDU): “That this was possible is due to the

CDU/CSU, which consistently took this position. Our goal is not just a home for everyone, but each their own home.”627 They reckoned the law would help raise the level of homeownership in the country.

Unsurprisingly, the Bundesrat met these proposals with resistance, arguing that, in some states, there would not be enough demand that would merit distributing the majority of funds to owner-occupied homes. Moreover, the federal states argued that the federal government’s insignificant share of funding puts them in no position to impose such rules.

Instead, the states proposed to offer as much funding for homeowners as they can, which would still leave them with some room for maneuver to respond to regional needs. In a standoff with the Bundesrat, the Schmidt government agreed that, while not every state needed to reach the 50 percent homeowner mark, the national average of all social housing funding should at least match the 50 percent mark.628 Indeed, between 1976 and 1988, the share of subsidized owner-occupied homes matched or exceeded 50 percent for most years.629 While this can be seen as a success for the political right, the overall number of social housing units decreased to almost negligible levels.

626 7th German Bundestag. 162nd Session, Bonn (10 April 1975). 627 7th German Bundestag. 162nd Session, Bonn (10 April 1975). 628 In a minor reform in 1980, the Schmidt government increased the income limits for middle-income families. The main goal of this law was to liberalize the social housing rental sector (i.e., rental property investors were allowed to prematurely pay back their public loans, at which time their rental property would not have to adhere to social housing standards any longer). See Wohnungsbauänderungsgesetz 1980. 629 In the early 1980s, the funding share was briefly below 50 percent, which caused the CDU-led opposition to question the Schmidt government in the Bundestag. The Schmidt government responded that this would

180 Celebrating a balanced housing market in the 1980s, the Kohl government (CDU-

FDP, 1982-1998) did little to change the social housing programs. Housing minister, Oscar

Schneider (CSU), trumpeted the successes of the German housing market that was

“functioning as well as never before,” which would finally allow for raising the country’s homeownership rate from 39 to 50 percent.630 This animated the Kohl government to expand the homeownership component of social housing.631 In its 1986/87 report, the housing ministry stated that the federal government “does not view building rental units as one of its tasks any longer … it is, however, the federal government’s goal to create homeownership.”632 Only in 1988 did the Kohl government reform the social housing programs by introducing a new instrument of support. The so-called “third way” of social housing gave the Länder more flexibility in negotiating directly with investors, homeowners, and non-profit housing associations about funding rental and owner- occupied housing.633 This instrument gave the Länder the opportunity of focusing on specific local and regional developments, which is partly the result of the influx of 700,000 ethnic German resettlers from Eastern Europe (Spätaussiedler) in the late 1980s.634 The instrument, supported by the Social Democrats, was designed to increase the housing supply, so as to keep down house prices in the larger housing market.635 One year later,

Kohl government eliminated the tax-exempt status of non-profit housing associations,

be because of increased interest rates, land prices, and construction costs, which made it difficult for ordinary people to become homeowners in those years. 630 Oscar Schneider (CSU), 10th German Bundestag. 250th Session. Bonn (November 27, 1986). 631 The Kohl government provided additional funding for social rental and owner-occupied housing in the amount of DM1bn each. 632 Bundesbaublatt 1987. 633 Gesetz zur Änderung des Zweiten Wohnungsbaugesetzes, 1988. Also see Hamm (1989). 634 Source: Federal Office of Administration. 635 Beschlußempfehlung und Bericht des Ausschusses für Raumordnung, Bauwesen und Städtebau (16. Ausschuß), December 2, 1988.

181 which was a political setback for the political left.636 At the same time, social housing reached a historic low point of 37,000 subsidized homes in 1988, most of which were owner-occupied units.

In sum, social housing policies decoupled from the macroeconomic growth model in the 1970s and 1980s. As the housing shortages were overcome, social housing relegated from one of the most essential issues in German politics to one with little political and economic salience. Where the programs supported the growth model in the early postwar period by keeping down the cost of living, continuing large-scale social housing programs would have stimulated housing in unwanted ways in times of already balanced housing markets. Accordingly, the number of new social housing units decreased to merely 40,000 units per year by the late 1980s. 637 Within these parameters of retrenchment, the social housing programs in this period subsidized owner-occupied units more strongly than in earlier policy periods -- a success celebrated by the political right. But this shift came at a time when the number of subsidized social housing units was already very low.638 The result of this period is that the homeownership rate did not increase significantly,639 while the social housing policies were down to the count.

636 For instance, the non-profit housing associations’ share of building permits plummeted from 25-35 percent of all residential building permits in the 1960s to merely 6 percent in the late 1980s. Source: Bundesbaublatt. 637 The center-right parties had long criticized the fact that many households exceeded the income limits for their social housing units, which reinforced their policy retrenchment of social rental units. 638 Federal spending on social housing constituted only DM1-2bn annually between 1970 and 1989. 639 The building societies maintained their housing finance market share of around 30 percent in 1979, while the share of the savings banks (17.5 percent) and the mortgage banks (11.4 percent) decreased slightly. Source: Bundesbaublatt.

182 Retrenchment: The reform of social housing programs in post-unification Germany

In the 1990s and 2000s, social housing programs decoupled even further from the growth model, which contributed to its narrowed focus and eventual retrenchment in this period.

After the reunification of the country, the German economy soon became the sick man of

Europe, with high unemployment, rising deficit and debt, high labor costs, and a rigid labor market.640 These factors threatened German export competitiveness, which had become an ever-larger share of the economy.641 As a result, there was widespread agreement across the political spectrum that structural reforms and austerity should revitalize export competitiveness. Among other things, policymakers across the political spectrum focused on the reduction of subsidies, so as to eliminate distortions in the economy

(Subventionsabbau). They also agreed that the country’s federalist setup needed overhaul, as it was holding back much-needed economic reforms,642 with complicated, mixed forms of governance in many areas.643 As Scharpf remarks, reforming federalism was intended to increase the efficiency of the German economy:

Given the economic heterogeneity of German regions, and the separation between

federal legislation and Länder administration, however, national policy could not

be sufficiently targeted to the needs of specific regions, whereas Länder

competence was insufficient to achieve the concerted effects which smaller nation

states could design for their more specialised economies. It made sense, therefore,

640 Manow and Seils 2000. 641 The Economist, “The sick man of the euro,” (June 3, 1999). 642 Katzenstein 1987; Manow and Seils 2000. 643 Scharpf 2008.

183 for ambitious Land governments to seek broad legislative authority over the

‘regional aspects’ of all economically significant policy domains.644

The reform of federalism, including the social housing programs, was part of larger structural reforms to reduce market distortions and increase economic efficiency.

The social housing programs represented some of these macroeconomic frictions with the growth model. First, they were an example par excellence of the complicated workings of federalism: concurrent jurisdiction, co-financing, and decisions at the state level that often did not match federal objectives. Second, as housing markets were affordable and relatively well-functioning in the late 1990s and 2000s, the social housing programs subsidized a rather unproductive area, which did not enhance the competitiveness of the export-oriented growth model. As a result, policymakers initially narrowed the focus of social housing policies -- i.e., focusing on modernizing homes, regional development, helping the poor, and creating homeownership -- but eventually retrenched them. The political left and right agreed to reform the social housing programs as part of their larger federalism reform package, which required a broad-based consensus to pass the two-third majorities in both chambers required for constitutional reforms. The elimination of social housing programs then tied in with other structural reforms, such as the Hartz labor and welfare state reforms645 and the elimination of the homeownership tax allowance.

Where policymakers celebrated a balanced housing market in the 1980s, the reunification of the country upset this equilibrium, integrating two very different housing markets. The Kohl government faced housing shortages in the metropolitan parts of West

Germany as well as growing vacancies in the East, in part because of population

644 Scharpf 2008, 512; also see Manow and Seils 2000. 645 Vail 2010; Hassel and Schiller 2010.

184 movements from East to West Germany (and the continued influx of Spätaussiedler from

Eastern Europe until the late 1990s).646 The East German housing stock required extensive modernization, given hundreds of thousands of uninhabitable homes, in order to adjust to the standard of the western parts. As the homeownership rate in East Germany was 12 percent lower than in the West, the center-right coalition wanted to boost homeownership, so as to equalize wealth differences between the East and West. On the heels of these developments, social housing made an unexpected, but short-lived, comeback in the 1990s, climbing above 150,000 housing units per year. But these and other programs contributed to an overheating East German housing market in the 1990s, with a housing crisis looming on the horizon.

In response to the housing challenges after reunification, the Kohl government

(CDU-FDP, 1992-1998) increased government support for the housing sector.647 In the early 1990s, the Kohl coalition revived the social housing programs to cope with housing shortages in the West and to stimulate investment and ownership in the East, along with massive tax incentives to stimulate housing in the country (see chapter two).648 The 1994 social housing reform reinforced these developments by further expanding income limits for potential homeowners (especially families with children), focusing on the modernization of housing stock (particularly in East Germany), and extending the relatively new “third way of subsidies.” The federal states welcomed the reform, as it

646 Between 1990 and 2000, roughly two million Spätaussiedler entered the country, producing strong net migration surpluses in the 1990s. 647 See Fördergebietsgesetz of 1991; Investititonszulagengesetz of 1991; Steueränderungsgesetz 1991, 1992; and the 1993 Aufbau Ost program. 648 It adopted a program for Western regions with housing shortages (DM700m) and increased income limits for social housing. By 1993, federal social housing funding increased to DM1.25bn in the new federal states and DM2.7bn in the old federal states. The federal states contributed roughly DM20bn in 1993. Source: Bundesbaublatt.

185 provided them flexible funding mechanisms to deal with their regional housing needs without being subject to the “golden lever”649 of the federal government. However, these post-unification housing policies, including roughly DM20bn of social housing spending per year in the early 1990s, contributed to an overheated East German housing market and eventually resulted in declining house prices650 and vacancies of one million homes in

2000.651 Consequently, the number of subsidized social housing units halved to about

60,000 by the late 1990s.652

During the social housing revival of the 1990s, the rental sector was the main beneficiary when compared to homeowners. As figure 4.4 demonstrates, between 1991 and

2004, the majority of subsidized homes were again found in the country’s rental sector (i.e.,

54 percent in the East and 59 percent in the West). The federal states followed the historical trend of privileging the rental sector over homeowners whenever there were housing shortages in the country.653 In an interview, a state government official in North-Rhine

Westphalia noted that the state’s social housing funding decisions were primarily based on three factors: the overall housing situation of the state, the urban structures of its regions, and mortgage interest rates. The official also admitted that, in practice, homeowners did

649 Report, Committee for Housing, Building, and Urban Development (26 April 1994). 650 Ruprecht, Geiger and Muellbauer 2016; Lindenthal and Eichholtz 2012. 651 Glock and Häussermann 2004; Georgakis 2004b. 652 It should be noted that the Kreditanstalt für Wiederaufbau (KfW), a government-owned development bank, started extending small subsidized loans to homeowners in 1996. The bank had already acted as a source of funding for social housing in the 1970s and the early 1990s. In 1996, the bank started its homeownership loan program, which grew to EUR3bn in 1999 (and EUR5.5bn in 2015). However, the program is relatively marginal compared to the loan programs of other countries, as borrowers only receive small-scale, subsidized loans for their homes. See Mertens 2015. 653 Even before reunification, in 1990, the Kohl government had already agreed to increase social housing funding to cope with the influx of ethnic German resettlers, in order to help produce half a million social housing units until 1993. Housing minister Hasselfeldt (1990, 2) called these pre-unification pressures on local housing markets “overwhelming.”

186 not have the highest priority when it comes to distributing social housing funds in the state.654

Figure 4.4: Approved social housing units in the old and new federal states, 1991-

2004.655

600,000

500,000

400,000

300,000

200,000

100,000

0 Homeowner Rental Homeowner Rental New states Old states

On the heels of these developments, the Schröder government (SPD-Green, 1998-

2005) scaled back and reformed the social housing programs. In 2001, when construction levels dropped as a result of large-scale vacancies in the East, the center-left coalition adopted federal demolition programs to balance the housing supply and demand of these areas.656 In the same year, the center-left coalition passed a far-reaching social housing reform. The reform’s goal was to transform the Second Housing Law’s signature theme of

654 Author interview (phone), housing ministry official. North-Rhine Westphalia, December 22, 2015. 655 Sources: own calculations; Bundesbaublatt; Statistisches Bundesamt. 656 The Stadtumbau Ost program was designed to demolish 350,000 homes in East Germany and cost the federal government and federal states roughly EUR2.7m between 2002-2009. See Georgakis 2004b.

187 supporting affordable housing for large segments of the population into programs that would mostly focus on those in need of affordable housing.657 The center-right parties, who had long criticized that many people lived in subsidized units without fulfilling the income criteria, concurred and welcomed the reform. This was because the center-left coalition viewed the national housing market as sufficiently functioning, as large parts of the population were able to find affordable housing, especially in light of housing surpluses in the East. Relatedly, the demographic projections were grim as a result of low fertility rates and declining net migration. All this would make additional large-scale, national housing construction obsolete. The social housing programs have therefore lost their earlier function of keeping down the cost of living and instead contributed to policy overshoot -- large-scale housing surpluses and vacancies in East Germany.

More specifically, the 2001 reform narrowed the scope of social housing programs down to modernizing the existing housing stock and targeting social groups and regions in need of housing support.658 As Bundestag member, Helmut Wilhelm (Green), put it:

The regional differences in the housing market -- we have repeatedly talked about

housing shortages in the metropolitan regions of Munich and Frankfurt, for instance

-- require the flexibilization of social housing instruments. We now allow the

Länder to react to regionally differentiated problems. The Länder will be able to

set income limits in a regionally differentiated way.659

The reform also granted the Länder autonomy in distributing social housing funds, allowing them to set funding criteria in flexible ways. This flexibility includes funding

657 Gesetz zur Reform des Wohnungsbaurechts, 2001. 658 Another reason for this reform was that many people lived in subsidized units without fulfilling the income criteria any longer in that they exceeded income limits but continued to receive benefits. 659 Wilhelm (Green); 14th Bundestag, 177th Session, Berlin (22 June 2001).

188 agreements between local communities and housing companies and associations in order to subsidize renting and homeownership.660

With no more acute housing shortages to tackle, even the center-left Schröder government centered its social housing efforts on creating homeownership. In times of extraordinarily low levels of construction and social housing (the number of social housing units dropped to merely 30,000 units in 2003), Achim Grossmann (SPD) noted in the

Bundestag:

We want more homeownership; I have already said that. For many people, who

engage with this topic, social housing means the creation of rental housing. This is

not correct. In the past – unfortunately increasingly less so – this also created

homeownership.661

While the majority of new social housing units was owner-occupied in the early 2000s, it was not nearly enough to have a meaningful impact on the country’s homeownership rate.

By then, social housing relegated to a limited and narrow policy tool.

Interest groups on the political left and right had mixed feelings about the creeping decline of social housing. The center-left housing interest groups continued to push for boosting social housing funds,662 because they still identified housing shortages in metropolitan areas,663 but some also conceded that bringing back the old days of large-

660 This aspect was also supported by the local communities, represented by the association of German cities (Deutscher Städtetag). See Georgakis 2004b.

661 14th Bundestag, 177th Session, Berlin (22 June 2001). 662 Interest groups in this camp include: the German association of renters (Deutscher Mieterbund), the non- profit housing associations and companies (Bundesverband deutscher Wohnungs- und Immobilienunternehmen, GdW), and the German association of cities (Deutscher Städtetag). See Georgakis 2004b. 663 Author interview (phone), representative of Deutscher Städtetag I, December 11, 2015; author interview (phone), representative of Deutscher Städtetag II, December 11, 2015.

189 scale social housing would be politically difficult.664 Yet, interest groups were unable to stop the demise of social housing programs for two key reasons. First, they did not speak with a united voice in these policy debates. Unlike the U.S. housing market, Germany’s political economy of housing is much less specialized in the financing and building of owner-occupied homes. This allows for a greater diversity of interest group views in the policymaking process. The building societies, for instance, viewed the social housing programs as the “worst waste of money,” producing housing surpluses beyond need and urged for the privatization of social housing.665 Similarly, the association representing property owners (Haus & Grund) argued that the programs would distort markets and that these programs had failed in recent decades.666 Second, the interest groups defending the social housing programs had much weaker economic arguments when compared to their

American counterparts. Unlike their U.S. counterparts, interest groups in Germany could not credibly claim that social housing programs reinforce the country’s growth model, which inherently weakens their influence.

In 2006, the grand coalition of Christian and Social Democrats under Chancellor

Merkel eliminated federal social housing programs as part of its larger federalism reform package. The reform transferred the authority of social housing to the federal states and eliminated federal funding for social housing programs. Until 2019, the Länder will be receiving compensation (EUR518 million per year) for taking over social housing on their own, but the states can freely decide how to use these funds, including for the reduction of

664 Author interview (phone), representative of GdW - Bundesverband deutscher Wohnungs- und Immobilienunternehmen, January 18, 2016. The representative acknowledged that social housing has become a very expensive instrument – building a few thousand units alone would cost billions of euros – which is difficult to sell politically. 665 Georgakis 2004b. 666 Author interview (phone), representative of Haus & Grund (H+G), January 14, 2016.

190 fiscal deficits. Social housing was one of the more obvious choices for policymakers to reform, because, for decades, the Länder had successfully demanded policy autonomy to deal with the different developments of their housing markets and provided the lion’s share of social housing funding. The eventual deal was that the federal government retained legislative authority over urban development,667 whereas the Länder received social housing. There was little debate in the Bundestag about social housing reform and even less public debate, as social housing was a low-salience concern at that time. Yet, the federal government gave up on its authority to shape social housing policy in the future, which concluded the slow erosion of social housing policy in the country.668

Yet, considering housing shortages to be a thing of the past may have been premature. It is true that German housing market was a source of stability during the financial crisis of 2007-09, with stable house prices in recent decades, at a time when the housing markets of other countries collapsed. Yet, the European debt crisis, in combination with Germany’s stellar economic performance, led to surging house prices in German superstar cities. This is because global and domestic investors continue buy up German properties in times of ultra-low interest rates and in search for safe havens, while immigrants keep flocking into the country from the rest of Europe.669 Moreover, the recent influx of refugees from the Middle East has created additional pressures on housing markets in Germany. Alarmed by these developments, the Social Democrats convinced their grand coalition partner, the Christian Democrats, to adopt rent price controls in 2015,

667 That includes programs such as Stadtumbau Ost, the demolition of vacant housing units, and Soziale Stadt, a large-scale urban development program to upgrade economically depressed and socially disadvantaged neighborhoods. 668 Some federal states continue to offer subsidies for homeownership and renting, but these subsidies are marginal and vary significantly across states. 669 Wijburg and Aalbers 2017; Voigtländer 2014.

191 a so-called “rental brake” to secure affordable rental housing. The grand coalition also increased the federal government’s social housing compensation payments to the federal states to EUR1bn in 2016 and EUR1.5bn from 2017-2019 in light of high numbers of incoming refugees and migrants, but the states retain the full discretion over how to use these funds.670 Indeed, housing minister, Barbara Hendricks (SPD), floated the idea of re- establishing concurrent policymaking in social housing between the federal government and federal states, but to no avail.671 The retrenchment of social housing programs deprived the federal government of its ability to adjust the housing supply in times of acute housing shortages.

In retrospect, members of the grand coalition view the retrenchment of federal social housing policy with skepticism. In an interview, a Social Democrat said that eliminating the social housing programs was a big mistake. The assumption was that the federal government was no longer required to deal with the country’s housing problems, but the German housing market did not behave in ways expected in the years after the reform.672 Another Social Democrat called the reform nonsense, as it was clear “there will be housing shortages again at some point -- and that’s precisely what happened.”673

Similarly, a Christian Democrat criticized that the federal states have yet to internalize their new social housing responsibilities.674 In recent years, then, affordable housing emerged as a hot-button issue in German politics, but the federal government no longer has legislative authority over social housing policy.

670 Federal Government, “Mehr Geld für den sozialen Wohnungsbau,” press release (July 12, 2016). 671 Nehls, A. “Der Bund zahlt, aber die Länder bauen nicht immer,” Deutschlandfunk (September 19, 2016). 672 Author interview, Bundestag member II (SPD). Berlin, September 9, 2015. 673 Author interview (phone), Bundestag member IV (SPD). September 25, 2015. 674 Author interview, Bundestag member I (CDU). Berlin, 22 June, 2015.

192 In sum, this period constituted a final break between social housing policies and the export-led growth model, which contributed to its eventual reform. While the reunification of the country entailed a short-lived revival of social housing -- especially rental housing -

- the policies were considered obsolete in times of affordable housing markets (and housing surpluses in some regions). The reform of social housing as part of the country’s federalism reform tied in with larger structural reforms, including the elimination of large-scale homeownership tax breaks, to increase economic efficiency and reduce market distortions within the German economy.675 The result of retrenchment is that social housing slowly lost its price-mitigating effect on the overall housing market over time. The social housing stock was halved from 3 million to 1.5 million in the past twenty years, a share of only 6.4 percent of all rental units in the 2010s.

Conclusion

This chapter has explained the rise and fall of social housing policy in the context of

Germany’s export-oriented growth model. Where social housing policies created some synergies with the export model in the early postwar years -- increasing the country’s housing supply in times of severe shortages, which helped keep down living costs, wages, and prices in the wider economy -- the policies decoupled from the growth model once the housing shortages subsided. Within these parameters, the political battles between the political left and right, and the federal states, were about the kind of supply to be subsidized

675 Similarly, the building society subsidy (Wohnungsbauprämie) was scaled down by the early 2000s. While the subsidy grew to become one of the most important housing subsidies by the 1970s, amounting to DM3bn in 1972 and contributing to a savings boom in building societies, the social-liberal governments scaled down the subsidies in the 1970s and early 1980s on the heels of rising fiscal deficits. With the temporary exception of reunification, when the savings subsidy increased temporarily, the subsidy was successively targeted by the political left, who had long viewed the subsidy as inequitable and benefiting the well-to-do. By the early 2000s, the subsidy was rather symbolic, amounting to merely EUR400-500m.

193 -- owner-occupied or rental units. The stakes were much higher in the immediate postwar decades, as the severe housing shortages required large-scale efforts to rebuild the country, which provided an opportunity to shape the country’s housing market long into the future.

For the most part, and much to the dismay of the powerful center-right political bloc, the federal states used their autonomy in distributing social housing funds to support the rental sector, which helped (re-)build Germany’s postwar nation of renters. As the social housing policies further decoupled from the growth model since the 1970s -- but especially in the late 1990s and early 2000s in times of well-functioning and affordable housing markets -- policymakers across the political spectrum reduced the programs, narrowed their focus, and eventually retrenched them as part of structural economic reforms, austerity measures, and federalism reform. These reforms had the goal of reducing distortions in the economy, balancing the budget, and boosting export competiveness.676

One of the chapter’s empirical contributions is to demystify the assumption that social housing policies in Germany solely subsidized rental markets. They included funding opportunities for both homeownership and rental markets, in large part because the Christian Democrats attempted to create a nation of homeowners. Despite their political heft in the postwar German political system, they struggled to realize their preferences of boosting homeownership against the strong resistance of the federal states. The German nation of renters was therefore not purposefully designed, but instead the result of fortuitous political constellations that privileged the rental sector over homeownership when it comes to social housing.

676 Yet, Reisenbichler and Morgan (2012) argue that structural economic reforms and austerity did not produce Germany’s subsequent economic miracle, but instead the decades-long adjustments in business- labor relations.

194 Finally, the chapter contributes to debates in political economy about the public- private welfare state and Christian Democracy. First, scholars have rarely explored how housing -- a core element of the welfare state and private family life -- has featured into the politics of Christian Democracy. Instead, scholars in this camp have often focused on health, pensions, and labor markets.677 Yet, the public-private nature of the German social housing model -- both for homeownership and rental markets -- blends in very well with the Christian Democratic welfare model. The focus on homeownership, in particular, fits the Christian Democratic ideology of conservative family life and private ownership.

Second, and relatedly, the social housing programs are quintessential examples of the broader public-private welfare state.678 The ways in which public policies support private housing markets have received little attention in the welfare state literature.679 This chapter shows how public policies supported private housing markets by lowering the cost of building and financing for private actors, such as housing associations, ordinary people, or building companies. In return, these private entities had to adhere to securing affordability and other housing standards. This resulted in an enmeshment between the postwar German state and private housing markets, which went on to shape housing for decades into the future.

677 Van Kersbergen 1995; Kalyvas and van Kersbergen 2010. 678 Hacker 2002; Morgan and Campbell 2011. 679 There are some notable studies on the U.S. case: see Thurston 2015; Howard 1997.

195 Chapter 5: Comradely Housing Capitalism: Mortgage Debt Policy in the United

States, 1930s-2010s

Introduction

Two innocuous-sounding corporations, Fannie Mae and Freddie Mac, were at the heart of the financial and housing debacle of 2008-09. The two cousins are listed on the New York

Stock Exchange and rank among the largest companies in the world by Fortune.680 They both specialize in mortgage finance, handling around six trillion dollars in mortgage debt, a number larger than the German government bond market.681 Fannie and Freddie issue bonds that are sold to international and domestic investors -- i.e., pension funds, governments, and hedge funds -- which makes the two institutions important not only to the American economy, but also the global economy.682 While the mortgage giants had long dodged the spotlight, they made headlines during the recent crisis. When they faced imminent bankruptcy in 2008, the Bush administration decided to bail them out with one of the largest bailouts in the country’s history, amounting to USD187bn. They have since remained in the hands of the U.S. government, and with it USD6.1tn in mortgage debt683 or 60 percent of the U.S. residential mortgage market. This led commentators to label the

U.S. housing finance market as “socialized”684 or a form of “comradely capitalism.”685

680 In 2017, Fannie Mae ranked 40th in the Fortune Global 500 ranking in terms of revenues (USD110bn), but 1st in terms of assets held (more than USD3tn). Freddie Mac ranked 124th in terms of revenue (USD63bn) and 4th in assets held (around USD2tn). 681 In 2016, the German government bond market amounted to EUR4.3tn. Sources: Housing Finance Policy Center; German Finance Agency. 682 H. Schwartz 2009; Acharya et al. 2011. 683 This number refers to mortgages held or securitized by these enterprises. Source: Housing Finance Policy Center. 684 See, for instance, Mervyn King, the former head of the Bank of England, quoted in: McLean 2015, 9. 685 The Economist, “Comradely capitalism: How America accidentally nationalised its mortgage market,” (August 20, 2016).

196 What makes these mortgage behemoths central to this study is their unique relationship with the American state, even long before the bailout. Fannie and Freddie were created by the U.S. government in the early and mid-twentieth century, respectively, and have since enjoyed the backing of the federal government, tax exemptions, and access to credit lines with the U.S. Treasury.686 This allowed them to borrow cheaply in financial markets, crowd out private competitors, and make billions of dollars in profits. To cement their privileged status, they spent millions on lobbying inside the Beltway and contributed to the campaigns of both political parties in Congress.687 U.S. presidents routinely appointed some of the corporations’ board members. When it comes to housing, the longstanding principles of U.S. free-market capitalism do not apply, as the mortgage giants owe much of their economic heft to the American state.

Public support for Fannie and Freddie is by no means the only way in which home mortgage markets have enjoyed privileges as part of the country’s state-based homeownership mortgage model. Where the German federal government offered loans or interest-rate subsidies directly to homeowners, its American counterpart mastered the art of extending government guarantees in the primary and secondary mortgage markets. In the primary market, the Federal Housing Administration (FHA), the Department of

Veterans’ Affairs (VA), and the Department of Agriculture (USDA) offer mortgage insurance for homeowners. In the secondary market, Fannie Mae and Freddie Mac buy

686 Koppell 2003. 687 Both Fannie and Freddie have their own political action committees – otherwise known as PACs – that support candidates in Congressional elections. According to the Center for Responsive Politics, from 1989 until 2008, Fannie and Freddie have spent USD4.8m on political campaigns (around USD3m financed by their PACs).

197 mortgages, package them together, and resell them as mortgage-backed securities with a guarantee against investor losses.

These practices subsidize the cost of mortgage debt for homeowners and thus fulfill important welfare state functions in the housing area. Although most mortgage holders in the United States benefit from Fannie and Freddie -- the institutions buy and resell people’s mortgages in the capital market, which reduces long-term mortgages rates -- ordinary people hardly ever notice their existence, as they operate in the off-budget terrain of the state.688 Yet, the benefits of these government programs are not shared equally by

American society, as they privilege homeowners over renters (who tend to be poorer)689 and have long discriminated against minorities.690 Moreover, Fannie and Freddie carry with them large concentrations of financial risk, given their dominant position in the mortgage market. As the recent bailout of Fannie and Freddie demonstrated, taxpayers are on the hook for the two institutions, having followed a business model of privatizing profits in good times and socializing losses in hard times.691 More generally, these programs are quintessential examples of the hidden, delegated, submerged, or public-private welfare state, offering public support for private housing markets.692

While the current status of Fannie and Freddie is raising eyebrows among scholars, political science research has rarely studied the origins and growth of the country’s state- based homeownership mortgage model.693 Answers to why U.S. policymakers have

688 Mettler 2011. 689 The multi-family rental programs of these government agencies are miniscule when compared with their homeownership programs. 690 Freund (2007), Hayward (2013), Thurston (2015), and Mettler (2005) provide excellent accounts on how many of these policies have long favored white homeowners and discriminated against nonwhites. 691 Krugman, “Fannie, Freddie and You,” New York Times (July 14, 2008). 692 Mettler 2011; Hacker 2002; Howard 1997; Morgan and Campbell 2011; Thurston 2015. 693 For a notable exception, see Koppel (2003). Also see Acharya et al. (2011) for a study in economics, Quinn (2009) in sociology, and Jackson (1980, 1985) in history.

198 created and sustained such a model might point to the influence of powerful housing interest groups.694 As they benefit from public support that props up housing markets, it is not inconceivable that housing groups -- who are among the most powerful groups inside the Beltway -- used their influence to shape housing finance policies in this direction.695

Another important body of work has emphasized partisan divides when it comes to social and economic policy,696 including in the housing area.697 Chapters two and four show that strong center-right parties in Germany adopted (and long defended) homeownership policies against political forces on the left. The American state-based mortgage model might therefore be the cumulative result of partisan struggles, where the political right was able to create and preserve public support for homeowners against the political left.

While partly illuminating, these approaches turn a blind eye to the macroeconomic context in which the state-based homeownership model evolved.698 This chapter concurs with these approaches in their focus on how political parties and interest groups help explain policy outcomes, but it also shows that the American consumption-oriented growth model is key in shaping party preferences and interest group power in the first place. First, policymaking around the state-based mortgage model was characterized by a remarkable and longstanding bipartisan consensus in favor of public support for home finance rarely seen in other social policy areas in the United States. Contrary to those who believe that such a consensus could be the product of a strong culture of homeownership,699 this chapter shows that the deeper source of this policy consensus lies in the country’s growth model.

694 Howard 1997; Hornstein 2005; Freund 2007. 695 Howard 1997, 93. 696 Esping-Andersen 1990, 16-18; Korpi 2006; Allan and Scruggs 2004; Garrett 1998; Huber and Stephens 2001. 697 See Ansell (2014); also see Bohle (2014); H. Schwartz and Seabrooke (2008, 242). 698 Prasad 2012; Rajan 2010. 699 Dreier and A. Schwartz 2014, 524; Jackson 1985.

199 Second, it is fair to say that housing interest groups have influenced policy outcomes, but this view requires nuance. What makes these interest groups influential is that they promote public policies that politicians of both parties regard as effective growth strategies. At the same time, their direct policy influence is limited in that they support what policymakers wanted to promote in any case -- a strong housing market and economic growth. In sum, the U.S. growth model shaped both the preference convergence of both parties and the sources of interest group power when it comes to housing finance policy.

This chapter argues that the consumption-led growth model has entrenched mortgage policies from the early twentieth century to the present. In response to weak aggregate demand during the Great Depression, the Hoover and Roosevelt administrations adopted large-scale housing programs and agencies, including the FHA and Fannie Mae, to stimulate credit, liquidity, and consumption. Policymakers across the political spectrum soon discovered the complementarities of these policies with the country’s early consumption-oriented growth model based on Keynesian demand management, wage growth, consumer credit, mass production, and private consumption.700 These deeper linkages helped shape a broader policy consensus among politicians of both parties, who viewed housing finance policies as effective growth strategies. Concomitantly, these macroeconomic features have amplified the voices of housing groups as agents of the growth model, as they promoted what was seen as effective growth strategies. By the

1960s, the number of homeowners in the country skyrocketed and the political economy of housing was firmly established as one centered on owner-occupied housing, which helped cement the state-based homeownership mortgage model.

700 Prasad 2012; Boyer 1990; Logemann 2012; Piore and Sabel 1984; Temin 1976, 1990; Slichter 1944, 1954.

200 From the 1960s until the late 1980s, when the days of Fordism and Keynesianism came to an end, the American growth model started to rely more strongly on credit-led, private consumption.701 As housing finance is the largest source of consumer credit in the country, this further elevated the importance of housing finance for the country’s growth model. Successive administrations and Congress have championed new ways of promoting mortgage credit and consumption – most notably through the creation of a government- sponsored securitization market of mortgage funding (i.e., mortgage-backed securities) designed to offset mortgage illiquidity in times of rising interest rates. This “housing finance revolution”702 placed Fannie (and its new cousin Freddie) squarely at the center of the country’s credit-based consumption model. Yet, politicians did not stop there, as the

Bush and Clinton administrations kept pushing mortgage lending to lower-income and minority households in the 1990s and 2000s. The dark spot on the horizon was the looming housing crash of the 2000s. At that point, housing finance policies -- including Fannie and

Freddie -- were so entrenched with the U.S. growth model and global financial system that there was broad agreement among political parties to take control of the battered mortgage giants, which nationalized parts of the mortgage market.

The economic fundamentals of government guarantees and mortgage securitization

Unlike Germany, where the federal government offered direct loans or interest-rate subsidies until the mid-2000s, the American state predominantly offers government guarantees in the primary and secondary mortgage markets.703 In the primary market, U.S.

701 Baccaro and Pontusson 2016; Krippner 2011. 702 Green and Wachter 2007. Green and Wachter show that, in this period, the housing finance market transitioned from a deposit-based system towards a system based on the capital market. 703 Green and Wachter 2005.

201 government agencies offer insurance on private mortgages for eligible homeowners against a fee. Insurance against mortgage default allows banks to offer mortgage loans at cheaper interest rates, given the risk-free nature of these loans, which tends to stimulate mortgage lending. For instance, the FHA offers mortgage insurance for households of modest means.704 Similarly, the VA offers guarantee programs for veterans, whereas the USDA provides mortgage benefits for households in rural areas.705 While the FHA has insured 34 million mortgages since its creation in 1934,706 an average of 410,000 per year, the VA insured more than 22 million since 1944, averaging 308,000 loans per year.707 The fees collected for mortgage insurance have usually exceeded the expenses for defaults in most years. However, the CBO estimates that the FHA guarantee program incurred an overall cost of USD15bn from 1992-2012, due to the wave of defaults during the crisis.708

Another way in which the federal government subsidizes mortgage debt is through the Federal Home Loan Banks (FHLB). The FHLB system is a government-sponsored entity owned by eleven regional banks and their member institutions (i.e., savings and loans, insurance companies, credit unions, and commercial banks). The purpose of the institution is to provide cheap funding to its members to support liquidity in the housing finance market.709 Given its government-sponsored status, the FHLB can borrow funds at

704 To receive FHA mortgage insurance, among other things, homeowners have to meet certain credit-score criteria and the USD640,000 loan limit, have a history of steady employment for at least two years, and come up with a down payment of 3.5 percent. 705 Fetter 2013. 706 The FHA’s share of mortgage originations, for instance, increased from 9 percent in 1996 to 18 percent during the crisis in 2009 and dropped again to 13 percent in 2016. The origination volume includes the purchase and refinancing of mortgages per year. Source: HUD. 707 In 2015, the FHA insured 1.1 million mortgages (in the amount of USD245bn), whereas that number is 630,000 for the VA (USD153bn) and 166,000 (USD24bn) for the USDA. Sources: FHA, VA, USDA. 708 Chirico and Mehlman, “FHA’s Single-Family Mortgage Guarantee Program: Budgetary Cost or Savings?” Congressional Budget Office Blog (October 21 2013). 709 Hofmann and Cassell 2002, 2005.

202 attractive rates in financial markets while financing its operations through issuing agency bonds -- an agency with assets in the amount of USD1.3tn in 2007.710 In contrast to Fannie and Freddie, the institution survived the financial crisis without requiring public assistance.711

In the secondary mortgage market, private banks or government-sponsored enterprises, such as Fannie and Freddie, buy primary mortgages, package them together, and sell them as mortgage-backed securities (MBS) to investors.712 Instead of offering loans directly to homeowners, this practice increases the liquidity of banks by taking off mortgage debt from their balance sheets, which frees up bank lending capacities, increases housing demand, and pushes down mortgage rates.713 While this process is not confined to government-sponsored agencies, they have become the key players in the secondary mortgage market. Fannie and Freddie perform two major functions -- investment and securitization.714 On one hand, they invest in and hold mortgage debt in their portfolios, which is financed by issuing agency bonds. On the other, they securitize mortgage debt and sell these securities to investors with a guarantee.715 Fannie and Freddie can buy and sell a broad array of private mortgages and have enjoyed implicit (pre-2008) and explicit

(post-2008) government backing.716 The government-backed status of these agencies has

710 The FHLB’s assets grew from USD200bn in 1990 to USD1.3tn in the late 2000s. See Hoffmann and Cassell 2010, 6. 711 Hoffmann and Cassell 2009. 712 Currently, the loan limit for agency purchase is USD424,000, with exceptions in high-cost areas. 713 Passmore 2005. 714 A third government-sponsored agency in the secondary mortgage market, Ginnie Mae (publicly-owned), guarantees the principal and interest of mortgage-backed securities (consisting of mortgages insured by the FHA and VA). The amount of mortgages securitized by Ginnie Mae increased from USD600bn in 2000 to USD1.7tn in 2016. Sources: Housing Finance Policy Center; OFHEO. 715 The volume of securitized and mortgages held by Fannie Mae and Freddie Mac increased from USD400tn and USD338bn in 1990 to USD1.3tn and USD1tn in 2000 to USD2.7tn and USD1.7tn in 2016. Source: Housing Finance Policy Center. 716 Passmore (2005, 466) estimates that Fannie and Freddie receive an implicit subsidy that ranges from USD122bn to USD182bn per year. The Congressional Budget Office (CBO) reckons that, in 2009, Fannie

203 allowed them to borrow money at attractive rates in financial market and provided an edge over their private competition.717 In addition, their special status has attracted foreign investments in Fannie and Freddie securities, which exerted additional downward pressure on U.S. mortgage rates.718 Correspondingly, the agencies were able to increase their combined share of the residential mortgage market from less than 10 percent in 1981 to 45 percent in 2000 and even 60 percent in 2016 (or six trillion dollars out of a ten-trillion- dollar market in 2016).719 Finally, the United States is not alone in securitizing mortgages, but stands out for its high degree of government involvement. Instead of issuing mortgage- backed securities, German banks use covered bonds -- a pool of mortgages and other assets720 -- to refinance their lending activities.721 However, the country does not have government-backed enterprises or government guarantees in the secondary mortgage market, as it instead offers private investor protections. 722

Public support for the U.S. mortgage market significantly reduces the cost of mortgage debt and is therefore an important element of the public-private welfare state.723

While government guarantees are not direct spending programs, they subsidize mortgage

Mae and Freddie Mac government guarantees cost the taxpayer around USD42bn. See CBO, “An Overview of Federal Support for Housing,” Economic and Budget Issue Brief, November 2009. 717 Without government guarantees, banks would incur the risk of asset-liability mismatches of lending long at low rates and borrowing short at potentially higher rates, which would make it riskier for banks to offer the 30-year, fixed-rate mortgage and result in higher mortgage rates for homeowners. See Green and Wachter 2005, 110. 718 H. Schwartz 2009; Seabrooke 2010. 719 Source: Housing Finance Policy Center. 720 Covered bonds are not exclusively backed by housing, but also by other forms of collateral, such as ships, airplanes, or public sector loans. 721 Lucas et al. 2008. 722 Covered bonds are more conservative than U.S.-style mortgage-backed securities in that they only include 60 percent of the home value to prevent losses from a potential fall in house prices. Banks also have to ring- fence the covered bond pool -- i.e., banks retain a significant proportion of these bonds in their portfolios, which do not fall under insolvency proceedings in the case of bank insolvency, so as to satisfy the claims of covered bond investors. This procedure is required under German law (under the Pfandbrief Act) and monitored closely by national regulators. 723 Mettler 2011; Hacker 2002; Howard 1997.

204 debt by insuring billions or trillions of dollars in the housing market -- with significant distributive economic and social consequences. In the United States, these policies have overwhelmingly focused on the owner-occupied market -- especially for white middle class families724 -- privileging homeowners over renters and “pushing Americans away from dense multiunit dwellings toward sprawling single-family detached homes.”725 It is important to note that all of these agencies -- from FHA to Fannie Mae -- are allowed to subsidize multi-family home mortgages, but they do so only marginally.726 In addition, the national character of mortgage guarantees tends to harmonize mortgage rates across U.S. regions with different risk levels and produce standardized mortgage products.727 These factors stand in stark contrast with Germany, where federal mortgage policies were far more regionalized and overwhelmingly favored the rental market sector. Finally, while government guarantees may not always cause immediate budgetary strains, the financial crisis of 2008-09 demonstrated that taxpayers are on the hook in the case of mortgage default.

The rise of government guarantees in the mortgage market from the Great

Depression until the 1960s

Today’s housing finance policy architecture emerged during the Great Depression -- a period in which consumption and housing had already been essential elements that contributed to economic growth.728 The Great Depression was a full-blown housing crisis.

724 Freund 2007; Thurston 2015, 256. 725 Glaeser 2011, 5. 726 With USD1.2tn in 2016, the U.S. multi-family mortgage market is much smaller than the market for single-family homes (USD10.3tn), which partly explains why the government-sponsored agencies held and securitized much more single-family home debt. Source: Federal Reserve Board. 727 Hurst et al. 2016. 728 Gjerstad and Smith 2014. Also see White, Snowden, and Fishback 2014.

205 When aggregate demand plummeted and the housing market collapsed, Republican and

Democratic administrations -- supported by influential housing interest groups, such as the realtors and the savings and loans industries -- attempted to restore liquidity in mortgage markets and stimulate housing demand, with the goal of reviving consumption in the economy. To do so, they created housing finance programs that refinanced and guaranteed home mortgages to get banks back to lending. These policies soon created strong synergies with the consumption-oriented growth model and helped boost the U.S. economy out of the depression. This constitutive moment of the entrenchment of housing finance policy and the U.S. growth model of consumption would go on to shape the capacities and interests of policymakers and interest groups for future policy action. In addition, these policies transformed the formerly regionalized, non-standardized, and unregulated housing finance system -- based on risky, short-term mortgages with variable interest rates -- into a national, standardized, and regulated mortgage market with long-term, amortizing, and fixed-rate mortgages. And these programs contributed to transforming the country from a nation of renters into one of homeowners from the 1940s until the 1960s, when the homeownership rate rose dramatically from its post-depression low of 43 percent in 1940 to roughly 62 percent in 1960.729

The early American consumption-led growth model formed in the depression era and created strong interlinkages with New Deal housing finance policies. Contrary to the

German economy, which focused on restraining consumption, price stability, savings, and export competitiveness, “the United States was laying the foundations for a growth model

729 However, this development overwhelmingly benefited white homeowners in suburban areas over nonwhites in urban areas, who were often renters. See McCabe 2016.

206 based on consumption” during the Great Depression.730 The American growth model in the

Fordist era was based on wage growth, consumer credit, mass production, and Keynesian demand management, all of which tended to stimulate private consumption.731 First, the

United States did not have a national or sectoral collective wage bargaining system found in Germany, which led American labor unions to push for higher wages in this period.732

As Temin pointed out, the United States adopted a “high-wage” approach, which then translated into higher private consumption.733 Second, it is widely known that the New

Deal and postwar eras led to an increase in government spending, economic demand management, and welfare state expansion.734 Third, contrary to Germany after WWII which encouraged the establishment of a savings regime, expanding consumer credit to finance mass consumption was a policy priority in the United States.735 As Logemann expresses, the depression-era credit policies, including those for housing finance, “helped pave the way for the American mass consumer economy of the second half of the twentieth century.”736 Finally, the United States adopted a mass production and consumption regime in the 1940s,737 including the standardized mass production of suburban homes.738 As

Lizabeth Cohen notes, “new house construction provided the bedrock of the postwar mass consumption economy, both through turning ‘home’ into an expensive commodity for purchase by many more consumers than ever before and by stimulating demand for related

730 Prasad 2012, 81. 731 Prasad 2012; Piore and Sabel 1984; Boyer 1990. 732 Slichter 1944, 1954; Morton 1950. Slichter, a prominent labor economist at the time, viewed the strong role of unions with skepticism, fearing rising inflation and uncompetitive industries in the United States and therefore promoted the adoption of a national wage bargaining mechanism. 733 Temin 1990, 301; Piore and Sabel 1984. 734 Katznelson 2013; Piore and Sabel 1984, ch. 4. 735 Logemann 2008; Prasad 2012; Ryan, Trumbull, and Tufano 2011. 736 Logemann 2008, 527. 737 Piore and Sabel 1984. 738 Jackson 1980, 1985.

207 commodities, such as cars, appliances, and furnishings.”739 The country’s early state-based homeownership mortgage model, which was created in the depression-era, seamlessly blended in with the growth model. Housing finance policies reinforced these components of the growth model, as they stimulated housing demand, consumer credit, the mass production and construction of suburban housing -- and related consumer goods, such as cars and appliances -- and housing wealth. This, in turn, fuels consumption in the wider economy. In this period, the consumption-oriented growth model created strong linkages with the country’s state-based homeownership model. Yet, it was not until the 1940s that the American economy fully recovered from the Great Depression.

The Great Depression already demonstrates the link between housing and consumption in the larger U.S. economy. Economic historians have established that, prior to the depression in the 1920s, the U.S. housing market had surged, with booming construction, an increase in property values by 38 percent, and a mortgage credit volume that tripled from USD9bn to USD30bn.740 At the time, housing credit was based on short- term mortgages (2-5 years) with variable interest rates and large balloon or bullet payments at the end of the mortgage period.741 Yet, when private household consumption and aggregate income plummeted as the result of the economic shock in 1929,742 the country’s housing market collapsed. Property values fell by 50 percent, a quarter million homes per year were foreclosed at the peak of the depression in 1933, and construction activity fell by 90 percent.743 This was important because residential investment was around 6 percent

739 Cohen 2004, 237. 740 Snowden 2010; White 2014; Field 2014. The construction boom reached its peak in 1925, with almost one million new housing units produced that year. 741 It should be noted that the S+Ls had already offered medium-term (8-12 years), amortizing mortgages, whereas commercial banks often offered bullet or balloon mortgages. See Snowden (2010). 742 Temin 1976; Romer 1990; Mishkin 1978. 743 Green and Wachter 2007; Field 2014, 65; White 2014.

208 of GDP in 1926 -- a record high surpassed only briefly in the mid-2000s prior to the recent housing crash -- and then dropped to one percent in an already contracted economy in

1933.744 Some economists argue that, in the 1920s and 1930s already, the drop in aggregate consumption was linked to the housing sector. For instance, Gjerstad and Smith, a 2002

Nobel laureate, explain that “[a]lthough we cannot unambiguously identify the cause of the collapse in consumption, the buildup of household debt almost surely played a significant role.” They continue to argue that residential construction “plays an outsized role in the household balance sheet because it became increasingly leveraged during the decade

[1920s], and the price collapse during the Depression seriously reduced household wealth and solvency.”745 Housing and consumption are linked through a number of channels -- a drop in house prices reduces residential construction and hurts household wealth and spending abilities, which, in turn, negatively affects employment and production. While this mechanism does not go uncontested in the literature,746 few doubt the importance of both housing and consumption for the U.S. economy at that time. According to the Gjerstad and Smith, “[d]uring the Depression, the decline in expenditures on new residential units plus the decline in consumption accounted for 72.9 percent of the total decline in GDP.”747

This sent a powerful message to policymakers -- that housing and consumption needed to be revived.

To assess the state of the housing crisis, President Hoover (1929-1933) convened a housing conference in 1931, where a powerful public-private alliance formed in support of

744 Field 2014, 64-65. 745 Gjerstad and Smith 2014, 86-87. 746 While Field (2014), for example, acknowledges the relationship between housing and consumption during the Great Depression, he argues that the relationship was more pronounced during the recent Great Recession. 747 Gjerstad and Smith 2014, 111. In 1933, for instance, only 90,000 housing units were produced in the entire country.

209 housing finance. The conference included policymakers, interest groups, and experts in order to deliberate over solutions for the growing housing crisis.748 The 3,000+ participants developed a set recommendations about the future of housing policy, which, in Hoover’s words, was “not to set up government in the building of homes but to stimulate individual endeavor and make community conditions propitious.”749 This statement captures

Hoover’s preference for public support for the private market -- or what today might be called the public-private welfare state -- which would become a key principle of U.S. housing finance policy for decades to come.750 At that time, Hoover found a powerful ally in the National Association of Real Estate Boards (NAREB) -- a group of highly professionalized realtors that had long pushed for the expansion of homeownership and federal support in the home finance market, while opposing public housing which would open the door to socialism.751 This public-private alliance of policymakers and interest groups was the first move in forming a political bloc favoring public support for housing finance.

In a first step to tackle the housing finance crisis, the Republican Hoover administration, along with a divided Congress,752 established the Federal Home Loan

Banks (FHLB) in 1932. The FHLB is a quasi-governmental system of twelve quasi-public regional banks, which provides cheap short-term and long-term funding to the savings and loans banks. At that time, thrifts were important lending institutions in the U.S. mortgage

748 Freund 2007; Hornstein 2005; Jackson 1980. 749 Herbert Hoover, “Address to the White House Conference on Home Building and Home Ownership.” December 2, 1931. 750 As Secretary of Commerce, Hoover contributed to the 1922 Better Homes in America campaign, which was a public-private effort to promote homeownership and modernize homes, as well as the Own Your Own Home Campaign that was started by the realtors in 1917. He viewed these public-private partnerships as a guiding principle of economic development. See Freund (2007). 751 Hornstein 2005; Freund 2007; Hayward 2013. 752 By divided Congress, I mean that neither party has a majority in both chambers.

210 market,753 but they were hit hard during the depression, when they suffered from loan losses.754 The immediate policy goal was to counter foreclosure, losses in housing wealth, and falling house prices in an illiquid market, with the housing industry lamenting that

“mortgage money has practically disappeared.”755 The long-term objective was to stimulate home lending and liquidity and reduce the cost of home mortgages. As Hoover stated:

The purpose of the system is both to meet the present emergency and to build up

homeownership [finance] on more favorable terms than exist today. The immediate

credit situation has for the time being in many parts of the country restricted the

activities of building and loan associations, savings banks, and other institutions

making loans for home purposes, in such fashion that they are not only unable to

extend credit for the acquirement of new homes, but in thousands of instances they

have been unable to renew existing mortgages with resultant foreclosures and great

hardships.756

Influential housing interest groups, including the realtors and the S+Ls, supported the creation of the FHLB, as they stood to gain from supporting housing credit,757 which would

753 The S+L’s share of mortgage lending was around 25 percent in the 1920s, while that of the mutual savings banks was 16 percent, the insurance companies 8 percent, and the commercial banks 10 percent. The remainder was provided by non-institutional lenders. See White (2014, 135). 754 Pizzo, Fricker, Muolo 1989. 755 Walter Schmidt, National Association of Real Estate Boards, U.S. Senate Committee on Banking and Currency, Hearings, January 20 and 27 and February 15 and 16, 1932. 756 Herbert Hoover, “Statement About Signing the Federal Home Loan Bank Act.” July 22, 1932. 757 Morton Bodfish, the chief S+L lobbyist at the time, successfully made the case for setting up the FHLB as a reserve system for the S+Ls to ensure liquidity and offer a government backstop: “We want this [FHLB] structure erected in a sound, conservative way, in which it will function without coming down here 5 years later or 10 years later or the first time we have another depression, or before we get out of this one, and say to you gentlemen – well, to quote Shakespeare, ‘Save me, Cassius, or I sink.’ Building and loan is not here asking a hand-out in any sense of the word. We merely feel that there should be set up a reserve structure--a banking system, if you please, which will serve the home financing institutions of the country.” See U.S. House Committee on Banking and Currency, Hearings, March 10, 17, 18, 21, 22, 23, 24, 25, 28, 29, 30, 1932.

211 “place resources at the command of the home-financing institutions, which will lead, first, to lower costs of mortgage credits, and, second, to higher percentage loans to the sturdy, honest, home purchaser.”758 While the FHLB system did increase the flow of credit and liquidity to some degree, it was not enough to directly help homeowners facing foreclosure, nor encourage ordinary people to take out loans, nor fix the broken structure of the mortgage lending system.

In a second step, as part of its New Deal legislation, the Democratic FDR administration (1933-1945), backed by strong Democratic majorities in Congress, established the Home Owner’s Loan Corporation (HOLC) in 1933.759 This quasi- governmental agency, which was overseen by the FHLB, temporarily purchased mortgages that were at risk of default and refinanced these mortgages into longer-term, amortizing mortgages with a fixed interest rate. The goal was to provide liquidity in the mortgage market, stop foreclosure, directly help struggling homeowners, and stimulate housing -- or, in the words of President Roosevelt, to offer homeowner relief to end the “deflation which was rapidly depriving many millions of farm and home owners from the title and equity to their property.”760 The HOLC financed its activities by issuing its own bonds and received support from the U.S. Treasury.761 The institution was revolutionary in that it restructured the terms of one million mortgages into the kinds of mortgages we know today -- long-

758 William Best, President, Building and Loan League, Hearing, U.S. House Committee on Banking and Currency, Hearings, March 10, 17, 18, 21, 22, 23, 24, 25, 28, 29, 30, 1932. 759 The HOLC stopped refinancing delinquent mortgages in 1936 and was dissolved in 1951. 760 Franklin D. Roosevelt: “Statement on Signing the Home Owners Loan Act.” June 13, 1933. 761 In 1934, in an amendment to the HOLC Act, the U.S. government elevated the status of HOLC bonds to those backed by the full faith of the U.S. government, because the U.S. government previously had not clearly guaranteed these bonds. According to President Roosevelt, the goal of the amendment was to “assure the continued progress on a self-sustaining basis of the making of loans for the purpose of refinancing home mortgages without interruption.” Franklin D. Roosevelt, “Message from the President of the United States Recommending Enactment of the Legislation to Guarantee the Principal of Bonds of the Home Owners’ Loan Corporation.” February 28, 1934.

212 term, amortizing mortgages with fixed interest rates.762 The legislation was, again, pushed by the realtors and S+Ls, arguing that “the construction industry is the biggest industry in this country, and it has simply got to revive before there can be any other revival of business.”763 Yet, banks remained hesitant to lend, as they had absorbed massive losses not too long ago, while the HOLC only helped restructure existing mortgages, but did not generate new mortgage lending.764

In response to these challenges, in a third step, the FDR administration and

Congress established the FHA as part of the National Housing Act of 1934. The agency offered mortgage insurance on long-term, fixed-rate, amortizing mortgages with lower down payments.765 Lenders were attracted by the risk-free nature of FHA-insured mortgages, which slowly created a new national, standardized mortgage market based on long-term, amortizing mortgages with a fixed interest rate.766 By reducing the risk for private banks, these government guarantees significantly lowered the cost of home mortgage debt and mortgage rates, and it stimulated bank lending and liquidity. Without increasing direct public spending, the instrument was designed to boost consumer and bank confidence as well as encourage housing investment by reducing mortgage rates, which

762 Green and Wachter 2005. 763 See Walter Schmidt, NAREB, U.S. Senate Committee on Banking and Currency, Hearings, April 20 and 22, 1933. He also argued that additional federal support and more comprehensive housing finance reform was needed to establish liquidity in the mortgage market and lower interest rates: “I feel that unless a comprehensive bill covering the mortgage field on a very conservative basis is enacted, that you will not accomplish for the home owner what you are setting out to do, because I do not think you will put the mortgage in the shape of a liquid instrument into which it must be put if that whole mortgage structure is to survive such periods as we are having now and if you are to come to a lessening in interest rate.” 764 Green and Wachter 2005. 765 The median loan-to-value ratio for FHA-loans incrementally increased from 79 to 93 percent between 1950 and 1970, while that of conventional loans increased from 66 to 77 percent during that time. See Fetter (2013). 766 As documented by Fetter (2013, 117), the median loan term of FHA mortgages increased from 20 years in 1950 to 29 years by 1970, while that of conventional mortgages increased from 11 to 21 years during the same time period.

213 would go on to generate job growth in the construction sector (where unemployment was very high) and economic growth. According to a report from the Senate banking committee, the goal of the bill was to “provide employment, and stimulate industry; to improve conditions with respect to home-financing … by creating a system of mutual mortgage insurance.”767 Accordingly, the legislation was supported by the S+Ls, realtors, and homebuilders, who viewed the “nonliquidity of the mortgage” as the main problem in the housing finance market.768 This view is echoed by Marriner Eccles, then assistant secretary of the Treasury and one of the main architects of the country’s housing programs:

the reason for unemployment is not because people do not need a mass of things

that would add to their comfort, give them their necessities; it is not because they

are unwilling to work, the most of them, to secure the things they desire; it does not

mean that we live in an economy of scarcity, for we live in fact in an economy of

plenty; but there seems to be a lack of getting money into the hands of people who

desire to spend it. Now, that is not because there is any shortage of money. As a

matter of fact, we have in our banks today an excess of reserves … The idea back

of this program is to induce private lending institutions to take up this credit

expansion, to undertake to get people to borrow … These funds should go, it seems

to me, into the capital market through mortgage lending, go into the housing

field.769

767 U.S. Senate Committee on Banking and Currency, Report, “National Housing Act,” June 8, 1934. 768 See Walter Schmidt, NAREB, U.S. Senate Committee on Banking and Currency, Hearings, May 16-24, 1934. 769 See Marriner Eccles, assistant secretary of the Treasury, U.S. Senate Committee on Banking and Currency, Hearings, May 16-24, 1934.

214 In his testimony, Eccles viewed housing as an effective way of overcoming unemployment by stimulating credit, demand, and consumption. In retrospect, Eccles recalled that “in a depression the proper role of government should be that of generating a maximum degree of private spending through a minimum amount of public spending.”770 This view also reflects the larger debates about housing finance policy during the depression era, which mainly revolved around macroeconomic issues of stimulating credit, demand, and economic growth. In its first twenty years of operation, from 1934 to 1957, the FHA insured

4.6 million mortgages.771

Relatedly, the National Housing Act of 1934 encouraged the creation of (public or private) national mortgage associations that would ensure the flow and liquidity of mortgage credit. Specifically, the Act authorized the FHA to approve mortgage associations “(1) to purchase and sell first mortgages ... and (2) to borrow money for such purposes through the issuance of notes, bonds, debentures, or other such obligations.”772

However, by 1937, the FHA had not approved a single national mortgage association

(presumably because private investors were hesitant to set up mortgage companies in times of economic uncertainty)773 and, at the same time, President Roosevelt felt that the sluggish housing market was holding back the recovery of the larger U.S. economy:

The long-continued lag in building is a drag on all industry and trade. This presents

an urgent problem which is the common concern of industry, labor, and

government. All business needs the infusion of orders and the diffusion of

770 Eccles 1951, 148-9. 771 Source: Historical Statistics of the United States (1975). Between 1958 and 1970, the FHA insured another 5.8 million mortgages. 772 See Title III of the National Housing Act of 1934. 773 Quinn 2009.

215 purchasing power that come when building is thriving. Great numbers of people

look directly or indirectly to the construction industry for employment. This

industry, to a greater extent than any other, can put idle funds to work and thus

speed up the circulation of the nation’s money supply. This, in turn, would increase

national income, reduce unemployment … The government, however, can take the

initiative by bringing about a reduction of financing costs, by making it easier for

families of moderate means to buy or rent new houses, and by providing

mechanisms to make it practicable for private enterprise to engage in large-scale

housing operations for the mass market.774

For Roosevelt already, the housing market was something larger than just an economic sector -- it was the transmission belt to stimulate employment and growth for the broader economy. To unclog the transmission, he tasked the FHA to set up and oversee the National

Mortgage Association of Washington (its name was quickly changed to Federal National

Mortgage Association or, in short, FNMA or “Fannie Mae”) to purchase FHA-insured mortgages and free up the lending capacities of banks to achieve housing and economic growth. 775 By 1952, Fannie Mae held FHA or VA home mortgages in the amount of

USD2.2bn, a share of only three percent of total outstanding mortgage debt.776 Although this number seems miniscule compared to what Fannie’s balance sheet is today, it has reinforced the larger policy infrastructure of government support for housing finance and would soon grow to dimensions unforeseen and unintended by its creators.777

774 Franklin D. Roosevelt, “Message to Congress on Legislation for Private Construction of Housing,” November 27, 1937. My emphasis. 775 It financed these activities by issuing bonds to investors. 776 Source: Historical Statistics of the United States (1975). 777 Mortgages held by Fannie kept increasing to USD5bn in 1965 (a share of merely 2 percent of total outstanding mortgage debt) and USD21bn in 1970 (a 6 percent share of total mortgage debt).

216 As the housing market and the economy started to recover in the early 1940s,778 partly boosted by wartime production, the FDR administration adopted mortgage guarantee programs for veterans as part of the Servicemen’s Readjustment Act of 1944 (i.e., “G.I.

Bill”).779 With the vivid memory of the Great Depression, this part of the G.I. Bill was designed to stimulate credit, construction, and consumption in the U.S. economy once

WWII came to an end. In a statement, Roosevelt remarked that the bill was to counter:

the serious problem of economic reconversion and readjustment after the war, so

that private industry will be able to provide jobs for the largest possible number …

A sound postwar economy is a major present responsibility.780

The mortgage program allowed returning veterans to take out loans, guaranteed by the U.S. government, with very low down payments and interest rates.781 The American Legion and

Veterans of Foreign Wars, two veterans associations, supported the bill,782 along with the general support of the major housing interest groups, such as the realtors, who viewed the

G.I. Bill’s housing provision as the “greatest single stimulant” for the housing sector.783

The Truman administration (1945-53), helped by strong majorities in Congress, continued along this path when it extended these benefits to veterans from the Korean War in 1952.784

In the first twelve years after WWII, the VA insured close to five million home mortgages,

778 In the early 1940s, housing construction improved and around 700,000 housing units were started in 1941. 779 Mettler 2005. 780 Franklin D. Roosevelt, “Statement on Signing the G.I. Bill.” June 22, 1944. 781 The median loan-to-value ratio for VA-loans was very high -- i.e., 91 percent in 1950 and increased to 95 percent in 1970 -- allowing veterans to take out loans with very low to no down payments. See Fetter (2013). 782 In 1944, the Legion had 200,000 members and was one of the main sponsors of the bill. 783 See Lee Cooper, “Realty Men Adopt Post-War Report,” New York Times (July 1, 1944). 784 See Fetter 2013.

217 which helped expand the homeowner constituency in the country and increased the

American state’s footprint in the mortgage market.785

These larger developments had significant distributive consequences in this period.

The homeownership rate increased dramatically from its low of 44 percent in 1940 to 62 percent in 1960. The same is true of residential housing construction, which started booming in the postwar period, increasing the number of housing units started from its

1933 trough of 90,000 to a new high of 1.6 million units per year in 1955.786 Similarly, housing wealth tripled from its 1933 low of USD79bn in 1933 to a peak of USD282bn in

1953.787 The total mortgage volume increased from USD24bn in 1934 to USD69bn in

1952, almost half of which (e.g., 41 percent) was backed by the federal government, and generated private consumption in the larger economy.788 However, where white households celebrated the successes of middle-class entry and homeownership in suburban areas, racial minorities were often left behind, as the redlining practices of the FHA actively discriminated against minority neighborhoods and contributed to racial segregation as well as housing inequality.789 In addition, federal policy privileged suburban housing over urban areas, as, in the words of Jane Jacobs,

[e]ndless suburban sprawl was made practical (and for many families was made

actually mandatory) through the creation of something the United States lacked

785 Source: Historical Statistics of the United States (1975). Between 1958 and 1970, the VA insured an additional 2.3 million mortgages. 786 Source: Historical Statistics of the United States (1975). This number remained above one million well into the 1960s. 787 Source: Historical Statistics of the United States (1975). 788 Source: Historical Statistics of the United States (1957). Also see Grebler et al. (1957). 789 Thurston 2015; Freund 2007; Hayward 2013; McCabe 2016. Also see Mettler (2005) for how VA loan guarantee programs, often administered by private banks following redlining guidelines, marginalized black veterans. The homeownership rate for African-Americans increased from 23 to 38 percent between 1940 and 1960 -- a rate much lower than that for white households at the time.

218 until the mid-1930’s: a national mortgage market specifically calculated to

encourage suburban home building … A national mortgage market has obvious

advantages in bringing the demand for money together with a distant supply of

money quickly and sensitively. But, particularly when it is diverted so heavily into

one kind of growth, it has its disadvantages, too.790

Unlike Germany, where housing finance policies offered subsidies for homeownership and renting, the United States established an infrastructure of public support predominantly for the home finance market.

One intriguing development in this period is the astonishing bipartisan agreement about stimulating housing finance in these legislative episodes. Where other New Deal policies -- such as public housing programs for the poor 791 or pro-labor legislation792 -- were much more controversial and ultimately undone, public policies to support home finance markets were cemented in this period. This section has argued that politicians across the political spectrum viewed housing finance as a key factor in reviving and stimulating the economy. Other New Deal policies fared worse than home finance programs, partly because they were perceived to be less important for the consumption-led growth model.

In sum, the Great Depression was the key moment for the entrenchment of the emerging consumption-led growth model and housing finance policy in the country. It was in this period that politicians of both parties, supported by housing interest groups, discovered the national importance of housing finance for the U.S. growth model of

790 Jacobs 1961, 308. 791 See Goetz 2013. Between 1934 and 1954, the FDR administration financed the completion of around 1.4 million public (rental) housing units. 792 Piore and Sabel 1984.

219 consumption. In the words of Marriner Eccles, then promoted to the chair of the Federal

Reserve:

The significance of a new housing program that could revive the economy was not

lost on President Roosevelt. He knew that almost a third of the unemployed were

to be found in the building trades, and housing was by far the most important part

of that trade. A program of new home construction, launched on an adequate scale,

not only would gradually help put those men back to work but would act as the

wheel within the wheel to move the whole economic engine. It would affect

everyone, from the manufacturer of lace curtains to the manufacturer of lumber,

bricks, furniture, cement, and electrical appliances. The mere shipment of these

supplies would affect the railroads, which in turn would need the produce of steel

mills for rails, freight cars … .793

Whether Republicans or Democrats, politicians favored policies that would restore and generate housing demand, liquidity, and growth.794 Housing interest groups -- empowered by these macroeconomic factors – often helped fill in the policy details by providing their expertise and advice to policymakers.795 The importance of this policy episode cannot be understated, as the deep interlinkages between housing finance policy and the U.S. growth model commenced in this period. In addition, these policies have contributed to increasing numbers of homeowners and a strong, national political economy centered around owner- occupied housing. These larger developments then set the stage for the politics of housing finance policy in future episodes.

793 Eccles 1951. 794 Also see Koppell 2003; McCabe 2016; Green and Wachter 2005; Freund 2007. 795 Freund 2007.

220 The financialization of mortgage markets from the 1960s until the late 1980s

From the late 1960s until the late 1980s, policymakers of all stripes adapted to increasingly tumultuous economic realities -- rising inflation, slower growth, and increasing unemployment paired with global economic shocks -- by redefining the entrenched nature of the growth model and housing finance policies. The American growth model underwent significant changes in response to the macroeconomic challenges of the 1970s. As Western economies entered a period of welfare state retrenchment and deindustrialization796 -- including a move away from Keynesian demand management and wage growth797 -- they readjusted their growth strategies to compensate for the drop in aggregate demand (i.e., in government spending and wage growth).798 Where the German economy doubled down on its export strength, the United States financialized its economy and laid the foundation for a credit-based consumption model.799 Housing played a key role in this process of financialization.800 Yet, housing markets were similarly impacted by these larger macroeconomic strains, especially by rising interest rates that caused severe mortgage illiquidity in the country, which impeded the transmission effects of housing in the wider economy. To restore these transmission effects, Democrats and Republicans in Congress and White House administrations were set to inject liquidity in the housing market and provide new sources of housing funding in the secondary mortgage market -- through the government-sponsored agencies, Fannie Mae, Freddie Mac, and Ginnie Mae -- so as to stimulate credit and consumption. These two co-evolving developments resulted in a strong

796 Iversen and Wren 1998. 797 Piore and Sabel 1984. 798 Baccaro and Pontusson 2016. 799 Baccaro and Pontusson 2016; Krippner 2011; Prasad 2012. 800 Jorda, Schularick, and Taylor 2016; Prasad 2012.

221 coupling of housing finance policy and the American credit-based growth model of consumption.801

In this period, policymakers laid the groundwork for what Green and Wachter

(2007) call the “housing finance revolution.” Mortgages had long been financed through the deposits of savers, mostly through S+Ls.802 Yet, politicians of both parties liberalized and championed the secondary mortgage market to generate new sources of mortgage finance in response to inflationary and interest-rate pressures, which had strained the S+Ls since the mid-1960s. The growing role of government-sponsored mortgage-backed securities as the new major source of housing finance -- predominantly issued by Fannie and Freddie -- placed the two agencies at the center of the American mortgage market. The government-steered financialization of housing therefore co-evolved with the larger trend of financialization of the U.S. consumption-led growth model,803 which has increasingly relied on credit-based consumption.804 Mortgages are by far the most important form of consumer credit, which made housing finance policy -- constitutive of the secondary mortgage market -- and the growth model virtually inseparable. The remainder of this section focuses mostly on the dynamic changes of housing finance policies in the secondary mortgage market, which were brought about by successive Republican and Democratic administrations.

801 H. Schwartz 2009; Prasad 2012. 802 In 1970, the S+Ls were the largest source of housing finance, with a market share of 56 percent of total outstanding debt. Also see Kohl (2015) for the historical origins of the S+L industry in the 19th century. 803 Krippner 2011; Aalbers 2008; Schularick and Taylor 2012; Jorda, Schularick, and Taylor 2015. According to Green and Wachter (2007, 38-39), household debt as a percentage of household income increased from 20 percent in 1949 to 46 percent in 1979 and continued to rise to 73 percent in 2001. They also show that mortgage debt as a percentage of GDP rose from 18 percent in 1952 to 30 percent in 1976 to 40 percent in the late 1980s and more than 70 percent in 2004. 804 Baccaro and Pontusson 2016; Crouch 2009; Prasad 2012; Gemici 2016.

222 In response to pressing mortgage liquidity problems on the heels of rising interest rates from the 1960s until the late 1980s, successive administrations -- from Johnson to

Reagan -- and both parties in Congress engineered and championed mortgage securitization that would ensure the flow of mortgage credit. First, in the late 1960s, the Johnson administration (1963-69) “privatized” Fannie Mae -- a move that hardly released Fannie to the private market, as the agency continued to enjoy government sponsorship. Second, it allowed Fannie to issue mortgage backed securities (consisting of mortgages insured by the FHA or VA) and, relatedly, created a new government agency -- Ginnie Mae -- designed to kick off the mortgage backed securities market by providing guarantees on these new securities. Third, the Nixon administration created yet another government- sponsored agency -- Freddie Mac -- and allowed both Fannie and Freddie to purchase, sell, and securitize conventional mortgages not insured by the FHA or VA. Together, these provisions were intended to increase housing finance funds and the liquidity of the mortgage market. Fundamentally, they also expanded the reach of the American state in the mortgage securitization business, a market financially engineered and dominated by the U.S. government. As the liquidity problems in the mortgage market continued throughout the 1980s, the Reagan administration deregulated parts of the mortgage market to stimulate mortgage credit by allowing for different types of variable-interest rate mortgages and facilitating private competition in the securitization market.

The financialization of the mortgage market started with the Johnson administration’s Housing and Urban Development Act of 1968, which was supported by large Democratic majorities in both chambers. In a first step, the Act privatized Fannie

Mae, which would now act as a privately-owned enterprise. Yet, the company retained its

223 status as a government-sponsored enterprise with preferential tax treatment, implicit backing of the U.S. government, presidential appointments of the company’s board members, and its congressional charter. Sarah Quinn (2017) argues that the privatization of Fannie was a political move to take Fannie’s debt off the government’s balance sheet on the heels of budgetary strains caused by the Vietnam War and the Great Society programs.805 While budgetary pressures were certainly important short-term considerations, the broader long-term goal of reforming the housing finance structure at that time, including Fannie’s reorganization, was to improve mortgage liquidity, credit, and the availability of low-cost mortgages in the country, as rising interest rates had put significant pressure on the S+Ls and led to a moderate mortgage crisis in 1966.806 The trick was to privatize Fannie without divorcing it completely from the federal government and to enhance its abilities to supply mortgage credit -- functions that the Johnson administration considered too important to leave to the private market.

The concern about increasing mortgage credit and liquidity is especially pronounced in the 1968 Act’s provision that authorized and encouraged the creation of mortgage-backed securities in the secondary mortgage market. It established that Fannie might issue mortgage-backed securities so long as the underlying mortgages were backed by the FHA or VA, so as “to provide a greater degree of liquidity to the mortgage investment market and an additional means of financing its operations.”807 To achieve that

805 For a detailed, historical account on how Fannie was privatized, see Quinn (2017). 806 The thrifts faced pressure when ordinary people and investors took their savings and investments in more profitable areas, such as U.S. Treasuries, a move that became especially attractive when interest rates started increasing. As thrifts were limited in how much interest they could pay on deposits -- because of a provision called regulation Q and conservative FHLB interest-rate restrictions -- and what investments they could undertake to compensate for dwindling deposits, they faced significant financial pressure and were unable to supply sufficient mortgage credit. See Green and Wachter (2005). 807 See Title VIII, Section 804 of the Act. Ginnie Mae guaranteed its first MBS in 1970 (while Freddie Mac and Fannie Mae guaranteed their first MBS in 1971 and 1981, respectively). Between 1970 and the early

224 goal, it created a publicly-owned government-sponsored agency, Ginnie Mae, tasked with guaranteeing the “principal and interest on any mortgage-backed securities issued by

FNMA, and also on any similar securities issued by other approved private issuers so long as they are backed by mortgages or loans guaranteed or insured by FHA, VA.”808 Ginnie’s guarantee program was designed to steer investors into the mortgage-backed securities market. In doing so, the federal government moved first in creating mortgage-backed securities, hoping that the private sector would emulate mortgage securitization, because

“if such [mortgage-backed] securities become well enough established so that many private issuers are issuing them, they could constitute a significant factor in attracting investment funds to the field of mortgage investment.”809 Senator Bob Bennett (R-UT) articulated that the purpose of these provisions was to re-establish a functioning and liquid mortgage market by channeling private investments into the housing finance market:

For many years the housing industry in this country has had as one of its principal

problems the lack of available credit for mortgage financing. It is very hard for

mortgages to compete with corporate securities in attracting capital … It is hoped

that [the bill] will provide a mechanism for the creation of a type of mortgage-

backed securities which will be purchased by pension funds and other types of

investors… thereby making more investment money available for the mortgage

market. The expectation is that FNMA will issue the first of such securities to

establish a market for them, and that thereafter mortgage bankers and other

2000s, the volume of MBS guaranteed by Ginnie Mae increased from USD100bn in 1980 to USD600bn in 2000. Ginnie Mae is self-financed by collecting fees on their MBS insurance from the issuers of MBS. See OFHEO, Report to Congress (June 15, 2003), p. 14. 808 See Title VIII, Section 804. 809 U.S. House Committee on Banking and Currency, “Report on Housing and Urban Development Act of 1968” (1968).

225 mortgage lenders and investors could come in and issue their securities. The bill

clearly pledges the full faith of the United States and credit of any amounts due

under this guaranty.810

Policymakers in Congress, both Democrats and Republicans, wanted to provide an “answer to the financial ills that have beset the housing and home financing industries for many years.”811 In Congressional hearings, the housing interest groups not only expressed their support for the provisions to increase liquidity, but they also helped draft parts of the legislation.812

Shortly thereafter, the Republican Nixon administration (1969-74) signed the

Emergency Home Finance Act of 1970 with the help of the Democratic Congress, creating

Freddie Mac, a government-sponsored agency to aid the thrift industry.813 The goal of the bill was to increase liquidity for the reeling S+L market and, in the words of the chairman of the Senate banking committee, John Sparkman (D-AL), “to get as much money in the home mortgage market as we can. Trying to stimulate it all we can.”814 At the same time, the 1970 Act authorized Fannie and Freddie to buy and sell conforming mortgages without

810 See Congressional Record, Senate, May 28, 1968. It was hard for mortgages to compete with corporate securities, as corporate securities were more profitable than mortgages, given that depository institutions were limited in how much interest they could pay on deposits. 811 See Bob Bennett (R-UT), Congressional Record, Senate, May 28, 1968. 812 See Philip Jackson and Richard Morris, members of the influential NAREB, who complained about the 1966 mortgage crisis and their industry’s poor economic performance. To overcome tightening problems in the mortgage market, they proposed to “reconstitute FNMA as an independent corporate instrumentality of the United States and authorize it to deal in conventional loans as well as FHA-insured and VA-guaranteed mortgages.” They also advocated for the practice of mortgage securitization by the government-sponsored agencies, which would attract considerable investment in the housing finance market. See Hearings on Mortgage Credit, Senate Committee on Banking and Currency, June 12, 26, 27, 28, 1967. 813 Freddie Mac was modeled after its cousin, Fannie Mae, and initially owned by the thrift industry until it was privatized in 1989 (while retaining its government-sponsored status). 814 See Senate Committee on Banking and Currency, “Secondary Mortgage and Mortgage Credit,” Hearing, March 2, 3, 4, 5, 6, 1970.

226 government insurance by the FHA or VA.815 These reforms were a direct response to macroeconomic and liquidity problems that have clogged the transmission between housing and the larger economy. As Greta Krippner writes, “an acute recession in the construction and housing industries quickly dampened activity in other sectors, restraining the broader economy.”816 While these reforms initially did not do enough to tackle the underlying problems of the country’s housing finance architecture,817 their long-term consequences are profound, as they provided the foundation of the mortgage-backed securities market that would soon develop into the most important source of housing finance. Once again, the bipartisan consensus around the issue is striking, with a strong preference for increasing mortgage liquidity and stimulating home finance on both sides.

Rising inflation and skyrocketing interest rates in the 1970s further strained the country’s housing market. While the thrifts struggled to stay solvent, residential investment and housing starts hit new lows.818 The Reagan administration’s housing agenda correspondingly aimed at alleviating the housing recession, lowering the cost of mortgages, and incentivizing private competition in the secondary mortgage market. In his first year in office, in 1981, Reagan set up a commission on housing, which recommended the

815 The bill allowed both Fannie and Freddie to invest in and securitize conventional mortgages not insured by the FHA or VA, so as to encourage competition between the two companies. They were also allowed to package them into mortgage-backed securities. Yet, Fannie, Freddie, and Ginnie effectively eliminated private competition for mortgage-backed securities, given their government-sponsored status that made Fannie and Freddie securities attractive to investors. 816 Also see Krippner 2011, 61. 817 In 1980, the Carter administration passed the far-reaching Depository Institutions Deregulation and Monetary Control Act, which significantly liberalized and deregulated the thrift industry by eliminating interest-rate ceilings and granting S+Ls broader authorities in their investment and banking activities. 818 While housing starts reached a low of one million in 1982 (down from its 1972 peak of 2.4 million), mortgage rates climbed to 16 percent in 1981 (down from 7 percent in the early 1970s). Similarly, residential investment dropped to merely 3.2 percent of GDP in 1982, a number not been seen for at least 30 years. Source: FRED.

227 deregulation of mortgage-backed securities and the S+Ls, which would go on to lower mortgage rates and increase liquidity.819

The housing lobby of realtors, mortgage bankers, homebuilders, and S+Ls was deeply unhappy at the time. They felt they had “unfairly borne the brunt of destructively high interest rates.”820 To appease the housing lobby, Reagan invited members of the industry to the White House in order to assure them that “there is no anti-housing bias in this administration.”821 While the Reagan administration internally acknowledged the importance of the housing groups – the realtors, in particular822 -- their direct policy influence was limited. In fact, there was very little policy disagreement between these groups and the Reagan White House. Well before the meeting, the Reagan administration had already developed a “HELP for Housing” plan, which explored “ways to achieve an effective ‘countercyclical stimulant’ for the economy: a program to get housing production going and create jobs.”823 The Reagan administration clarified its stance in support of housing during the meeting, but it is unlikely that either the meeting or the housing lobby more generally have altered the administration’s housing preference.

The Reagan administration first adopted the St. Germain Depository Institution Act of 1982, which allowed the thrifts to issue non-conventional, adjustable-rate mortgages.

819 White House, Memorandum, “Report of the President’s Commission on Housing,” June 1, 1982; President’s Commission on Housing, “Financing the Housing Needs of the 1980s: A Preliminary Report on Housing Finance,” 1982. 820 Joint Statement of American Bankers Association, Mortgage Bankers Association of America, National Association of Home Builders, National Association of Mutual Savings Banks, National Association of Realtors, U.S. League of Savings Associations, “An open letter to President Reagan and Members of Congress,” March 3, 1982. The statement was also published as a full-page ad in the Washington Post. 821 White House meeting protocol, March 19, 1982. 822 A White House staff memo underlines the importance of the realtors and their policy endorsements: “The 760,000 member NAR is one of the most politically active of all associations and word of their endorsement of the President’s economic recovery program will have a profound impact on others.” See White House, Meeting Brief for the President, “To accept the NAR endorsement for the President’s economic recovery program,” March 16, 1981. 823 White House, Memorandum, “HELP for Housing,” February 16, 1982.

228 The objective was to counter the “changes in interest rates [that] have seriously impaired the ability of housing creditors to provide consumers with fixed-term, fixed-rate credit” and to provide “adequate credit supply.”824 In Reagan’s words, the Act would offer “help for housing, more jobs, and new growth for the economy.”825 This proposal was supported by the thrift industry, which continued its struggle of fighting maturity mismatches and capital outflows in a high interest rate environment.826 This would have been unthinkable half a century earlier, when the thrifts had championed and pioneered the fixed-rate mortgage during the Great Depression. Yet, hard times led them to temporarily abandon the fixed-rate mortgage in order to stay afloat.827

In a second reform, the Secondary Mortgage Market Enhancement Act of 1984, the

Reagan administration removed legal restrictions for private banks and investors for trading mortgage-backed securities.828 This is because, in 1984, the government-sponsored agencies had dominated the securitization market, with a market share close to 90 percent.

The Reagan administration intended to introduce more competition in the secondary mortgage market, which would generate important “downward impact” on mortgage rates by broadening “the number of participants channeling investor capital to the

824 See Title VIII, “Alternative Mortgage Transaction Parity Act of 1982.” The Act itself specifies that the purpose of this bill was “[t]o revitalize the housing industry by strengthening the financial stability of home mortgage lending institutions and ensuring the availability of home mortgage loans.” 825 Ronald Reagan, “Remarks of the President in the signing ceremony for the Depository Institution Amendments of 1982,” October 15, 1982. 826 See John Dalton, Federal Home Loan Bank Board, U.S. Senate Committee on Banking and Currency, April 7, 1981. 827 Savings and loan representatives articulated the industry’s acceptance of variable-rate mortgages: “one can do nothing and hope for a sharp reduction in inflation and interest rates, which would lower the cost of funds and allow S&L’s to resume making long-term, fixed-rate mortgages. This may take a long time to come about, and in the interim there would be an intolerable shortage of mortgage credit … the variable-rate mortgage will be just like a fixed-rate mortgage, and the payments will not go up … the vast majority of loans made in California will be VRM’s [variable-rate mortgages].” See Jerry Pohlman, California Federal Savings and Loan, Hearing, U.S. Senate Committee on Banking and Currency, April 7, 1981. 828 Also see Office of Management and Budget, “Memorandum for the President, Secondary Mortgage Market Enhancement Act of 1984,” October 2, 1984.

229 homebuyer.”829 As a result of the liberalization of the mortgage market, adjustable-rate mortgages became more commonly used, peaking at 60 percent of all new mortgage originations in 1989.830 Relatedly, the government-sponsored enterprises, Fannie and

Freddie, entered yet another field of mortgage securitization -- that is, variable-rate mortgages.831 Yet, these reforms could not prevent the thrift industry from collapsing in

1989.832 This came at a time when the S+L’s market share of total mortgage debt held halved from more than 48 percent in 1980 to less roughly 22 percent in 1990.833 Finally, it is important to note that, while the Reagan administration slashed government spending on public housing,834 it did not scale back the government’s footprint in the home mortgage market, viewing it as a key industry to promote economic growth in the country. It is important to note that the Reagan years were characterized by a Democratic House of

Representatives, which could have blocked these laws. This is a testament to the larger policy consensus of promoting mortgage liquidity, credit, and housing consumption. Given that housing finance legislation to help housing is perceived to be in the national interest of promoting economic growth, this incentivized cooperation between the two parties.

In sum, the financialization of mortgage markets ties in with the larger transformation of the U.S. economy toward credit-financed consumption and growing

829 U.S. Senate Committee on Banking, Housing, and Urban Development, “Report on the Secondary Mortgage Market Enhancement Act of 1983,” November 2, 1983. 830 Green and Wachter 2007. 831 Starting in 1981, Fannie and Freddie have bought conforming, adjustable-rate mortgages -- mostly those with interest-rate or payment caps -- and held them in their portfolios. There was some underspecified leeway in what constituted a conforming mortgage. In general, Fannie mortgages had to adhere to certain loan size limits, loan-to-value-ratios of roughly 80 percent, and meet certain investment quality standards. This leeway was kept deliberately vague in the following decades and allowed Fannie and Freddie to enter the increasingly risky subprime mortgage field. Yet, in the 1980s, the majority of loans purchased was still fixed-rate mortgages. See Acharya et al. 2011. 832 See Pizzo, Fricker, and Muolo (1989) for a detailed account of the S+L crisis, which required a government bailout that cost the taxpayer USD123bn (Source: Federal Reserve History). 833 Source: Statistical Abstract of the United States (1995). 834 See Pierson 1994.

230 household debt at the time.835 In response to growing mortgage liquidity problems in times of rising interest rates, policymakers from both parties revolutionized the mortgage market by championing a new source of housing funds -- government-sponsored mortgage-backed securities.836 The federal government not only created and championed the securitization market, but it also became its most central actor through Fannie Mae, Ginnie Mae, and

Freddie Mac by the late 1980s. At each reform along the way, these agencies entered uncharted financial territory, discovered new sources of mortgage funding, credit, and liquidity, or pushed the boundaries of eligibility, all of which helped grow a multi-trillion- dollar securitization market. Given the problems and transformations in the housing finance sector in this period, including a period where mortgage credit was scarce, homeownership remained relatively flat, ranging between 63 and 65 percent from 1970 until 1990.

From boom to bailout: Credit growth, housing bubble, and the nationalization of

U.S. housing finance, 1990s-2010s

In 1990s and early 2000s, the synergies between housing finance policy -- government- sponsored mortgage securitization, in particular -- and the U.S. growth model reached new highs. This period saw unprecedented growth in house prices,837 mortgage debt,838 and

835 Baccaro and Pontusson 2016. According to Green and Wachter (2007), mortgage debt as a percentage of GDP increased from 30 percent to 40 percent of GDP between 1970 and 1990. 836 The share of outstanding residential mortgage debt held by Fannie Mae, Ginnie Mae, and Freddie Mac increased from 16 percent in 1980 to 30 percent in 1991 (and grew to one trillion dollars in 1992). Source: Statistical Abstract of the United States (1995). 837 Every major house price index shows massive house price gains between 1990 and 2007. See, for instance, S&P CoreLogic Case-Shiller Home Price Indices. 838 Mortgage debt as a percentage of GDP increased from 42 percent in 1992 to 70 percent in 2007. Source: Federal Reserve Flow of Funds.

231 mortgage securitization,839 partly fueled by low interest rates and capital inflows from abroad. As Herman Schwartz notes, “the U.S. housing finance system gave the U.S. economy above-average employment and GDP growth.”840 In addition, the U.S. housing finance market also integrated with the global financial system in this period, as U.S. mortgage-backed securities became a major asset class for investors.841 Global investors helped bring down the cost of mortgages, stimulate housing, and fuel consumption in the

U.S. economy. The strong synergies between housing finance policy and the credit-based consumption model in this period did little to upset the bipartisan consensus of continuing the liberalization the mortgage market while retaining or increasing the government’s footprint. In search of new sources of housing and economic growth, Republicans and

Democrats pushed the boundaries of mortgage securitization to new levels by including previously denied segments of the market, especially minority groups.842 Specifically, they tasked Fannie and Freddie with investing in mortgages held by households with low and moderate income to stimulate mortgage lending and growth in lower-income and minority communities.843 At the same time, Fannie and Freddie relaxed their underwriting standards and started investing in high-risk subprime mortgages, a move tolerated by politicians and regulators alike.844

839 Their mortgage market share (of residential debt outstanding) increased from 32 percent in 1992 to 41.5 percent in 2000 and 43 percent in 2004. Source: FHFA. 840 H. Schwartz 2009, xv. 841 See H. Schwartz (2009) for an excellent overview of the domestic and international economic implications of the crisis. 842 Rajan 2010. The homeownership rate for the black and Hispanic population was roughly 43 percent in 1994 (compared to 70 percent of white households). Source: U.S. Census Bureau. 843 It is important to note that most of these mortgages were not the high-risk subprime loans that caused financial crisis of 2007-08 (characterized by high and variable interest rates and fees, often issued without the proper financial documentation of borrowers, who often had little to no income and impaired credit histories). Instead, these were mostly non-predatory, affordable mortgage programs operated by community banks with proper financial documentation and moderate risk levels. See Bhutta (2015). 844 DiVenti 2009.

232 Yet, when the brewing crisis in the U.S. subprime mortgage market erupted in 2008

-- partly the result of policy overshoot in the housing area -- it brought the U.S. economy and global financial system on the brink of collapse. As Fannie and Freddie held subprime mortgages, they were exposed to financial losses and faced bankruptcy. This economic shock constituted a critical test for the housing finance policy equilibrium, which could have resulted in retrenchment. Yet, without hesitation, U.S. policymakers again increased and then retained public support for the two mortgage giants by seizing control of their operations, so as to retain liquidity and halt falling consumption. The remainder of this section details policy developments from the housing boom of the 1990s and early 2000s until the housing crash in the late 2000s.

Despite the memory of the S+L crisis of the late 1980s and early 1990s that required a large government bailout, the George H.W. Bush administration (1989-1993) introduced a lenient regulator for Fannie and Freddie and expanded their affordable housing goals.

First, the Federal Financial Safety and Soundness Act of 1992 established the Office of

Federal Housing Enterprise Oversight (OFHEO) at HUD to oversee the growing mortgage business and systemic risk of Fannie and Freddie. Second, it tasked the Secretary of HUD with overseeing their affordable housing goals of providing credit to low and middle income households and underserved communities. The regulatory part of the bill was significantly watered down by the successful lobby efforts of the government-sponsored agencies,845 preventing stricter regulatory oversight, caps on executive pay,846 and

845 According to a Washington Post report, a Fannie Mae official stated that the company was “communicating with every member of Congress who we think cares about Fannie Mae and cares about housing and telling them that this bill [with high capital standards for Fannie and Freddie] needs to be killed.” See Albert Crenshaw, “Fannie Mae Flip-Flops on Oversight Bill,” Washington Post (September 29, 1992). 846 In the late 1990s, James Johnson, then Fannie Mae’s CEO, received a salary between USD6-7m per year.

233 significantly higher capital standards for the two firms,847 following the mantra: “[i]f the system isn’t broke, don’t fix it.”848 They successfully argued that tighter regulations would have led to increasing mortgage rates for homeowners and fees for investors.849 The policy- oriented part of the bill specified affordable housing goals for the government-sponsored agencies, partly pushing them into the lower-quality mortgage market.850 The Democratic

Congress, in particular, felt that mortgage lending for low and moderate income segments dried up as a result of the S+L crisis and successfully pushed for the affordable housing provision.

Later in the 1990s, the Clinton administration (1993-2001) pursued the goal of expanding homeownership among minority groups as a vehicle for growth. In 1995, the administration released its “national homeownership strategy” -- a one-hundred-point plan for regulators, practitioners, and homeowners -- acknowledging the economic potential of housing for producing economic growth, which reads:

Homeownership is a commitment to economic growth. Homeownership helps

generate jobs and stimulate economic growth. The design, construction, and

rehabilitation of homes employs local labor and uses a vast array of American-made

products and services. Homebuilding has often led the economic recovery from

847 Fannie’s CEO, James Johnson, wanted to prevent “too much day-to-day intrusion” by regulators as well as rising mortgage rates; see Albert Crenshaw, “Fannie Mae, Freddie Mac Blast Bush Plan: Firms suggest Regulations Could Raise the Cost of Mortgages.” Washington Post (May 30, 1991). 848 See Paul Barru, Chairman, National Association of Home Builders, Hearings, House Committee on Banking, Finance, and Urban Affairs, July 18 and 19, 1991. 849 Albert Crenshaw, “Fannie Mae, Freddie Mac Blast Bush Plan: Firms Suggest Regulations Could Raise the Cost of Mortgages.” Washington Post (May 30, 1991). 850 It is important to note that earlier legislation had already started to (vaguely) formulate affordable housing goals. See, for example, Title VIII, Section 802, Housing and Urban Development Act of 1968, which stated that the Secretary of HUD could “require that a reasonable portion of FNMA’s mortgage purchases be related to housing for low and moderate income families.”

234 national recessions due to its strong job multiplier effect and because increased

housing starts and home sales represent renewed economic confidence.851

That housing boosted the U.S. economy out of the 1993 recession certainly shaped

Clinton’s view on the sector’s economic potential.852 His public remarks on the 1995 strategy closely resembled Marriner Eccles’ metaphor of housing as the “wheel within the wheel” to stimulate the economy:

When a family buys a home, the ripple effect is enormous. It means new

homeowner consumers. They need more durable goods, like washers and dryers,

refrigerators and water heaters. And if more families could buy new homes or older

homes, more hammers will be pounding, more saws will be buzzing. Homebuilders

and home fixers will be put to work. When we boost the number of homeowners in

our country, we strengthen our economy, create jobs, build up the middle class, and

build better citizens.853

As the homeownership rate among white households was already above 70 percent, Clinton attempted to boost homeownership among nonwhite households, which stood at around 43 percent. A former White House official stated that:

The mood in the White House in 1993 was not: ‘We are in a boom!’ But: ‘Oh god,

we have a recession on our hands! What can we do to get out of it?’ ... It fits with

Clinton’s ownership ideas, it fits with his equity ideas, because you were only able

to increase the homeownership rate if you could increase it for blacks, Latinos,

minorities, and women … It hit his equity buttons, and for Clinton that was huge.

851 HUD, “the National Homeownership Strategy: Partners in the American Dream,” 1995. 852 Leamer 2007. 853 Bill Clinton, “Remarks on the National Homeownership Strategy,” Washington, D.C., June 5, 1995.

235 It hit the homeownership society button. And we needed something exciting going

into the 1996 election. So that’s where the homeownership thing came from.854

The strategy was an attempt at enhancing partnerships between local governments, banks, realtors, and homebuilders, and communities, many of whom had denied various social groups access to mortgage credit and housing-related services. As the White House official stated:

If the realtors were not showing those people houses, they aren’t going to buy. The

bankers and the mortgage brokers aren’t talking to them and the bankers aren’t

giving them loans. Nothing is going to happen. So you had to bring everybody to

the table to agree that they would make the necessary changes in order to

accomplish this.855

The strategy therefore aimed at pushing the boundaries of the market and influencing the lending and business practices in the housing industry, so as to generate housing growth in previously neglected segments of the market. The Clinton administration therefore viewed raising homeownership among minority groups as sound social policy.

In line with this strategy, the Clinton administration focused especially on extending the reach of Fannie and Freddie. First, in successive steps, it increased the agencies’ affordable housing goals, so as to encourage banks to increase mortgage lending to low and moderate income groups.856 Second, in a 1995 directive, the administration revised the Community Reinvestment Act (CRA), which had required banks to extend

854 Author interview, former White House official III. Washington, D.C. July 16, 2014. 855 Ibid. 856 The affordable housing goals – i.e., Fannie and Freddie purchases of low- and moderate-income mortgages as a percentage of total mortgages -- increased from 30 percent between 1993 and 1995 to 40 percent in 1996 and 42 percent between 1997 and 1999. Source: Federal Housing Finance Agency.

236 credit to underserved communities since 1977.857 Dissatisfied with the existing level of credit extension to such communities, the administration sought to increase access to credit by subjecting banks to stricter performance-based reviews by regulators.858 In Clinton’s words, this would allow financial institutions to:

… discover new, profitable lines of business. And it doesn’t cost taxpayers a dime.

It can create miracles in small towns and big cities from coast to coast, miracles

like mortgage or business loans for people who never thought they could own a

house or business.859

The logic was straightforward: the more mortgage lending and securitization in underserved communities, the more community and business development, consumption, and economic growth. According to a Treasury report issued in 2000, the reform has contributed to increasing the lending activities of banks to low and moderate income households in underserved areas.860 It is important to note that, for the most part, CRA- related lending for borrowers with impaired credit ratings did not resemble the subprime mortgages responsible for the 2008 crash.861 Finally, in 1999, Fannie and Freddie further relaxed their underwriting standards and slowly started investing in high-risk subprime

857 Aalbers 2009. 858 Board of Governors of the Federal Reserve System, “The Performance and Profitability of CRA-Related Lending,” July 17, 2000. 859 Bill Clinton, “Statement on Reform of Regulations Implementing the Community Reinvestment Act,” April 19, 1995. 860 U.S. Department of the Treasury, “The Community Reinvestment Act After Financial Modernization: A Baseline Report,” 2000. Also note that regulators asses the performance of banks in serving the credit needs of low and moderate income households and communities, issuing public ratings of these banks. 861 Bhutta and Canner 2009. Their data show that only few CRA-related loans were subprime mortgages (i.e., 6% in 2005-06). Instead, CRA-related lending, often special programs developed with non-profit organizations for households of moderate means, performed quite well during the crisis. Also see Bhutta and Canner, “Assessing the Community Reinvestment Act’s Role in the Financial Crisis,” FEDS Notes (May 26, 2015).

237 mortgages, a relatively small segment of the mortgage market at that time.862 This move was encouraged by shareholders and tolerated by regulators and policymakers, at a time when Fannie Mae was under investigation for racial discrimination in its underwriting practices.863

In what it called an “aggressive housing agenda,” the George W. Bush administration (2001-2009) seamlessly continued Clinton’s push for expanding homeownership among minorities.864 The goal was to close the homeownership gap between white and nonwhite households, which should produce 5.5 million new homeowners and generate strong economic activity in the country. The administration reckoned that:

… meeting the President's goal to close the housing gap will involve $256 billion

in economic activity in the form of construction and remodeling jobs, spending on

household goods, and other benefits. Because of rising home values, Americans are

enjoying more than $2.5 trillion of greater housing wealth than they did at the

beginning of 2001. 865

To achieve that goal, in 2003, it introduced the American Dream Downpayment Act, a

USD200m HUD-administered program that assisted homeowners with their down payments. A year later, in 2004, the administration adopted the zero down payment initiative for FHA mortgages. The third push was increasing Fannie and Freddie’s

862 In 2000, the volume of subprime mortgage originations was USD100bn, an overall share of 10 percent of total mortgage originations. 863 See Steven Holmes, “Fannie Mae Eases Credit to Aid Mortgage Lending: Minority Homeownership May Increase,” New York Times (September 30, 1999). 864 George W. Bush, “Fact Sheet: Expanding Homeownership Opportunities for All Americans,” Office of the Press Secretary, December 16, 2003. 865 Ibid.

238 affordable housing goals from 2001 to 2008.866 For the Bush administration, the humming housing market was one of its key achievements -- a seemingly robust economic performance despite the burst of the dot-com bubble, the 9/11 terrorist attacks, and the subsequent wars in Afghanistan and Iraq. As Bush remarked:

We can put light where there’s darkness, and hope where there’s despondency in

this country. And part of it is working together as a nation to encourage folks to

own their own home.867

While members of the Bush administration did foresee some dangers in the housing finance market, 868 they did not push hard enough to toughen regulations on the mortgage giants.

In 2003, the administration proposed the Federal Enterprise Regulatory Reform Act, which would have established a new regulator for Fannie and Freddie under the U.S. Treasury, citing concerns about their growing portfolios, opaque accounting practices, and the lack of proper regulation by OFHEO.869 However, the proposal was met with resistance by the

Democrats in Congress and housing interest groups, such as the homebuilders,870 fearing that the mortgage giants would be forced to scale back their affordable housing activities,

866 Between 2000 and 2007, the affordable housing goals increased from 42 percent in 2000 to 55 percent in 2007. Source: Federal Housing Finance Agency. 867 George W. Bush, Speech at Conference on Minority Homeownership, George Washington University, Washington, D.C., October 15, 2002. 868 In 2003, Treasury Secretary John Snow stated that Congress should pass “legislation to create a new Federal agency to regulate and supervise the financial activities of our housing-related government sponsored enterprises.” Similarly, Bush’s chief economic advisor, Greg Mankiw, stated that a new regulator for Fannie and Freddie would be required to reduce systemic risk, with the “broad authority to set both risk-based and minimum capital standards” and “receivership powers necessary to wind down the affairs of a troubled GSE.” See The White House Office of the Press Secretary, “Setting the Record Straight: Six Years of Unheeded Warnings for GSE Reform,” Washington, D.C., October 9, 2008. 869 See John Snow, U.S. Treasury Secretary, Hearing, Senate Committee on Banking, Housing, and Urban Affairs, October 16, 2003. He stated that: “Our national system of housing finance plays a key role in promoting homeownership. We might call it one of the economic wonders of the world.” 870 See Kent Conine, NAHB, Hearing, House Committee on Financial Services, September 25, 2003. In the hearing, the NAHB argued that the U.S. Treasury is ill-suited to house a new regulator, given its insufficient expertise in housing matters.

239 which would hurt housing growth.871 In the words of a former economic advisor to

President Bush, Lawrence Lindsay, “[n]o one wanted to stop that bubble … It would have conflicted with the president’s own policies.”872 While Fannie and Freddie appeared cooperative during Congressional hearings relating to housing finance reform between

2003 and 2005, they spent USD164m in lobby efforts behind the scenes from 1999 to

2008.873

It is well documented that, by then, the house prices bubble was well underway.874

While this house price boom benefited well-to-do homeowners through capital gains, which they could use to increase consumer spending, it also enabled the less well-off to climb the housing ladder, producing a virtuous circle of credit expansion and consumption.875 Concomitantly, these developments allowed homeowners to take out equity from their homes to pay for services, such as health care, or consumer goods, such as cars, or to start small businesses, which further stimulated consumption.876 The result was that the subprime market expanded from 9.5 percent of all mortgage originations in

1996 to 23.5 percent in 2006 (or close to USD700bn in mortgage volume).877 As the

871 Ranking members of the Democratic Party opposed the reform proposals, such as Congressman Barney Frank (D-MA), who stated that: “these two entities – Fannie Mae and Freddie Mac – are not facing any kind of financial crisis … The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.” Similarly, Senator Harry Reid (D-NV) opposed the reform, because: “we cannot pass legislation that could limit Americans from owning homes and potentially harm our economy in the process.” See The White House Office of the Press Secretary, “Setting the Record Straight: Six Years of Unheeded Warnings for GSE Reform,” Washington, D.C., October 9, 2008. 872 Quoted in: Becker, Stolberg, Labaton, “Bush drive for home ownership fueled housing bubble,” New York Times (December 21 2008). 873 See Financial Crisis Inquiry Commission, “Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States,” January 2011, xxvi. 874 Knoll, Schularick, and Steger 2017. 875 H. Schwartz 2009. 876 Greenspan and Kennedy (2008) estimate that the extraction of home equity amounted to USD590bn per year between 1991-2006. 877 Sources: Inside Mortgage Finance; FCIC.

240 subprime business boomed in the early 2000s -- sustained by house price gains -- private banks started securitizing mortgages at much higher rates, even overtaking Fannie and

Freddie’s overall securitization market share for the first time in 2005.878 In turn, these developments pressured Fannie and Freddie to invest in subprime loans to recover their losses in market power.879

Yet, when mortgage delinquencies went up, the collapse in house prices produced a massive demand shock to the U.S. economy. Mian and Sufi (2014) convincingly argue that the fall in house prices led to declining household consumption, because overly indebted households were forced to cut back spending -- either because of foreclosure or losses in housing wealth -- which then led to negative cascade effects throughout financial system and the entire economy.880 As Ben Bernanke, the former chair of the Fed, noted recently about the crisis:

Now the reason it was more damaging, of course, as we know now, is that the credit

intermediation system, the financial system, the institutions, the markets, were far

more vulnerable to declines in house prices and the related effects on mortgages

and so on than they were to the declines in stock prices.881

Eric Rosengren, the president of the Boston Fed, echoes this view:

878 Fannie and Freddie’s share of the securitization market (i.e., securitized mortgages as a share of total mortgage originations each year) fell from 50 percent in 2003 to 32 percent in 2005, while that of the private sector increased from 15 percent in 2003 to 40 percent in 2005. This is because private banks issued large numbers of “private-label” MBS (often pooling together subprime mortgages) during the housing boom. Source: Housing Finance Policy Center. 879 Acharya et al. 2011. 880 Mian and Sufi (2014); also see H. Schwartz (2009). The overall share of private residential investment fell from 6.6 percent (as a share of GDP) in 2006, an all-time high, to 2.4 percent in 2010, an all-time low (source: FRED). 881 Cited in: Mian and Sufi (2014, 132).

241 the sharp declines in housing prices can have additional negative effects, with broad

implications for macroeconomic outcomes and monetary policy -- broader,

perhaps, than may be assumed and incorporated into most statistical models of the

economy.882

For the U.S. economy, housing is no sector like any other. According to these central bankers, it produces much stronger transmission effects -- both positive and negative -- than the stock market and most other sectors. In other words, during the crisis, the key transmission between housing and the wider economy was broken.

Before discussing how policymakers responded to the broken housing finance system, it is instructive to briefly evaluate to what extent housing finance policies have contributed to the crisis in the first place. Some have argued that public support for housing finance fueled the housing bubble and assigned the brunt of the blame to the federal government.883 While the vast presence of the American state in the mortgage market makes it difficult to exonerate the federal government from any blame, these views are oversimplified. The Financial Crisis Inquiry Commission (FCIC), for instance, concluded that public policies contributed to the crisis, but did not cause the crisis, for which there are numerous other factors found in the private sector, including reckless and predatory lending.884 For instance, in an interview, a former Freddie Mac official stated that the role of the Clinton and Bush administrations in pressuring Fannie and Freddie to take on risky subprime mortgage loans is overstated, as the companies moved into the subprime market

882 Eric S. Rosengren, “Housing and Economic Recovery,” Remarks at the Economic Outlook Seminar Stockholm, September 28, 2011. 883 Wallison 2015; Calomiris and Haber 2014. 884 Financial Crisis Inquiry Commission, “Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States,” January 2011, xxvi.

242 for other reasons (i.e., the risky subprime mortgages did not fall under the agencies’ affordable housing goals).885 According to the FCIC, Fannie and Freddie got into riskier mortgages, because they followed larger market trends on Wall Street.886 This chapter does not settle this debate, but it shows that the difficulty in assigning blame for the crisis lies in the intertwined nature of the private housing market and public policies, which have co- evolved over decades.

The financial crisis of 2008-09 was then a major test for U.S. housing finance policy. It is not unreasonable to expect far-reaching policy change or retrenchment in the housing area, which was the center of financial turmoil. After all, the Obama administration

(2009-2017) went after the powerful banking industry, which faced the most significant financial reforms since the Great Depression: the Dodd-Frank Wall Street Reform and

Consumer Protection Act of 2010.887 When it comes to housing finance, the co-sponsor of

Dodd-Frank, Barney Frank (D-MA), even noted that:

Fannie and Freddie should be abolished. You shouldn’t have this shareholder-

public thing. That clearly, in retrospect, was a problem. But I think some form of

ultimate federal government guarantee is an important thing.888

Yet, U.S. policymakers opted for increasing the American state’s footprint during the crisis by taking over Fannie and Freddie -- initially to rescue housing finance and, later on, not

885 Author interview, former Freddie Mac official, Washington, D.C., September 6, 2016. 886 Financial Crisis Inquiry Commission, “Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States,” January 2011, xxvi. 887 Kastner 2014. 888 Jon Prior, “Rep. Barney Frank wants to see Fannie and Freddie abolished,” Housing Wire (July 5, 2012).

243 do any damage to it -- without adopting comprehensive housing finance reform, an important issue curiously absent from post-crisis presidential campaigns.889

When Fannie and Freddie almost went out of business in the fall of 2008, the Bush administration and the Democratic Congress adopted a number of measures to rescue the government-supported Wall Street firms. In 2008, they passed the Housing and Economic

Recovery Act, which gave the U.S. Treasury the authority to extend unlimited emergency lending to Fannie and Freddie890 as well as to seize control of the two battered mortgage giants through their newly created regulator, the Federal Housing Finance Administration

(FHFA). The rationale was most memorably given by then Treasury Secretary Hank

Paulson, stating that “[i]f you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.”891 However, this measure did little to restore investor confidence in the two companies, nor improve the financial health of the two mortgage giants,892 whose stock prices kept plummeting and lost more than 80 percent in value.893

Days before the collapse of Lehman Brothers in 2008, the Bush Treasury then used its authority to place the battered Fannie and Freddie into government control.894 The U.S. government not only bailed out the two companies with USD188bn,895 but it also placed the two institutions in government conservatorship. From then on, the U.S. Treasury would

889 See, for example, Ben Lane, “Here’s the housing story (or lack thereof) of the 2016 election: How housing didn’t matter in this campaign,” Housing Wire (November 8, 2016); David Rohde, “On Housing, Obama and Romney’s Plans Add Up to Zero,” The Atlantic (October 26, 2012). 890 Prior to the crisis, Fannie and Freddie both had a credit line of USD2.25bn. See Koppell 2003. 891 Quoted in: Andrew Sorkin, “Paulson’s Itchy Finger, on the Trigger of a Bazooka,” New York Times (September 8, 2008). 892 Frame et al. 2015. 893 For instance, Fannie’s stock price fell from over USD80 in 2004 to USD7 in early September 2008 (right before the bailout) and to less than one dollar after the bailout in late September. 894 Conservatorship means that the FHFA, the Treasury’s housing regulator, controls and oversees the operations of both companies regardless of shareholder interests. Fannie and Freddie are still off-budget agencies. 895 McLean 2015; Acharya et al. 2011.

244 control the two institutions by choosing its leadership and collecting its profits. 896 In an interview, a former FHFA regulator stated that:

When Paulson pulled the trigger, it was like an FDIC bank takeover. I mean the

FHFA went into the enterprises … It’s very dramatic. It’s very law and order. For

Fannie and Freddie, it was humiliating.897

There was widespread agreement among Republicans, Democrats, the Federal Reserve, and housing interest groups that this was necessary in order to “strengthen the U.S. housing market and promote stability in our financial markets.”898 Similarly, Paulson justified the bailout, because “Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe.”899 As international investors owned hundreds of billions of dollars in Fannie and Freddie -- assuming that the U.S. government was behind them -- the U.S. government faced the risk of losing its creditworthiness if it had allowed the corporations to fail.900 Conservatorship then allowed mortgage securitization to continue and stabilized the level of liquidity in the mortgage market, so as to enable ordinary people to refinance or acquire mortgages.901 In the words of the former housing regulator:

896 Frame et al. 2015. 897 Author interview, former FHFA official. Washington D.C., July 25, 2014. 898 Federal Reserve, Press Release, September 9, 2008. Since 2008, the Fed has provided about USD1.8tn in monetary stimulus for the housing sector, including Fannie and Freddie. When interest rates hit the zero- lower bound, the Fed launched large-scale asset purchases of Fannie Mae, Freddie Mac, and Ginnie Mae mortgage-backed securities and debt in order to bring down mortgage rates, increase bank lending, and stimulate consumption. 899 Guha, Giles, Scholtes, Chung, “US takes control of Fannie and Freddie,” Financial Times (September 8 2009). 900 McLean 2015. 901 Frame et al. 2015.

245 The economic generative power of the housing market just so outweighs anything

else you can fiddle with. We have two things we pump up when we need to pump

them up. We pump up the stock market and we pump up the housing market. The

world wants to buy U.S. Treasuries and the world wants to buy agency bonds.902

This again underlines the interwoven relationship between housing finance and the U.S. growth model, which is, in part, financed by surpluses from overseas.903

Although government conservatorship was supposed to be a short-term measure, the Obama administration and Congress initially abstained from adopting (or even debating) comprehensive housing finance reform. Only years later, in 2013, the Obama administration and Congress offered housing finance reform proposals, but half- heartedly.904 Several proposals envisioned the restructuring of the housing finance architecture and the role of the U.S. government within it. First, the 2013 PATH Act, proposed by far-right House Republicans, suggested the elimination of Fannie and Freddie, a bill that would have fully privatized the secondary mortgage market. This would have constituted a significant retreat of the American state from the mortgage market, but the proposal was quickly dismissed. It was seen as too extreme by the Obama White House,

Democrats, and moderate Republicans in Congress.905 As the former president of Ginnie

Mae, Joseph Murin, noted with respect to reducing the government’s role in housing finance:

902 Author interview, former FHFA official. Washington D.C., July 25, 2014. 903 H. Schwartz 2009; Seabrooke 2010. 904 In 2011, the Obama administration laid out some broad options for future housing finance reform as mandated by the Dodd-Frank Act, but without spending much political capital to implement these options. See U.S. Treasury & HUD, Reforming America’s Housing Finance Market, 2011. 905 Author interview (phone), policy staffer, House majority leader, Eric Cantor (R-VA). September 1, 2014.

246 The assumption that, even with time, private markets would simply pick up the role

of the GSEs and Ginnie may or may not be accurate. But what if it is wrong? The

economic chaos would be astronomical, and simply picking up the pieces of the

infrastructure we had just replaced would be no mean feat ... Mortgage lending

would become much riskier for banks and non-bank lenders … The cost of a

mortgage would likely go up.906

Second, Congress discussed some bipartisan reform bills. These proposals suggested winding down and replacing Fannie and Freddie with a new federal mortgage corporation, but the bills retained a key function for the federal government in the home finance market.907 Reforms along these lines were supported by the Obama White House and the realtors,908 homebuilders,909 and mortgage bankers.910 Yet, these proposals stalled in

Congress, as for many Democrats and Republicans the proposal would increase the cost of mortgages and therefore hurt the housing market and consumption. According to a

906 Joseph Murin, “Caution: GSE reform could have serious unintended consequences,” Housing Wire (May 26, 2015). 907 Both the Johnson-Crapo and Corker-Warner bills suggested the establishment of the Federal Mortgage Insurance Corporation (FMIC) that would replace Fannie and Freddie. The FMIC would insure privately issued mortgage-backed securities in return for a fee, but investors would have to take a certain percentage (e.g., 10 percent) of first losses in the case of large-scale mortgage default. 908 See Gary Thomas, President, NAR, Hearing, Senate Committee on Banking, Housing, and Urban Affairs, October 29, 2013. In his testimony, Thomas stated that “any new secondary market entity replacing the enterprises must have an explicit government guarantee to ensure the availability of affordable credit products for all creditworthy individuals and families… A federal guarantee is essential to ensure borrowers have access to affordable mortgage credit. Without government backing, creditworthy consumers will pay much higher mortgage interest rates and mortgages may at times not be readily available.” 909 See Rick Judson, President, NAHB, Hearing, Senate Committee on Banking, Housing, and Urban Affairs, November 7, 2013. He stated that “[w]hile NAHB agrees that the current degree of government intervention is unsustainable, an ongoing, though more limited, government role must be maintained to avoid future interruptions in the flow of credit to mortgage borrowers … the relative cost of housing credit would increase from current levels as home buyers ultimately bear the charges needed to attract the private capital and cover the cost of the government guarantee. However, NAHB believes that such a system would entail lower housing credit costs than one that relied exclusively on private players.” 910 David Stevens, President, MBA, Hearing, Senate Committee on Banking, Housing, and Urban Affairs, October 31, 2013. Stevens stated that: “[w]ithout this government backstop, the mortgage market would be smaller and mortgage credit would be more expensive, meaning that qualified lower and middle class households would have less access to affordable mortgage credit.”

247 Congressional staffer, the proposals retained too much state in the housing market for far- right Republicans, while the bills did not do enough to promote affordable housing for progressive Democrats.911 A third option of recapitalizing and releasing the mortgage giants to their pre-crisis status was also rejected by the Obama administration, an option that would “willfully [recreate] the very system that helped do this nation so much harm.”912 The inability and unwillingness to reform led White House economists to describe the housing finance system as the “key unfinished piece of business from the financial crisis.”913 In an interview, a Ginnie official noted that the incentives of pursuing housing finance reform waned, as house prices recovered and mortgage lending and liquidity improved.914 It is also fair to say that the increasing polarization of Congress contributed to the failure of reform.915

Instead of prioritizing comprehensive housing finance reform, the Bush and Obama administrations adopted short-term measures to restore liquidity and stabilize house prices.916 From 2007-2016, the Mortgage Debt Relief Act allowed homeowners to exempt from taxes income generated through debt forgiveness (or cancelled debt after foreclosure).917 In 2009, the Obama administration also adopted the Making Home

911 Author interview (phone), policy staffer, House majority leader, Eric Cantor (R-VA). September 1, 2014. For instance, Senator Elizabeth Warren (D-MA) said that: “[i]t is harder to get a Freddie or Fannie mortgage than at any time in history. [Johnson-Crapo] would cut the pool of qualified borrowers by 20%. Think about that, one in five families who would be eligible today would not be.” Cited in: Trey Garrison, “Johnson- Crapo reform bill voted to Senate floor,” Housing Wire (May 15, 2014). 912 Michael Stegman, “Remarks at the Annual Conference of the National Association of Affordable Housing Lenders.” Washington, D.C. (October 29, 2015). 913 Furman and Stock, “The Moment Is Right for Housing Reform,” Wall Street Journal (10 April 2014). 914 Author interview, Ginnie Mae official. Washington, D.C., March 8, 2016. 915 McCarthy, Poole, and Rosenthal 2016. 916 In addition to these programs, in 2012, the U.S. government negotiated USD25bn in settlements with five major banks as a consequence of their wrongdoing in the run-up to the crisis as part of the National Mortgage Settlement. The U.S. government subsequently also negotiated multi-billion-dollar settlements with individual banks. Large parts of these funds were used for forgiving homeowner debt, restructuring loans, or other benefits. 917 The U.S. Treasury estimates the cost of the tax break to be roughly USD13.7bn from 2008-2017.

248 Affordable Program with USD45.6bn, which includes two core components: the Home

Affordable Modification Program (HAMP) designed to restructure home loans (i.e., reducing interest and principle payments) and the Home Affordable Refinance Program

(HARP) allowing underwater homeowners to refinance their mortgages at lower rates. 918

The key rationale was that, if homeowners receive some debt forgiveness and refinancing help, this would prevent foreclosure, falling house prices and instead stimulate aggregate demand and consumption. Although criticized for their miniscule size919 and a messy rollout,920 these measures offer additional evidence that the federal government tried to stabilize house prices as well as reactivate credit and consumer spending.

It goes without saying that homeowners were not the only ones hit by the crisis, as many renters struggled with their rent payments and faced the prospect of eviction.921 Yet, renters have received far less in government support than homeowners during the crisis

(and, of course, long before the crisis). The Housing and Economic Recovery Act of 2008 set up a National Housing Trust Fund to support affordable rental housing, especially for very low-income households, but the Fund has thus far only paid out USD174m to the

918 The HAMP program is financed by the Troubled Asset Relief Program (TARP), which was created by the Bush administration in 2008. From 2009 to 2016, almost two million households have used the program. In the same time period, the HARP program has helped 3.4 million homeowners refinance their mortgages by the end of 2016. Finally, the Making Home Affordable program also included other programs, such as the Home Affordable Foreclosure Alternative (HAFA) program, which facilitates the short sales or deeds-in-lieu of foreclosure for banks and troubled homeowners. Sources: U.S. Treasury; Federal Housing Finance Agency. 919 Economists across the political spectrum argued that the Obama administration should have reduced the mortgage debt of homeowners more forcefully. See Mian and Sufi (2014); Feldstein (2011). 920 Author interview, HUD official. Washington, D.C. August 1, 2014. The Obama official mentioned that the rollout and process of HAMP was messy, as homeowners required to submit extensive documentation (and banks often mishandled processing homeowner applications for HAMP modifications), which led homeowners to complain to their members of Congress, who passed on these criticisms to the Obama administration. 921 Desmond 2016.

249 federal states.922 When compared with homeownership, affordable rental housing just is not a priority in the U.S. political landscape.923 Powerful housing groups, such as the realtors or homebuilders, do not necessarily oppose low-income or public housing. In an interview, a low-income housing advocate stated:

They don’t want to be perceived as being in opposition to what we do, because we

have a cachet of authenticity … They all like to be seen as supporting us. They all

give us money. And major banks give us money. It’s sort of: ‘saving their souls.’

They don’t give us tons of money, but they give us money, they support us. So we

have very cordial relationships with everybody.924

This shows that the powerful lobby groups are able to buy off the little resistance from low- income housing advocates for strategic reasons.

Finally, the Trump administration has voiced its desire to tackle housing finance reform, but remained vague on the details. U.S. Treasury Secretary, Steve Mnuchin, highlighted that the administration promotes reforms to secure liquidity in mortgage markets, while reducing taxpayer exposure to Fannie and Freddie:

… we promote necessary liquidity in the housing markets. These are very

important to the economy and we want to make sure in no way do we not have that,

922 The Fund was supposed to be financed through Fannie and Freddie starting in 2008, but these institutions were placed into conservatorship in the same year. The FHFA, the new conservator of Fannie and Freddie, then temporarily suspended the Fund until 2016. See Sheila Crowley, President, National Low Income Housing Coalition (NLIHC), Hearing, Senate Committee on Banking, Housing, and Urban Affairs, November 7, 2013. Crowley made a plea for increasing the Fund in order to “produce, preserve, rehabilitate, and operate rental homes that extremely low income households can afford.” Also see, “How the Federal Government Plans to Stop the ‘Worst-Case’ Housing Crisis,” Citylab: The Atlantic (Aptil 4, 2016). 923 Desmond 2016. 924 Author interview, NLIHC representative. Washington, D.C. August 5, 2014.

250 but also making sure that we don’t put taxpayers at risk and leave these entities as

they are.925

While Mnuchin seems to acknowledge the central role of housing finance markets to the

U.S. economy, the administration did not offer any reform details -- a policy issue all the more important as regulators have sounded the alarm about Fannie and Freddie’s massive concentration of financial risk and declining capital buffers.926

More generally, the most important point of contention about recent housing finance reform proposals was the effect of reducing the government’s presence in the mortgage market on the pricing of mortgages, house prices, and consumption, which reflects the deep entrenchment of housing finance policies and the consumption-led growth model. As a former U.S. Treasury official remarked: “[t]here was the overall concern that this would wind up being too expensive relative to where things are now.”927 It is likely that any reduction of the government’s footprint would increase the price of mortgages, given that the market would have to take on more risk and absorb losses.928 Moreover, policymakers and interest groups mentioned that the government’s role was not only to help subsidize the cost of mortgages, but also to provide a backstop in the case of market failure, given the size of the market and its systemic importance. These macroeconomic concerns of stimulating demand, housing, and consumption are key in explaining policy expansion and stability of government support for homeowners in the United States. This stands in stark contrast with the German case, where center-left and center-right political

925 Steve Mnuchin, White House, “Press Briefing by Secretary of Treasury Steve Mnuchin on Financial Services Executive Order and Memoranda,” (April 21, 2017). 926 See Prepared Remarks of Melvin L. Watt, Director of the Federal Housing Finance Agency, at the Bipartisan Policy Center, Washington, D.C. (18 February 2016). 927 Author interview, Treasury official. Washington, D.C., August 1, 2014. 928 Trey Garrison, “GSE reform will drive up mortgage rates,” Housing Wire (April 28, 2014).

251 blocs fought over regional, family, and redistributive concerns, when discussing reform proposals.

In sum, both parties, backed by major interest groups, had a strong preference for rescuing the housing finance system during the recent crisis. Given that the housing market was the source of distress and perceived to have transmission effects into the wider economy, injecting and stabilizing liquidity in the housing sector was seen as an effective way to kill two birds with one stone. Yet, the unintended consequences were that the U.S. government nationalized significant parts of the mortgage market, currently guarantees roughly USD6tn in mortgage debt, and effectively eliminated private market competition.929 Even the most fervent advocates of public support for private housing -- the realtors, homebuilders, and mortgage bankers -- agree with housing regulators and some leading Democrats and Republicans that the federal government has assumed an outsized role that spiraled out of control. But the macroeconomic constraints today are even larger than half a century ago, which is convincingly put by Acharya et al.:

This is what so far allowed successive presidential administrations to encourage

ever-larger short-term consumption and spending during their tenures. It may seem

odd that in a game between two political parties to get the seat, both would agree

on a strategy to promote housing finance at successively higher levels over time …

And while each presidential administration is working its way through its term,

aided by Fannie’s and Freddie’s balance sheets and off-balance-sheet guarantees,

929 For instance, in 2016, the share of privately securitized mortgages was below one percent. Source: Housing Finance Policy Center.

252 the competitive landscape of the financial sector is altered as they enter more

mortgage markets.930

By the time of the financial crisis, housing finance had become so entrenched with the

American model of credit and consumption that policymakers showed little hesitation in nationalizing large parts of the U.S. mortgage market in order to stabilize liquidity, house prices, and consumption. That two of the largest Wall Street firms, Fannie and Freddie, are still in the hands of the U.S. government -- a scenario unimaginable for any other firm on

Wall Street -- is the cumulative result of successive policy decisions that have slowly expanded the role of the American state in the U.S. housing finance market, which has become the “growth machine” of U.S. consumption and credit. 931

Conclusion

This chapter has explained how the U.S. consumption-led growth model has entrenched the country’s state-based homeownership mortgage model. The constitutive moment of entrenchment was the Great Depression, when policymakers, supported by interest groups, established a set of housing finance policies to stimulate mortgage credit, liquidity, and consumption. These early policies soon created deep interlinkages with the consumption- based growth model, which then contributed to growing numbers of homeowners and developing a national political economy of housing finance. These linkages also created a broad-based policy consensus among both major parties, supported by major housing interest groups, who viewed housing finance policies as effective growth strategies. The late 1960s until the late 1980s were periods of transition, when policymakers responded to

930 Acharya et. al 2011, 171-2. 931 H. Schwartz 2009, 175.

253 rising interest rates and the resulting mortgage illiquidity by creating a new securitization market of long-term mortgage funding (i.e., mortgage-backed securities). This so-called

“housing finance revolution” tied in with a shifting U.S. growth model that has become increasingly dependent on credit-based consumption. It was in this period that Fannie and

Freddie became the most important engines of mortgage lending and credit-led economic growth in the country. The final period, from the 1990s to the financial crisis of 2008-09, was characterized by an aggressive push by politicians of both parties to expand mortgage lending to communities previously denied access to the market. While this strategy was seemingly successful until the mid-2000s, it reached its limits when the housing bubble burst in 2008. At that point, Fannie and Freddie were so entrenched with the U.S. economy and financial system that policymakers decided to rescue and take over the mortgage giants, nationalizing significant parts of the U.S. mortgage market.

This chapter makes a number of contributions to the comparative political economy literature. First, it shows that the social and economic preferences of U.S. policymakers were influenced by the macroeconomic growth model. Scholars of the welfare state have often focused on the conflicts between the political left and right when explaining policy social and economic policy developments,932 such as in the housing area.933 But they have neglected how macroeconomic features may produce identical preferences among otherwise opposing political actors. When it comes to housing finance policy, this chapter does not reveal diverging preferences between Republicans and Democrats, although both parties tend to disagree on many other dimensions of the welfare state, such as health care.

932 Esping-Andersen 1990, 16-18; Korpi 2006; Allan and Scruggs 2004; Garrett 1998; Huber and Stephens 2001. 933 See Ansell (2014); also see Bohle (2014); H. Schwartz and Seabrooke (2008, 242).

254 Instead, politicians of both parties have come to believe that public support for home finance -- stimulating mortgage lending and liquidity, housing prices and wealth, and consumption -- is in the national interest of producing economic growth that would also yield electoral benefits. As Raghuram Rajan notes:

Politicians love to have banks expand housing credit, for credit achieves many goals

at the same time. It pushes up house prices, making households feel wealthier, and

allows them to finance more consumption. It creates more profits and jobs in the

financial sector as well as in real estate and housing construction.934

This is the result of the entrenchment of housing finance policy and the U.S. growth model, which has shaped the interests and beliefs of policymakers over time.

Second, the U.S. state-based homeownership mortgage model is a constitutive element of the country’s consumption-led growth model. This view casts doubt on the often-held belief that the U.S. liberal or laissez-faire market economy is characterized by minimal government involvement in the economy.935 To the contrary, for almost a century, one of the economic key sectors of the U.S. economy – that is, housing -- has been characterized by strong government support.936 Given the importance of housing to the

U.S. economy and global financial system, and the ways in which public policies are intertwined with the private housing market, this chapter concurs with those who have assigned a more prominent role to “the state” in U.S. capitalism.937

934 Rajan 2010, 31. 935 Hall and Soskice 2001; Hall and Gingerich 2009; Hall and Thelen 2009; also see Rueda and Pontusson 2000; Crouch and Streeck 1997. 936 Prasad (2012) labels government intervention in housing finance “mortgage Keynesianism.” Also see Krippner (2011); Quinn (2017). 937 Prasad 2012; Krippner 2012; Thurston 2015; Quinn 2017; Freund 2007; Mazzucato 2011; Hacker 2002.

255 Third, U.S. policymakers have chosen a path of public support for private markets in achieving social policy objectives: low-cost homeownership. But the public-private nature of this relationship makes policymakers vulnerable to the economic performance of these markets. Policymakers have a stake in a functioning public-private relationship -- voters can punish them if these markets fail to deliver the desired outcome -- which significantly limits their room for maneuver when it comes to major housing finance reforms. The chapter has shown that, if housing finance markets experience economic struggles, then policymakers often responded with ratcheting up policy support. Public- private welfare arrangements can be risky for policymakers and ordinary people, as the success of these arrangements hinges upon market success.

Fourth, in-depth case studies of key economic sectors, such as housing finance, yield insights into the functioning of growth models and the politics of public policies.

Existing scholarship has fruitfully investigated what makes economic models tick, either emphasizing their aggregate economic output938 or supply-side institutions,939 but has rarely disaggregated economic models into sectors that produce growth (perhaps with the notable exception of manufacturing). That U.S. policymakers dramatically intervened in the housing market is not due to an inherent fondness for housing, but the sector’s central position able to stimulate the consumption-led growth model. The position of economic sectors within growth models is important in shaping economic policy in advanced economies.

Finally, the state-based homeownership model contributes to inequality in the

United States. One of the key features of this model is the deep commitment to

938 Baccaro and Pontusson 2016. 939 Hall and Soskice 2001.

256 homeownership finance -- and the absence of support for affordable rental or public housing. It therefore benefits mainly those willing and able to buy their own homes, but they do little for people unable and unwilling to climb the property ladder. To the contrary, the current level of public support for housing finance tends to stimulate house prices, which can be detrimental for renters, who, in the absence of pay increases, find themselves caught in a bind of unaffordable rental markets.940 Similarly, these policies have long discriminated against urban and non-white households, reinforcing racial941 and wealth inequality942 in the country. While some have voiced their concern over growing affordability crises, as ordinary people struggle to make ends meet and often face the prospect of eviction, policymakers on the national level remain reluctant to act on behalf of struggling renters.943 This chapter suggests that this is because the affordable rental housing sector is not entrenched with the consumption-led growth model, which makes a much-needed shift from supporting homeowners towards renting unlikely.

940 Florida 2017. 941 Freund 2007; Hayward 2013; Thurston 2015. 942 Rognlie 2015; Piketty 2014. 943 Desmond 2016; Florida 2017.

257 Chapter 6: Central Bank Stimulus for Housing Markets in the United States,

Germany, and Europe, 1930s-2010s

Introduction

The Federal Reserve (Fed) made headlines when it adopted a multi-trillion-dollar stimulus program for the country’s housing market in response to the recent financial crisis. When short-term interest rates reached the zero-lower bound and the conventional arsenal of monetary policy seemed depleted in advanced economies, central banks resorted to unconventional programs -- large-scale asset purchases of government or housing bonds known as “quantitative easing” -- in order to put downward pressure on long-term interest rates to stimulate the economy. As part of these unconventional programs, the Fed bought an astonishing amount of two trillion dollars in mortgage-backed securities between 2008-

2017. The desired effect of these purchases was to bring down mortgage rates, aid the housing market, and stimulate the wider economy. Monetary stimulus for housing has since become a major pillar of the country’s state-based homeownership model to support housing finance. These expansionary monetary programs are all the more important, as they outlived the short-lived comeback of Keynesian fiscal policy during the Great

Recession that gave way to austerity-led policies shortly after the crisis.944

Yet, other central banks in advanced economies stimulated housing much less. The

European Central Bank (ECB), for instance, provided only marginal assistance to housing markets as part of its unconventional, large-scale quantitative easing programs.945 Where the Fed accumulated close to two trillion dollars in mortgage debt, the ECB only bought

944 Farrell and Quiggin 2017; Blyth 2013. 945 Lombardi and Moschella 2015; Bindseil 2014.

258 roughly EUR250bn in housing-related assets, such as covered bonds and asset-backed securities between 2008-2017 (see figures 6.1 and 6.2).946 Instead, the ECB expanded its balance sheet in other areas, such as temporary lending facilities. But why has the Fed provided extensive monetary stimulus for housing, while the ECB has not?947

Figure 6.1: Mortgage-backed securities held by the Federal Reserve, 2008-2017.948

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946 Please note that many, but not all, covered bonds and asset-backed securities are backed by housing loans, as they might also be covered by other assets classes, such as ships, airplanes, or cars. Similarly, not all European countries developed large covered bond markets. 947 At the time of writing, central banks are currently debating scaling down their balance sheets -- but not necessarily to pre-crisis levels. Yet, this would most likely happen gradually over long periods of time. See Erin Ferris, Soo Jeong Kim, and Bernd Schlusche, “Confidence Interval Projections of the Federal Reserve Balance Sheet and Income,” FEDS Notes (January 13, 2017). Also see Ben Bernanke, “Should the Fed Keep Its Balance Sheet Large?” Ben Bernanke’s Blog (September 2, 2016). 948 Source: Federal Reserve Board.

259 Figure 6.2: Covered bonds and asset-backed securities held by the European Central

Bank, 2008-2017.949

500,000

450,000

400,000

350,000

300,000

250,000

200,000 Euros Euros (millions) 150,000

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0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

This chapter argues that macroeconomic growth models in the United States and

Europe explain the variation in monetary stimulus for housing during the recent crisis. The ways in which central banks are embedded in larger macroeconomic structures almost naturally influences monetary policy. Hall and Franzese (1998, 524-5) have convincingly argued that elements of national growth models – such as collective bargaining structures

-- impact central banking, as “economic performance is deeply affected by the institutional organization of the political economy and cannot be explained well without reference to variation in it.” In short, as growth models vary, so do the preferences of central bankers.

In the credit- and consumption-led U.S. economy, the Fed identified housing as the key transmission sector for economic growth. The Fed viewed monetary stimulus for housing

949 Source: European Central Bank. This includes the covered bond purchase programs I, II, and III, and the asset-backed security purchase program.

260 as a growth strategy that would stimulate the two key elements of the U.S. economy -- credit and consumption. That the Fed swiftly stimulated housing was not the result of an affinity for the sector, but its centrality for the consumption-led economy. In contrast, the

ECB hardly stimulated housing, because the central bank did not identify the sector as a major element of European growth models. The economies of the eurozone differ not only in their emphases on consumption or exports for generating growth,950 but also in the degree to which housing is a key sector within these growth models.951 The export-oriented growth model in Germany, for instance, does not primarily rely on stimulating private consumption and consumer credit, but instead on price stability -- including in the housing market -- wage restraint, and savings. The German Bundesbank -- along with other

“hawkish” members of the ECB, such as the Dutch central bank -- therefore promoted a conservative approach to asset purchases in housing and other markets, so as to maintain price stability, market discipline, and financial stability. Both national central banks had already warned about their “overheating” housing markets in recent years.952 As stimulating housing and consumption does not fit the macroeconomic features of some powerful European economies, the ECB’s purchase programs were decidedly more timid.

Importantly, these monetary policy responses have deeper historical roots that challenge the common notion that central banks in advanced economies are independent from the influence of politicians.953 That the Fed intervened so massively in the country’s

950 Stockhammer 2016; Stockhammer, Durand, and List 2016. 951 Johnston and Regan 2017. 952 De Nederlandsche Bank, Financial Stability Report, Autumn 2017, p. 19; Bundesbank, “Possible overvaluation of residential property in German cities,” 2013. 953 See Fernandez-Albertos (2015) for a good review on the central bank independence literature in political science. See Binder and Spindel (2017) for discussions on the limits of the Fed’s independence as well as Berman and McNamara (1999) on the ECB’s independence. Also see Goodman (1991), Bernhard (1998), McNamara (2002). For scholarship in economics on central bank independence and macroeconomic performance, see Alesina and Summers (1993); Fischer (1995).

261 housing market was no accident. Since the early twentieth century, Congress and the White

House have extended the Fed’s authority of buying housing bonds in the open market, with the implicit assumption – and often explicit demand -- that the Fed should stimulate housing. Politicians viewed the Fed as another vehicle to stimulate the housing market and, with it, economic growth. While the Fed was bullied into stimulating housing in the late

1960s and early 1970s, it did so only reluctantly and moderately until the recent crisis. This is because, as Binder and Spindel argue, such programs can blur “the boundary between monetary and fiscal policy,” which would put central banks in the position of picking winners and losers.954 Yet, during the 2007 crisis, the Fed needed no convincing, as it perceived housing to be the source of distress and the key transmission belt to stimulate growth in the wider economy. These policy episodes then cast doubt on the independence of the Fed, given the political conflicts around stimulating housing between Congress and the Fed.955

Central banks in Europe, such as Germany’s Bundesbank, have also experimented with monetary housing programs -- but only marginally.956 In the 1950s, the Bundesbank intervened into the country’s housing market by buying covered bonds in the open market.

The goal was to support the private capital market after the country’s currency reform and housing crisis in the postwar years. While this episode questions the bank’s prominent narrative of credible monetary policy that helped stabilize the country’s currency and inflation (and preventing moral hazard),957 these programs were rather marginal.

954 Binder and Spindel 2016, 189. 955 See Binder and Spindel 2016, 2017; Conti-Brown 2016. For a study that challenges the independence of the Bundesbank, see Lohmann (1998). 956 National central banks of other countries might have similarly experimented with such programs. 957 For an excellent history of the Bundesbank, see Marsh 1992.

262 Subsequently, the Bundesbank did not engage in activities to stimulate housing. When the

ECB was created in 1998, it had the authority of buying housing bonds as part of its open market operations in the eurozone, but only used its authority during the recent crisis.

Importantly, the policy episodes during the crisis demonstrate that even the ECB -- often celebrated as one of the most independent central banks with, in the words of Berman and

McNamara, “almost complete freedom from democratic oversight and control”958 -- faced open political pressure and challenges from European policymakers, especially in finance ministries, when adopting unconventional monetary programs.

The economic fundamentals of unconventional monetary policy

Conventional monetary policy refers to central banks lowering or raising short-term interest rates (e.g., the federal funds rate in the United States or the refinancing rate in the eurozone). Unconventional monetary policies are often implemented to achieve monetary goals that cannot be achieved by adjusting short-term rates. If short-term rates approach the zero-lower bound – without producing signs of economic strength or meeting inflation targets, for instance -- then central banks have a number of unconventional policy options to provide further monetary stimulus. First, they can enter negative interest-rate territory to encourage bank lending (because banks would be charged negative interest on their deposits in the central bank).959 Two prominent central banks have recently pushed rates into negative territory, the ECB and the Bank of Japan, but there are political, legal, and economic limits to how much central banks can push rates into negative territory.960

958 Berman and McNamara 1999, 2. 959 Buiter 2009, 2010. 960 For instance, the ECB lowered its deposit rate to -0.4 percent and its main refinancing rate to 0 percent by late 2016. Source: ECB. While some highlight that central banks might face legal problems, such as whether

263 Second, central banks can buy large amounts of assets -- such as government or private sector bonds -- in the open market. The goal of this practice is to reduce long-term market interest rates and increase asset prices, which would encourage bank lending and stimulate consumption in the wider economy.961 This practice is most commonly characterized as quantitative easing (QE) or credit easing, as it increases the reserves of private banks and their abilities to lend, unleashing transmission effects for the wider economy.962

There are important channels through which bond-buying programs, including those for housing, can have transmission effects for the larger economy. Studies have established that large-scale asset purchases tend to lower long-term interest rates and increase the price of these assets, which, in turn, stimulates bank lending and consumption in the larger economy.963 Economists tend to explain this relationship with the signaling and the portfolio-balance channels. The signaling channel suggests that, when central banks engage in large-scale asset purchases, investors interpret this as a credible commitment to keep interest rates low for a considerable period of time.964 The portfolio balance channel suggests that, when central banks buy long-term bonds from investors and banks – say, Treasury bonds -- this would increase the price and lower the rates of these bonds. At the same time, it would encourage investors to buy broadly similar long-term assets with higher yields and risk, such as corporate bonds, which would then increase the price of these assets and lower their interest rates.

they are allowed to charge banks negative interest rates on deposits, others argue that negative rates are a profit-squeeze for banks. 961 There are legal limitations to what individual central banks can buy in the open market. 962 Bindseil 2014. 963 Engen, Laubach, and Reifschneider 2015; Hancock and Passmore 2015; Gagnon et al. 2011; Krishnamurthy and Vissing-Jorgensen 2011. 964 Bauer and Rudebusch 2013.

264 It is not uncommon for central banks to activate this transmission channel through the housing market. The housing sector is a prominent target for central banks given its large asset markets for mortgages with long maturities, allowing for large-scale interventions that can lower long-term mortgage interest rates. Central banks can lower mortgage rates by buying large amounts of housing bonds or securities in the open market, such as mortgage-backed securities or covered bonds. The goal of this practice is to increase the price of the purchased securities and exert downward pressure on mortgage interest rates, which stimulates housing demand, house prices, and bank lending.965 This pumps up the housing sector, with the goal of stimulating housing consumption and producing transmission effects into the wider economy.966

Whether intended or not, this places unconventional monetary policy supporting the housing sector squarely into the realm of the public-private welfare state. Much like tax breaks or government-supported mortgage securitization, these policies tend to stimulate the private housing market by lowering the cost of mortgage debt and increasing house prices – a practice that former Fed governor, Kevin Warsh, calls “fiscal policy in disguise.”967 As these central bank programs directly support the most valuable asset that ordinary people own, including the private social insurance that homeowners derive from their properties, central banks have played an active role in promoting private wealth and consumption through housing.

965 Krishnamurthy and Vissing-Jorgensen 2011. 966 A more sector-neutral process would be buying large amounts of government bonds, such as Treasury bonds in the United States (or potential euro bonds in the eurozone), which does not privilege some economic sectors over others, as the interest-rate effects are shared equally by all sectors. 967 Quoted in: Fleming, Sam, “Federal Reserve warned over maintaining big balance sheet,” Financial Times (May 7, 2017).

265 The Federal Reserve’s history of housing support, 1930s-2017

Little is known about the Fed’s unconventional monetary programs prior to the recent financial crisis. In three critical policy episodes -- the Great Depression, the early stages of mortgage financialization in the 1960s and 1970s, and the financial crisis of 2008-09 -- this section shows that U.S. policymakers gradually expanded the toolkit of monetary stimulus for housing, with the goal of stimulating credit and consumption in the wider economy.

The monetary policy toolkit evolved and was deployed in different ways from the Great

Depression until the recent crisis. During the depression, the FDR administration gave the

Fed the authority to channel funds into the country’s mortgage market, which was designed

-- and used by the Fed without much reluctance -- as a crisis mechanism to help reinforce already existing housing policies to overcome the housing crisis and revive the economy.

In the late 1960s, the Johnson administration and Congress expanded the Fed’s toolkit to channel funds into the secondary mortgage market, so as to counter rising interest rates and growing mortgage illiquidity. For its part, the Fed was reluctant to inject funding into these agencies at that time, given that it did not want to target and assist a specific economic sector in the absence of greater macroeconomic problems. Yet, the Fed eventually gave in to the pressure of Congress and provided moderate support for housing. Finally, during the financial crisis of 2008-09, the Fed used its toolkit aggressively and did not need much convincing. In times of ultra-low interest rates, it viewed stimulating housing as both an effective way to remedy the core source of the crisis and a growth strategy to reanimate the heart of the American growth model of consumption and credit. These monetary programs then tied in with already existing policies part of the country’s state-based homeownership model.

266 In the depression era, central bank stimulus reinforced the growing linkages between the emerging consumption-led growth model -- increasingly based on wage growth, consumer credit, mass production, and Keynesian demand management -- and housing finance policies in the 1930s. In response to the Great Depression, a major housing crisis leading to a drop in aggregate demand and consumption, policymakers across the political spectrum, including the Hoover and Roosevelt administrations, developed policies that would stimulate housing finance. These administrations created multiple government agencies, such as the FHLB, HOLC, the FHA, and Fannie Mae, to stabilize the housing market, stimulate mortgage lending, and revive consumption. More specifically, the FDR administration and Congress provided the Fed with unconventional tools to channel funding into the Home Owner’s Loan Corporation (HOLC) -- an institution that helped delinquent homeowners refinance and restructure their mortgages. At the time, policymakers across the political spectrum, but especially the FDR administration, regarded the housing sector as a key element to stimulate consumption in the wider economy. The monetary authority was then part of a larger set of institutions and programs adopted to revive the housing market and economic growth. The Fed -- then led by the country’s New Deal housing architect, Marriner Eccles -- used its authority and injected funds into the HOLC as a crisis measure to boost the country out of the depression. In sum, these new monetary tools reinforced existing housing finance programs that helped stimulate the American consumption-oriented growth model in the depression era.

When Congress created the Fed through the Federal Reserve Act of 1913, the central bank did not have the authority to buy obligations or bonds issued by government- sponsored agencies in the open market. According to the original Act, it could only

267 purchase bonds or obligations that were direct obligations backed by the full faith of the

U.S. government, such as Treasury bonds, as opposed to obligations issued by government agencies or quasi-governmental agencies.968 In the early twentieth century, quasi- governmental or government-sponsored institutions were rare and did not exist in the housing area, as they only gained momentum after the Great Depression.969 At that time, the Fed’s open market interventions were therefore limited to direct obligations of the U.S. government.

During the Great Depression, President Roosevelt (FDR) and the Democratic

Congress adopted a number of emergency measures to revive the battered housing market, which included the Fed’s new authorities to stimulate housing. Specifically, the FDR administration changed the Federal Reserve Act in 1934, authorizing the institution to purchase bonds issued by the Home Owners’ Loan Corporation (HOLC)970 -- a quasi- governmental agency that had purchased delinquent home mortgages and refinanced them at better conditions from 1933 until 1951.971 The Fed’s new authority was designed to reinforce the HOLC’s mission of reviving the country’s housing market by channeling funding into the agency. This authority was part of an amendment that elevated the status of HOLC bonds to those fully backed by the full faith of the U.S. government, because

968 The open market section of the original Federal Reserve Act of 1913, section 14(b), reads: “Every Federal Reserve bank shall have the power … To buy and sell, at home or abroad, bonds and notes of the United States, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental districts, such purchases to be made in accordance with rules and regulations prescribed by the Federal Reserve Board.” 969 See Glock (2016) for a discussion on the Federal Land Banks (FLBs), the first government-sponsored agencies established in 1916. 970The amendment changed the Federal Reserve Act’s section 14(b), authorizing the Fed to buy and sell “bonds issued under the provisions of subsection (c) of section 4 of the Home Owners’ Loan Act of 1933, as amended, and having maturities from date of purchase of not exceeding six months.” 971 Green and Wachter 2005.

268 these bonds previously “had not been clearly guaranteed as to principal and interest by the

United States.”972 According to President Roosevelt, the goal of the amendment was to

“assure the continued progress on a self-sustaining basis of the making of loans for the purpose of refinancing home mortgages without interruption … [t]he Home Owners’ Loan

Corporation should be enabled to extend further assistance for the modernization of homes as well as for the making of repairs.”973 In sum, reviving the housing market was a major policy priority for FDR, an objective that his administration pursued through multiple avenues, including central banking.

The Fed then used its new authority under chairman Marriner Eccles (1934-1948), who was appointed by FDR in 1934. As FDR’s former assistant secretary of the Treasury and one of the main architects of the New Deal’s national housing programs, Eccles was no stranger to the FDR administration. In Eccles’ own words, the goal of these New Deal housing programs was “to induce private lending institutions to take up this credit expansion” and that “funds should go, it seems to me, into the capital market through mortgage lending, go into the housing field.”974 It is therefore not surprising that the Fed decided to stimulate housing under Eccles’ leadership, whose economic ideas were very much in line with those of FDR.975 By 1939, the Fed purchased roughly USD6m in HOLC bonds, a number that soon increased to USD36m in 1943.976 As the HOLC was dissolved in 1951, the Fed did not have any outstanding HOLC debt by the late 1950s.977

972 Hackley 1973, 95. 973 Franklin D. Roosevelt, Message from the President of the United States Recommending Enactment of the Legislation to Guarantee the Principal of Bonds of the Home Owners’ Loan Corporation, February 28, 1934. 974 See Marriner Eccles, assistant secretary of the Treasury, U.S. Senate Committee on Banking and Currency, Hearings, May 16-24, 1934. 975 Eccles 1951. 976 See Federal Reserve, Annual Report of the Board of Governors of the Federal Reserve System (“Holdings of U.S. Government Securities by Federal Reserve Banks”), 1939, 1943. 977 Hackley 1973.

269 There was controversy in Congress about whether the Fed should also be allowed to buy bonds of other quasi-governmental housing agencies.978 The Great Depression entailed the creation of a number of such agencies, including the Federal Home Loan Bank

System (FHLB).979 In addition to HOLC bonds, the House Banking Committee proposed to make FHLB bonds eligible for bond-buying programs by the Fed.980 The former head of the FHLB endorsed the provision, as it would cause “money to flow over into the home- financing field.”981 However, the FHLB was not particularly popular among members of

Congress and developed a reputation as “the spoilsmen’s paradise.”982 Others disliked the

FHLB system, as it was created under President Hoover -- an institution “used for the aid of the Republican Party in that campaign.”983 Given that several members of Congress regarded the FHLB as politically charged and economically underperforming, the Senate blocked the provision.984

In sum, policymakers created new authorities for the Fed to purchase the bonds of the HOLC (but not those of the FHLB) to boost housing and mortgage credit. Under the leadership of Marriner Eccles, the country’s architect of New Deal housing legislation, the

Fed used its new authorities and supported the housing finance market by buying moderate amounts of HOLC bonds. As both FDR and Eccles regarded housing as the key sector to boost the economy out of the depression – given its systemic importance to the

978 The Fed was also allowed to buy bonds from the Federal Farm Mortgage Corporation since the Federal Farm Mortgage Corporation Act of 1934. See Hackley 1973. 979 The main function of the FHLB system is to provide low-cost credit to the savings and loans industry. 980 House Committee on Banking and Currency, Amendment to Home Owners’ Loan Act of 1933, March 26, 1934. 981 House Committee on Banking and Currency. Hearings: To Guarantee Bonds of Home Owners’ Loan Corporation. March, 1934. 982 Robert Luce (R-MA). See Congressional Record, House of Representatives, April 5, 1934. 983 Henry Steagall (D-AL). See Congressional Record, House of Representatives, April 5, 1934. 984 Committee of Conference, “Conference Report on Guarantee Bonds of Home Owners’ Loan Act,” April 16, 1934.

270 consumption-oriented growth model -- there seemed to be little controversy between the

Fed and politicians about adopting monetary stimulus for housing in this period. These actions then reinforced the emerging interlinkages between the consumption-oriented growth model and depression-era housing finance policies. While this practice proved of relatively little economic significance at that time, it was an important historical precedent for housing interventions by the Fed.

The second policy episode took place during the early stages of mortgage financialization in the 1960s and 1970s, when policymakers remade the country’s mortgage market. In the late 1960s, the country experienced rising inflation and interest rates, which hurt the housing market by increasing the cost of mortgage debt. Moreover, these developments led to illiquid mortgage markets, given capital outflows from housing to other sectors.985 Given electoral considerations, policymakers grew increasingly concerned about interest rate hikes and tight mortgage lending. To restore the liquidity of mortgage markets, the Johnson and Nixon administrations adopted a number of policy measures in the late 1960s and early 1970s, such as the creation of Fannie Mae, Ginnie

Mae, and Freddie Mac in the secondary mortgage market. These and other legislative actions were paramount in bringing about the so-called “housing finance revolution” from deposit-based to capital-based mortgage funding.986 These housing finance policies -- constitutive of the secondary mortgage market -- then tied in with the country’s evolving credit-led consumption model.

985 Depository institutions were limited in how much interest they could pay on deposits, which made other assets, such as Treasury bonds, more attractive in times of growing interest rates. 986 Green and Wachter 2007.

271 It was in this context that politicians shaped monetary policy to generate mortgage liquidity as part of a larger push to revamp the country’s mortgage market. The Johnson administration and Congress created new authorities for the Fed that allowed the institution to buy bonds issued by government-sponsored agencies, such as Fannie Mae, Freddie Mac, and Ginnie Mae. Politicians created these authorities with the goal of helping the strained housing market, which suffered from increasing interest rates. Yet, the Fed remained reluctant to make use of its new authority to stimulate housing. At the time, it did not consider housing as part of larger, systemic macroeconomic problems, such as a major national economic crisis. Instead, it reckoned that targeted housing support would violate the principle of economic neutrality. That the Fed eventually stimulated housing was due to the political pressure from Congress at the time -- but not because the Fed viewed monetary stimulus essential for the growth model -- which was a significant encroachment upon the independence of the Fed.

In 1966, the Johnson administration, together with the Democratic Congress, amended the Federal Reserve Act to authorize the Fed to buy and sell bonds of all government-sponsored agencies, such as the FHLB and Fannie Mae.987 The Fed could do so as long as these bonds were “a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States.”988 The reform came amid rising interest rates989 and fears that Democrats would face significant losses in the midterm elections.990

The goal of this provision was to stabilize mortgage rates and revive a weak housing market

987 Interest Adjustment Act of 1966. 988 Ibid. 989 The effective federal funds rate increased from 1.2 per cent in 1961 to above 5 per cent in 1966, reaching its highest level after WWII. Housing starts fell to 800,000 in October 1966 (down from 1.5m the year before). Similarly, residential investment declined to 3.5% of GDP (from its prior peak of 5.4% in 1963). 990 New York Times, “Democrats Fear Midterm Losses,” (February 17, 1966)

272 in times of otherwise tightening monetary policy. In a statement to Congress, President

Johnson remarked that he expected the central bank to “lower interest rates and to ease the inequitable burden of tight money.”991 Similarly, Congress viewed high mortgage interest rates as a burden on ordinary people and drag on the economy. For instance, the House banking committee stated that:

the greatest immediate injury to the average citizen lies in the drying up of the

mortgage market and the threat to the building industry … Unless substantial

relief is granted to the housing market, the impending devastation in

homebuilding and related industries could trigger a general recession

throughout the economy.992

The Senate banking committee concurred that “[t]his increase in interest rates … had particularly severe effects on special segments of the economy, such as the housing market and homebuilding.”993 The Fed’s authority to support housing was seen as the medicine to alleviate some pressures, as it would make housing-related bonds attractive to investors and allow quasi-government agencies to raise funds.994

Where the Johnson administration and Congress wanted the Fed to provide immediate support for housing, the central bank initially refused to intervene. The Fed certainly welcomed its new authority, as, in the words of then vice chair James Robertson, it did “increase the potential flexibility of open market transactions.”995 At the same time, the institution cautioned that its authority should not be used for the sole purpose of

991 Lyndon B. Johnson, Message from the President of the United Transmitting Proposals for Measures for Curbing Inflation and Preserving Our National Economy, Sep 8, 1966. 992 House Committee on Banking and Currency, Temporary Interest Rate Controls, July 28, 1966. 993 Senate Committee on Banking and Currency, Regulation of Maximum Rates of Interest Paid on Savings, September 14, 1966. 994 Ibid. 995 Ibid.

273 channeling funds into the mortgage market, but instead to provide the “power to interpose and prevent a disorderly market.”996 Large-scale purchases of housing bonds would have resulted in downward pressures on mortgage rates, at a time when the Fed increased interest rates in the economy. This would have favored the housing market over other sectors and signaled inconsistent macroeconomic strategies that push into opposite directions. The Fed therefore initially refused to intervene in the housing market.

Yet, soon thereafter, in 1968, a disgruntled Congress openly criticized the Fed for its inaction and discussed legislative changes that would force the central bank to intervene into housing. Up to that point, the Fed’s authority to intervene into housing at its own discretion had rested on a temporary provision (granted by the 1966 reform). While the

Fed, Congress, and White House agreed to put that authority on permanent legal footing, there was disagreement about the specific design of that new authority. The Congressional sentiment was that the Fed had not done enough to support housing. As Wright Patman (D-

TX), the chair of the House banking committee, noted, the Congress:

clearly established the fact that the Federal Reserve was to use its open market

powers to assist in assuring an adequate supply of funds for the home mortgage

market. To date, the Federal Reserve has done nothing in this respect.997

Congressman Henry Reuss (D-WI) concurred that central bankers: “have seen fit not to lift a finger to come to the aid of this important segment of the economy.” 998 The Fed would be obliged to do so, because housing is a “favorite object of national policy.”999 Similarly,

996 Senate Hearing, Committee on Banking and Currency, Regulation of Maximum Rates of Interest Paid on Savings, August 13, 1966. 997 House Hearing, Committee on Banking and Currency, To Extend for One Year the Authority for … Open Market Operations in Agency Issues, June 1968. 998 Ibid. 999 Ibid.

274 Senator William Proxmire (D-WI) even threatened to strip away the Fed’s independence if it remained unwilling to support housing:

You recognize, I take it, that the Federal Reserve Board is a creature of Congress?

… that the Congress can recreate it, abolish it, and so forth? … What would

Congress have to do to indicate that it wishes the Board to change its policy and

give greater support to the housing market?1000

This demonstrates the hostility of Congress towards the Fed, which, in their view, had not done enough to support housing.

Accordingly, Congress discussed two amendments that would have forced the Fed to stimulate housing under certain conditions. First, the Reuss amendment suggested “to authorize and direct the Federal Open Market Committee, so long as home-building finance is restricted by overall monetary stringency … to include in its portfolio in meaningful amounts obligations of the Fannie Mae and Federal Home Loan Bank

Board.”1001 Second, the Proxmire amendment had the objective of channeling “funds directly into the mortgage market” and directing the Fed to buy housing bonds, such as those issued by Fannie Mae, “when alternative means cannot effectively be employed to permit financial institutions to continue to supply reasonable amounts of funds to the mortgage market during periods of monetary stringency and rapidly rising interest rates.”1002 Both amendments lay out specific conditions under which the central bank ought to intervene into housing finance.

1000 Senate Hearing, Committee on Banking and Currency, Purchase of Treasury Securities and Interest on Savings, April 1968. 1001 House Hearing, Committee on Banking and Currency, To Extend for One Year the Authority for … Open Market Operations in Agency Issues, June 1968. My emphasis. 1002 Senate Report, Committee on Banking and Currency, Regulation of Maximum Rates of Interest Paid on Time and Savings Deposits, June 28, 1968. My emphasis.

275 But the Fed and the Johnson administration opposed the amendments. Instead, they favored a provision that granted the Fed the permanent authority of housing interventions at its own discretion. The Fed and White House identified two main problems with the

Congressional proposals. First, the amendments would privilege housing over other sectors. In the words of then Fed chair William Martin, this would be “prostituting -- and

I use that word deliberately -- the functions of the central bank when you pick out any segment of the economy and use the central bank to create credit to finance it.”1003 And second, as Joseph Barr, then Treasury Secretary, retorted: “when the Congress wants to do something in the social area or any other area that it approach the allocation of funds head on through the appropriation process.”1004 The Fed and Treasury convinced other members of Congress of their views. As Thomas Gettys (D-SC) remarked: “although I am very zealous about helping the housing industry … we might neglect the rest of the economy.”1005 Senator John Sparkman (D-AL) noted: “Bill Martin and Joe Barr and

Governor Robertson came to my office and had a long talk and I do know that they are very much disturbed about the proposal.”1006 The attempts of persuading members of

Congress ultimately bore fruit.

In 1968, the Johnson administration convinced Congress to allow the Fed to intervene into housing at its own discretion, but the political pressure to help the housing market did not subside. While the Fed managed to retain its legal autonomy when it came to open market interventions, it eventually gave in to political pressure and, in 1971, started

1003 House Hearing, Committee on Banking and Currency, To Extend for One Year the Authority for … Open Market Operations in Agency Issues, June 1968. 1004 Ibid. 1005 Ibid. 1006 Senate Committee on Banking and Currency, Executive Session, June 24, 1968.

276 building “a modest portfolio of agency issues.”1007 The newly appointed Fed chair, Arthur

Burns, offered the rationale for initiating these programs:

a number of members of Congress were of the view that System operations in

agency issues would be of substantial benefit. They felt that the Committee

had demonstrated an uncooperative attitude in the matter, and they had

repeatedly raised the question of why the System had not yet utilized the

authority to undertake outright operations granted by legislation five years

ago. He would favor affirmative action by the Committee today, since that

would be a positive step of some potential value to housing … Mr. Robertson

said that in his judgment the Committee had made a mistake in not acting on

this issue long ago.1008

By 1977, the Fed held USD3.5bn in Fannie Mae and roughly USD2bn in FHLB bonds.1009

The Fed’s holdings initially peaked in 1981, the year in which the federal funds rate rose to 19 percent (and with it, the conventional 30-year mortgage rate, which rose to 18 percent in the same year). These interventions were again moderate in size and mostly adopted to appease disgruntled lawmakers in Congress.

Simultaneously, the Fed strategized ways of winding down its housing bond holdings, which led to the gradual fall of holdings until the early 2000s. According to a former senior Fed official,

We owned the Fannie and Freddie securities for a while in the 70s and early

80s. It was Volcker in the mid-80s, who said: ‘let’s let the securities run off.’

1007 FOMC, Memorandum of Discussion, August 24, 1971. 1008 Ibid. 1009 Haltom and Sharp 2014.

277 So we allowed them to run off … We didn’t buy any more after 1984 or

1985, so we had owned them in the past, but we hadn’t for 20-something

years.1010

In 1976, Paul Volcker, then vice chair of the Federal Open Market Committee (FOMC),1011 indicated that he felt particularly uneasy about holding Fannie Mae bonds, as the agency would act increasingly like a private corporation.1012 Other FOMC members shared this view, but also hinted at likely Congressional resistance when it comes to winding down the Fed’s portfolio, as “the matter was sensitive in light of the attention given to housing in the Congress.”1013 Two years later, in 1978, the Fed voted in favor of slowly winding down its housing bond holdings. Volcker stated that: “[i]t seems to me that we pay too much tender loving care to these agency issues and treat them too much as a special case.”1014 But the central bank also concluded that it would be unwise to sell them outright, as this would create the wrong signals for markets, higher mortgage rates, and

Congressional resistance.1015 Instead, it adopted a strategy of letting these bonds run off slowly. When Volcker became the Fed’s chairman in 1979, its wind-down of housing bonds continued until the early 2000s. In Volcker’s words:

I think these agencies are anomalous institutions anyway, and I would just

as soon we didn’t hold any or buy any. But we have a history … If, say, we

buy them now, that could be interpreted as support in a way that may or

1010 Author interview, Fed official. Washington, D.C., July 10, 2014. 1011 The FOMC is the Fed’s monetary policy arm in charge of setting interest rates and open market operations. 1012 FOMC, Memorandum of Discussion, March 15-16, 1976. Fannie Mae had been privatized in 1968, while retaining its government-sponsored status. 1013 Ibid. 1014 FOMC, Transcript of Meeting, June 20, 1978. 1015 FOMC, Transcript of Meeting, March 26, 1985.

278 may not be desirable. I think we have to support them if they get in trouble;

but I'm not sure we should be treating their securities as the equivalent of

government securities, which is what they would like us to do and which

we did for a while-- still do, I guess, in some sense.

By the early 2000s, the Fed’s housing bond holdings had expired and the Fed did not purchase any more housing-related securities until the recent financial crisis.

In sum, in the 1960s and 1970s, lawmakers expanded the Fed’s toolkit of housing market interventions as part of a larger set of policies to reform the country’s housing market in light of interest rate pressures and mortgage illiquidity. These latter developments had created increasing electoral and economic concerns about the state of housing in the country. The expectation among politicians was that the Fed would soon buy large amounts of bonds to stimulate housing. While the Fed remained initially reluctant

-- it did not regard housing to be the source of national, macroeconomic problems that would justify large-scale support for the sector -- it eventually gave in to political pressure and bought moderate amounts of housing bonds in the 1970s, which were scaled down by the early 2000s. The political pressure from politicians was remarkable, which defies the often-held assumption of central bank independence.1016

The third key episode was the recent financial crisis of 2008-09, when the Fed made full use of its toolkit to stimulate the housing market with a multi-trillion-dollar bond- buying program. In the late 1990s and early 2000s, the interlinkages between the credit-led and consumption-oriented growth model and housing finance policy produced strong synergies that resulted in tremendous economic, housing, and credit growth.1017 Yet,

1016 Also see Binder and Spindel (2017) on the myth of the Fed’s independence. 1017 H. Schwartz 2009.

279 housing was also the epicenter of the brewing 2007 crisis that brought the U.S. economy to a standstill. Much like during the Great Depression -- and unlike the late 1960s and early

1970s -- the Fed viewed housing to be the source of macroeconomic distress and a transmission sector to kick start economic growth in the wider economy. Running out of conventional options at the zero-lower bound, the Fed made full use of its monetary toolkit.

It deployed monetary stimulus for housing as a growth strategy in order to lower mortgage rates, stimulate housing demand and prices, and consumption in the wider economy. The

Fed’s actions aimed at reanimating the linkages between the credit-led, consumption- oriented growth model and housing finance policy – i.e., the government-sponsored secondary mortgage market -- by buying assets securitized by Fannie Mae and Freddie

Mac, which had been placed under government conservatorship just prior to the Fed’s actions. Next to tax breaks and government guarantees in the primary and secondary mortgage markets, the Fed then added yet another layer of government support for home mortgages during the crisis. Yet, this time, politicians did not have to convince the Fed to take action. To the contrary, many Republicans criticized the Fed for its excessively loose monetary policy during the crisis, citing concerns about financial instability and a lack of market discipline.

In late 2008, the Fed started its first round of asset purchases, which included

USD500bn in mortgage-backed securities and USD100bn in housing agency bonds. The central bank was remarkably explicit about helping the housing market with these purchases. In a press release, the institution stated that the objective of these programs was

“to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets

280 more generally.”1018 After its decades-long reluctance to support housing, the Fed bought hundreds of billions of dollars in housing bonds in response to the crisis. In an interview, a former senior Fed official noted:

At some point, interest rates effectively hit zero. Then the issue was: how do

we help the economy? You help it by buying long-term securities. And there

are only really two choices. The Fed is limited in what it can buy to Treasury

securities or securities issued by the government. So there was precedent for

buying Fannie and Freddie securities even before they were under

conservatorship in 2008. By purchasing mortgage-backed securities, the Fed

was trying to influence the flow of credit and faith in the housing markets. We

were authorized to buy those securities and we bought them before. I saw that

the problems with the mortgage markets were a real impediment to easing

monetary policy and the transmission of easing monetary policy. It was an

important channel for monetary policy -- important in and of itself and because

it was the area causing problems. So if you could stabilize the housing market,

it would help stabilize the financial system. I think the Federal Reserve had

identified the weakness in the housing market, and the lack of a bounce back in

the housing market as one of the primary factors holding back the economic

recovery.1019

In other words, the housing market was a key sector through which monetary stimulus could be transmitted, given its centrality to the U.S. consumption-led growth model. This view echoes that of a staff economist, who said that the Fed bought mortgage-backed

1018 Federal Reserve, Press Release, November 28, 2008. 1019 Author interview, Fed official. Washington, D.C., July 10, 2014.

281 securities, because the market for mortgages was hurting and it was the key source of the crisis, perceived to have transmission effects into the wider economy.1020 These purchases then seemed justified given the liquidity problems in housing finance markets.1021 The Fed supported the housing market to kill two birds with one stone -- fixing the core source of the crisis and generating consumption in the economy.

Why did the Fed suddenly shift its position on these large-scale purchases, given its reluctance in earlier policy episodes? One major difference was that the Fed increased short-term interest rates on the heels of inflationary pressures in the 1960s and 1970s, which naturally comes at the cost of increasing mortgage rates and tighter mortgage lending. Stimulating housing in this context would have meant putting downward pressure on mortgage rates, while increasing rates for the rest of the economy -- an ambivalent policy move that the Fed defined as market-distorting. During the recent financial crisis, the Fed lowered short-term interest rates reaching the zero-lower bound, which then led to the use of unconventional monetary stimulus, so as to lower long-term interest and mortgage rates. Stimulating housing was therefore part of the larger macroeconomic objective of bringing down interest rates. The second difference between the two periods is that, contrary to the recent financial crisis, there was no national, macroeconomic crisis that had its origins in the housing market in the 1960s or 1970s. During the recent crisis, monetary stimulus for housing had the wider macroeconomic goal of stabilizing housing finance – the root cause of the crisis -- as well as stimulating credit, consumption, and economic growth through the housing market. In the words of Ben Bernanke, the former chair of the Fed, the U.S. economy was “far more vulnerable to declines in house prices

1020 Author interview, Fed economist. Washington, D.C., September 10, 2014. 1021 Author interview, Fed economist. Washington, D.C., September 10, 2014.

282 and the related effects on mortgages and so on than they were to the declines in stock prices.”1022 Eric Rosengren, the president of the Boston Fed, concurs and stated that the decline in house prices had “negative effects, with broad implications for macroeconomic outcomes and monetary policy.”1023 The housing sector -- including the effects of house prices and mortgage debt -- had become so central to generating economic growth by the mid-2000s that central bankers decided reanimate this systemically important sector.

Some (but not all) members of the Fed also viewed these programs as sound social policy, reinforcing fiscal measures aimed at helping homeowners. The programs directly help homeowners in a number of ways. First, they tend to lower mortgage rates, which helps distressed and affluent homeowners refinance their mortgages at better rates.1024

Second, they also allow new buyers to enter the housing ladder at historically low mortgage rates.1025 Finally, these programs tend to stimulate house prices and therefore stabilize the housing wealth of ordinary people, which, in turn, allows homeowners to tap their housing equity for consumer spending. Rosengren succinctly highlighted these social policy goals:

lowering the 30-year conventional mortgage rate would reduce the cost of

purchasing new homes, encourage refinancing by those with sufficiently

high credit scores and equity in their homes, and support fiscal policies that

are targeted at more-troubled homebuyers. It would help troubled and

healthy homeowners, stimulate the most distressed area of our economy, and

help financial institutions exposed to problems in housing.

1022 Cited in: Mian and Sufi (2014, 132). 1023 Eric Rosengren, “Housing and Economic Recovery,” Remarks at the Economic Outlook Seminar Stockholm, September 28, 2011. 1024 Joseph Gagnon and Michael Holscher, Purchases of Agency MBS and Debt. Dec 5, 2008. 1025 William Dudley and Brian Madigan, Memorandum: Plans for MBS purchases by the System Open Market Account, Dec 30, 2008.

283 This shows that the Fed supported not only an abstract housing market but also ordinary people, with the explicit social policy preference of helping homeowners -- a matter of contention within the Fed discussed below.

The majority within the Fed was not overly concerned with the potential market- distorting effects of these bond buying programs in this period, although some members did express their concerns. While these programs channeled investments into the housing sector, privileging housing over other sectors was seen as a necessary evil to stimulate aggregate demand in the larger economy. In an internal memo, staff economists note that:

This policy tool would tend to skew credit allocation toward one sector of the

economy … Nonetheless, some distortion of credit allocation may be an

acceptable price to achieve the Federal Reserve’s dual mandate of maximum

employment and price stability.1026

Similarly, the senior Fed official expressed that:

There was discomfort for sure, with the idea that the Federal Reserve was

allocating credit to particular a sector: housing. Some of the Reserve Bank

Presidents, in particular, worried that this would set a precedent and Congress

would come to us for other things. I didn’t see it as that big of a threat. I saw it

making policy more effective.1027

Yet, there were also a few vocal critics within the Fed, especially the presidents of the regional Federal Reserve banks. For instance, Charles Plosser, then president of the

Philadelphia Fed, voiced concern that these programs would invite pressure from politicians and interest groups:

1026 Joseph Gagnon and Michael Holscher, Purchases of Agency MBS and Debt. Dec 5, 2008. 1027 Author interview, Fed official. Washington, D.C., July 10, 2014.

284 We will get pressure from various interest groups to retain certain assets. We will

certainly, in all likelihood, get calls from consumers, builders, and Congressmen if

we start to sell mortgage- backed securities out of our portfolio in order to reduce

its size. We will hear fears that the mortgage rates may rise … the credit allocation

schemes we are pursuing run a real risk of impinging on our independence and our

ability to control our balance sheet and, hence, monetary policy.

The president of the Dallas Fed, Richard Fisher, noted that:

I don’t believe that we should be in the business of financing housing. I think that

is a matter for the Treasury and for other authorities, and I would like to get out of

that business as quickly as possible.1028

He even called the practice of buying housing bonds “social engineering.”1029

Jeffrey Lacker, president of the Richmond Fed, stated that the Fed’s bond-buying programs would distort credit allocations in the market and perpetuate “this really corrosive political economy in our country of tapping government resources to subsidize the housing market.”1030 In an op-ed in the Wall Street Journal, he elaborated that:

If the Fed’s MBS holdings are of any direct consequence, they favor home-

mortgage borrowers by putting downward pressure on mortgage rates. This

increases the interest rates faced by other borrowers, compared with holding an

equivalent amount of Treasurys. It is as if the Fed has provided off-budget funding

1028 FOMC, meeting transcript, January 26-27, 2010. 1029 FOMC, meeting transcript, April 26-27, 2011. 1030 FOMC, meeting transcript, September 20-21, 2011.

285 for home-mortgage borrowers, financed by selling U.S. Treasury debt to the

public.1031

However, the majority within the Fed viewed housing as the key impediment holding back the larger U.S. economy, which paved the way for additional housing bond purchases down the road.

On an important side note, the historical record is opaque on the decision-making process to initiate the first bond-buying program. In 2008, the Fed issued a short press release without any further documentation on how the decision to buy mortgage-backed securities was made.1032 At that time, it was unclear whether the Federal Reserve Board, the FOMC, or the Fed Chair initiated the decision. If the purchases had been characterized as an emergency measure, it may have fallen under the jurisdiction of the Board; if it had been characterized as an interest rate mechanism, then the FOMC would have been responsible. Such actions may also fall under the chairman’s authority to initiate emergency measures in-between FOMC meetings.1033 The FOMC minutes -- released only in 2015 -- reveal that Ben Bernanke, then Fed chair, initiated the programs after consulting

1031 Lacker, Jeffrey, and John Weinberg. “The Fed's mortgage favoritism.” Wall Street Journal (October 7, 2014). 1032 The Fed only issued a press release on November 25, 2008, stating: “The Federal Reserve announced on Tuesday that it will initiate a program to purchase the direct obligations of housing-related government- sponsored enterprises (GSEs)--Fannie Mae, Freddie Mac, and the Federal Home Loan Banks--and mortgage- backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae.” However, it is unclear as to who within the Fed authorized the purchase of these bonds. 1033 The authorization for domestic open market operations, reaffirmed on January 29, 2008, read: “In the execution of the Committee's decision regarding policy during any intermeeting period, the Committee authorizes and directs the Federal Reserve Bank of New York, upon the instruction of the Chairman of the Committee, to adjust somewhat in exceptional circumstances the degree of pressure on reserve positions and hence the intended federal funds rate. Any such adjustment shall be made in the context of the Committee's discussion and decision at its most recent meeting and the Committee's long-run objectives for price stability and sustainable economic growth, and shall be based on economic, financial, and monetary developments during the intermeeting period. Consistent with Committee practice, the Chairman, if feasible, will consult with the Committee before making any adjustment.”

286 with members of the FOMC on the phone, but without adopting a formal vote. In retrospect,

Bernanke admitted that his unilateral action was a mistake:

At the time, I felt comfortable with that decision. Since then, given how central the

MBS purchase program has become to our policy and given the issues of

governance that have been raised and we have all discussed, I now believe that I

made a mistake in doing that—I should have consulted more closely and then taken

a vote of the FOMC.1034

That the Fed adopted this consequential decision in such an opaque way1035 is remarkable in today’s world of central banking, where communication strategies can move entire markets.1036

Shortly thereafter, the Fed expanded its asset-buying programs of housing and

Treasury bonds. In 2010, it introduced a second round of quantitative easing that included the purchase of USD600bn in Treasury bonds, with the goal of bringing down long-term interest rates more generally – not just mortgage rates. In 2012, it started a third and final round of quantitative easing, with monthly purchases of USD40bn in mortgage-backed securities and USD45bn in Treasuries in order to “put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”1037 Again, there were some concerns within the Fed that the housing sector would be privileged, but the majority viewed the housing sector as holding back the economic recovery. According to the FOMC minutes:

1034 FOMC transcript, January 26-27, 2009. 1035 A FOIA request (2014-27) to disclose documents (i.e., memoranda and transcripts) leading up to the 2008 decision of purchasing mortgage-backed securities and agency debt was denied. 1036 Blinder et al. 2008. 1037 FOMC press release, October 24, 2012.

287 MBS purchases could be preferable because they would more directly

support the housing sector, which remains weak but has shown some signs

of improvement of late. One participant, however, objected that purchases

of MBS, when compared to purchases of longer-term Treasury securities,

would likely result in higher interest rates for many borrowers in other

sectors.1038

Much like the first round of housing asset purchases, the San Francisco Fed explains that the latest round of housing bond purchases was intended to:

stimulate the economy by pushing down residential mortgage interest rates. Lower

mortgage rates encourage home purchases and mortgage refinancing. When

mortgage rates are lower, payments are lower and house prices tend to rise.

Homeowners are better off and may spend more.1039

This again highlights the economic and social policy dimensions of these programs, which had expanded to an unprecedented amount of USD1.8tn until the end of 2014.

The Fed ended its balance sheet expansion with the so-called tapering of asset purchases in 2014, but retained its balance sheet holdings until 2017. These decisions were made in response to some upbeat economic data at that time.1040 It is likely that the Fed will slowly wind down its balance sheet of 1.8tn in housing bonds over a long period of time, but not necessarily to zero. In terms of pace, the Fed is likely to avoid sudden market shocks and therefore adopt a long-term strategy of wind-down. In terms of size, it will likely retain some portion of assets on their balance sheets, which would give it more

1038 FOMC, meeting minutes, September 2012. 1039 Michael Bauer, “Fed Asset Buying and Private Borrowing Rates,” FRBSF Economic Letter (May 21, 2012). 1040 FOMC, meeting minutes, December 2013.

288 flexibility to transmit monetary policy.1041 The balance sheet will likely remain sizable for the foreseeable future.

When it comes to the relationship between politicians and the Fed, tables turned during the recent financial crisis. While policymakers tried to bully the Fed into buying housing bonds in earlier periods, they were skeptical about its aggressive monetary policy during the recent crisis. In times of increasing polarization, Republicans viewed the quantitative easing programs with a great amount of skepticism, as, in their view, the Fed did too little to prevent the financial crisis, but did too much too to save Wall Street.1042

Most, but not all, Democrats viewed monetary stimulus more favorably, especially in light of their inability to adopt fiscal programs in Congress.1043 In 2015, the Republican Party proposed a bill, known as “Audit the Fed,”1044 to curb the institution’s independence by granting oversight authority to the Government Accountability Office. While the bill stalled in the last Congress, it may gain more traction under President Trump.

In sum, the Fed purchased large amounts of housing bonds to stimulate housing during and after the recent crash. By the time the crisis hit, housing finance policy and the

American credit-led and consumption-oriented growth model were inseparable. As housing had contributed to the humming U.S. economy in the late 1990s and early

2000s,1045 the fall in house prices had the reverse effect of amplifying the crisis, affecting the entire U.S. economy -- financial markets, in particular -- and parts of the global economy. Reviving housing meant supporting the heart of the American growth model of

1041 Ben Bernanke, “Should the Fed Keep Its Balance Sheet Large?” Ben Bernanke’s Blog (September 2, 2016). 1042 Binder and Spindel 2017. 1043 The Economist. “Why giving politicians influence over monetary policy is a bad idea.” (March 10, 2016). 1044 See Federal Reserve Transparency Act (draft bill). 1045 H. Schwartz 2009, xv.

289 credit and consumption that is deeply connected with other key sectors of the U.S. economy and the global financial system. Housing was not only holding back the economic recovery, but also the key sector through which monetary policy could be transmitted to stimulate the country’s consumption-led growth model. The result was that, by 2017, the Fed’s balance sheet expanded to USD4.5tn, including USD1.8tn in mortgage-backed securities and USD2.5tn in Treasury bonds.

Lessons from the German Bundesbank (1950s) and the European Central Bank

(2009-2017)

The European Central Bank also adopted large-scale unconventional monetary programs to stimulate the eurozone in response to the recent financial turmoil, but supported private housing markets much less when compared with the Fed.1046 The reason for the ECB’s timid policy response lies in the deeper macroeconomic features of eurozone growth models and the role of housing within them. First, monetary programs to stimulate housing and consumption do not reinforce the heterogeneous growth models of the eurozone -- some of which rely on exports, others on consumption1047 -- to the same degree as they do in the United States. Second, unlike in the United States, housing is not a key driver for economic growth in many European countries. Johnston and Regan convincingly show that in countries with strong wage bargaining coordination, usually export-oriented economies

(i.e., Germany and Austria), house price growth was restrained, while in countries with lower wage coordination (i.e., Ireland and Spain) housing markets had stronger momentum

1046 Lombardi and Moschella 2015, 2016. 1047 Stockhammer (2016), for instance, shows the eurozone variation in export-oriented economies (i.e., Germany, the Netherlands, and Austria) in northern Europe and consumption- and debt-oriented economies (i.e., Spain, Greece, and Portugal, and Ireland). Also see Stockhammer, Durand, and List 2016.

290 in recent decades.1048 More specifically, export-oriented Germany -- the largest economy in Europe and most powerful member of the ECB -- does not privilege stimulating private consumption and housing credit as part of its growth model, but instead relies on price stability, wage restraint, savings -- and an affordable housing market that keeps down the cost of living. The German and Dutch central banks already sounded the alarm about overheating housing markets in their countries.1049 Along with the Dutch central bank, the

Bundesbank promoted a conservative approach to large-scale asset purchases, so as to maintain price stability, market discipline, and financial stability.1050 For these and other reasons, the ECB bought only EUR250bn in covered bonds and asset-backed securities by

2017.

Before delving into these recent policy episodes, this section briefly documents that the Fed is not the only major central bank with a history of housing support and found an unlikely European counterpart in the Bundesbank. In the early 1950s, the Bundesbank supported the country’s capital and housing markets by buying covered bonds in the open market,1051 at a time when these markets were still reeling from the consequences of WWII.

This policy episode is instructive, because it does not conform to the Bundesbank’s prominent narrative of credible monetary policy that contributed to the country’s stable currency and inflation as well as preventing moral hazard.1052 Today, the Bundesbank is one of the most principled critics of ultra-loose monetary policies -- despite its own policy

1048 Johnston and Regan 2017; H. Schwartz and Seabrooke 2008.

1049 De Nederlandsche Bank, Financial Stability Report, Autumn 2017, p. 19; 1050 Steinberg and Vermeiren 2015. 1051 Council of the Bank of German States, 66th session, “open market decision to adopt purchase program of covered bonds,” 27-28 July, 1950. 1052 For an excellent history of the Bundesbank, see Marsh 1992.

291 history of unconventional monetary policy in extra-ordinary times that remains largely unknown.

In the early 1950s, the Bank of German States – the Bundesbank’s predecessor -- bought covered bonds to support the country’s housing and capital market in an otherwise restrictive monetary policy context.1053 These measures were part of larger efforts by the

Adenauer government to stimulate these markets.1054 In 1950, the Bank circulated a memorandum outlining its open market guidelines, stating that it wanted to increase the liquidity and prices of covered bonds that had lost in value after the country’s 1948 currency reform.1055 The Allied Bank Commission -- a body established by the Western

Allies in 1948 with powers to oversee monetary policy and veto some of the Bank’s decisions -- cautioned that this “might well endanger the currency.”1056 Shortly thereafter, the Bank decided to initiate asset purchases and, as figure 6.3 demonstrates, bought covered bonds in the amount of six million Deutsche Mark (DM) between 1950 and 1951.1057

1053 See the Bank of German States’ annual reports for the years 1950 and 1951, where it outlines the bank’s monetary policy objectives of restraining credit to stimulate exports and restrain consumption. 1054 The federal government also adopted large-scale tax breaks and other subsidies to support the capital and housing markets, as detailed in chapter two. 1055 The 1948 currency reform replaced the Reichsmark (RM) with the Deutsche Mark at an exchange rate of 1:10. The Bank of German States discussed purchasing a maximum amount between DM50-100m in covered bonds previously denoted in Reichsmark (RM) or up to 20 percent of all RM-covered-bonds in the open market. Also see Willi Schmidt, “Grundzüge der Interventionspolitik,” July 21, 1950. 1056 Allied Bank Commission, “Letter to the President of the Board of Directors, Bank deutscher Laender,” July 10, 1950. Please note that this commission was abolished in 1951. 1057 Council of the Bank of German States, 66th session, “open market decision to adopt purchase program of covered bonds,” 27-28 July, 1950; also see Bank of German States, “Interventionstätigkeit der Landeszentralbanken,” 27 February, 1951. The Bank had deliberated buying more covered bonds, but there was not enough demand from the mortgage and covered bond banks, with whom the Bank of German States consulted before buying these assets.

292 Figure 6.3: Covered bonds held by members of the Bank of German States (Bank

Deutscher Länder), 1950-1951.1058

7,000,000

6,000,000

5,000,000

4,000,000

3,000,000

2,000,000 Covered bonds held in DM in held bonds Covered

1,000,000

0 BY HB HH HE NRW RP SH BW Total

It is fair to say that, even in the 1950s, this number is rather marginal in the world of central banking. But the Bank pursued another, broader goal with these purchases. It used these small-scale open market interventions to “feel along the market for future interventions”1059 and potentially coordinate future actions with the finance ministry in order to support the capital market.1060 However, Willi Schmidt, then chair of the Bank, acknowledged that, if the overall goal of monetary policy ought to be restrictive, then large-scale asset purchases in the open market would contradict that goal, as these interventions would be

1058 Source: Bundesbank Archive. Please note that these programs also included the purchase of municipal obligations, which were a major funding source for social housing programs. 1059 Memorandum circulated in the Bank of German States, author unknown, January 17, 1951; also see Council of the Bank of German States, 66th session, “open market decision to adopt purchase program of covered bonds,” 27-28 July, 1950. 1060 Bundesminister der Finanzen, “Kurspflege durch Ankauf festverzinslicher Wertpapiere auf dem offenen Markt,” July 28, 1950.

293 expansionary and “threaten the stability of the currency in irresponsible ways.”1061 The

Bank therefore decided against future large-scale interventions in the covered bond market.

While the Bank adopted another small purchase program of covered bonds in Rhineland-

Palatinate in the amount of DM600,000 in 1954,1062 the Bundesbank voted to slowly sell its covered bond holdings in 1958.1063 While moderate in scale, this policy episode demonstrates that the Bundesbank engaged in unconventional measures to support private markets against warnings that these actions might threaten the stability of the currency and encourage moral hazard.1064 According to the Bundesbank, the institution has not engaged in any more bond-buying programs prior to the recent financial crisis.1065

When the ECB was created to set monetary policy in the eurozone in 1998, the

German Bundesbank became an influential member of the institution. It is widely known that the ECB was modeled after the Bundesbank’s mandate of price stability (and institutional design that assured a significant degree of legal independence)1066 -- and most notably not after the Fed’s partial mandate of full employment. As the Bundesbank represents the largest European economy at the ECB, it still yields a considerable amount of power, but it cannot dictate policy decisions with its single vote in the ECB’s governing

1061 Willi Schmidt, “Bemerkungen zu den einzelnen Punkten auf der Tagesordnung ‘Förderung des Kapitalmarkts (Sitzung des Gremiums Scharrenberg am 10. November 1951),” November 30, 1951. 1062 Bank of German States, “Sonderaktion zum Rückkauf von Auslgeichsforderungen aus der Ingangsetzung des Beleihungsgeschäfts,” February 15, 1954. This program was designed to channel the newly available funds for banks into the public bond market to finance compensation payments for banks and investors after the currency reform. 1063 Bundesbank, 22nd Council meeting, “open market decisions,” 24 April 1958. 1064 In the late 19th century, Max Wirth (1883), a German economist, already cautioned that “through outright purchases, one removes the responsibility of speculators, and one offers them the chance to play the same game. The reasons for the crisis are not removed by that, the liquidation is only postponed to eventually return in an even more threatening form.” Quoted in: Bindseil 2014, 220. 1065 Email correspondence, Bundesbank, Open Market Operations, October 24, 2014. 1066 McNamara 1999.

294 council.1067 The remainder of this section analyzes how and why the ECB has adopted moderate housing bond-buying programs during the recent crisis, with a particular focus on the preferences and influence of its most powerful member institution, the German

Bundesbank.

The key to understanding the ECB’s policy response during the recent crisis lies in the heterogeneity of macroeconomic growth models, and the role of housing within them.

First, as Stockhammer notes, European growth models are divided into largely two camps

-- consumption- and export-oriented growth models.1068 While export-led economies are largely found in Northern Europe, including Germany, Austria, and the Netherlands, consumption-led economies are located in Southern Europe, such as Spain, Greece, and

Portugal.1069 Unlike in the United States, stimulating housing, credit, and private consumption is not an overarching growth strategy for all European economies. Second, the housing finance markets of Europe are much less standardized and more fragmented when compared with their American counterparts.1070 The development of asset-backed securities markets and covered bond markets varies tremendously among European economies -- and these markets are generally less developed than in the United States.1071

The fragmented nature of European housing finance markets makes housing interventions more difficult. Finally, European mortgage vary greatly in their degrees of strictness, which influences the scope of market participation. While the German mortgage market is highly conservative -- with high down payments, transactions costs, and few subsidies for

1067 Belke and Styczynska 2006. The governing council consists of its 19 members banks and six executive board members, all of whom vote on issues in a rotating voting system. 1068 Stockhammer 2016; Stockhammer, Durand, and List 2016. 1069 Ibid. 1070 H. Schwartz and Seabrooke 2008. 1071 Vitols 2001.

295 homeowners – other eurozone mortgage markets, such as those in Spain or the Netherlands, are more lenient and offer homeownership subsidies.1072

These macroeconomic differences influenced the ECB’s policy decisions to support European bond markets during and after the recent crisis. The ECB started its first covered bond purchase program in 2009, when the financial crisis hit European banks and the covered bond market started to dry up.1073 The European covered bond market is an important element of the continent’s capital market, amounting to a volume of EUR2.5tn in 2014 -- but a number much lower than the U.S. mortgage-backed securities market of

USD6tn in 2017 -- which helps banks refinance and channel funds into housing and other markets. 1074 To stabilize that market, the ECB initiated its first purchase program by buying

EUR60bn in covered bonds until 2010.1075 Shortly thereafter, in 2011, it initiated its second covered bond purchase program, which amounted to EUR16bn until 2012. Although the

ECB had targeted purchases in the amount of EUR40bn for the second program, it prematurely stopped the program.1076 According to a senior ECB official, this was because the ECB feared squeezing out investors by buying large amounts of already scarce covered bonds, which were in high demand, and because the market had already been recovering.1077

1072 Aalbers 2008. The rate of homeownership in the eurozone also varies tremendously, ranging from roughly 50 percent in Germany and 54 percent in Austria to 75 percent in Portugal, Spain, and Ireland to over 90 percent in Slovakia and Slovenia, with an average of roughly 70 percent for the eurozone. Please note that these numbers measure the share of the population by tenure status (and not the share of households living in owner-occupied housing). Source: Eurostat. 1073 Axel Weber, “Pfandbriefmarket und Finanzkrise.” Speech at the annual meeting of the Association of German Pfandbrief Banks, Berlin, November 26, 2009. 1074 Sources: European Commission; Housing Finance Policy Center. 1075 ECB, “Decision of the European Central Bank of 2 July 2009 on the implementation of the covered bond purchase programme,” 2009. 1076 ECB, “Decision of the European Central Bank of 3 November 2011 on the implementation of the second covered bond purchase programme,” 2011. 1077 Author interview (phone), ECB official I. December 18, 2014; author interview (phone), ECB official II. January 19, 2015; author interview, ECB official IV, Frankfurt, March 30, 2015.

296 Yet, these asset purchases had a limited effect on housing markets. On one hand, these programs were miniscule in size when compared with what the Fed had bought around the same time. On the other, covered bonds are not exclusively backed by housing, but also by other forms of collateral, such as ships, airplanes, or public sector loans.1078 For instance, in the case of German bonds, the ECB bought EUR8bn in bonds covered by

German mortgages and EUR11bn in bonds covered by German public sector loans between

2009-2012.1079 The direct impact of covered bond purchases on European housing markets is therefore less pronounced when compared to mortgage-backed securities purchases in the United States.

The rationale for these early purchases was to re-activate the European covered bond and inter-bank markets. In contrast to the Fed, the ECB made no reference to targeting the housing market with these purchases. While European housing markets have partly benefitted from these purchases -- which one senior ECB official called: “collateral benefit”1080 -- it was not the ECB’s objective to provide specific support for housing.1081

Instead, as Francesco Papadia, the ECB’s former director of monetary operations put it, the

“ECB purchases were not targeting a reduction of long term yields but rather tried to

1078 Beirne et al. (2011) find that the first covered bond program had a positive impact, easing funding conditions for banks, encouraging banks to lend, and improving liquidity in the capital market. 1079 Each member bank of the eurosystem has purchased an amount of covered bonds equivalent to its capital key within the ECB. The capital key, the share by which the ECB is “owned” by each national central bank of the eurozone, is determined by the economic output and population of a country. Germany (18%), France (14%), and Italy (12%) hold the largest shares of the ECB’s capital key. 1080 Author interview (phone), ECB official I. December 18, 2014; author interview (phone), ECB official II. January 19, 2015. 1081 Author interview, ECB official IV, Frankfurt, March 30, 2015. The official also noted that the program did have some market-distorting effects, which provided an implicit subsidy and advantage for European covered bond and property markets.

297 remedy a market dysfunction in the covered bond segment.”1082 On the comparison with the Fed’s bond buying programs, a senior ECB official elaborated that:

The CBPPs had a different objective than the Fed’s purchase of MBS: the

ECB wanted to revitalize the inter-bank money market and revitalize the

monetary transmission mechanism by its purchases, while the Fed actively

supported the housing market, which went through a deep crisis. We thought

it was not our mandate to bail out the housing market in, say, Spain, which

should have been done fiscally … Our goal was not to fix the housing

system, but to help the banking and financial system. The ECB was limited

in what it could purchase that was safe and effective. Covered bonds were

safe, because they are backed by collateral, and they are effective, because

they’re used by banks, so you can have a transmission effect. Given the

structure of the European banking system, covered bonds were the most

effective and efficient instruments.1083

Another ECB official stated that, while stimulating housing might increase consumption in the U.S. economy, the same would not be true in Europe:

quantitative easing in the United States works through the wealth effect --

increasing private consumption and producing stronger growth. And we don’t have

this effect in Europe. We don’t have a market-based financial system, we have a

bank-based finance system … our transmission channel works through the

banks.1084

1082 Francesco Papadia, “Should the ECB Go Quantitative?” Money Matters Blog (January 20, 2014). 1083 Author interview (phone), ECB official III. December 8, 2014. 1084 Author interview, ECB official IV, Frankfurt, March 30, 2015. My translation.

298 In Europe, capital markets are less developed than in the United States, which means that purchase programs of housing-related assets are more limited. A third ECB official concurred that housing was not the main macroeconomic consideration when adopting the covered bond programs, stating that:

I think the support of housing markets was not the focus. So housing was not

the endpoint of the transmission mechanism, but it was the intermediate one

in terms of supporting funding of the banking system. And covered bonds

were secure instruments, which we could purchase relatively

conveniently.1085

A fourth ECB official echoed that these programs were instead designed to revive the capital market and banking system, but not to stimulate housing:

It was not so much helping real estate, it was more about helping banks and

also helping the biggest private sector bond segment in Europe … At that

time, especially during the first bond purchases, it was very impaired. So

that means: little liquidity, little turnover, difficulty of functioning. The idea

was that we help the banks and we help the market more than we help the

housing sector … I don't think you can say that the housing sector, in the

case of Europe, was an objective at all. Indeed, there are some who say that,

in some places, we are seeing again something of too much enthusiasm for

real estate, for instance in Germany.1086

Indeed, the German Bundesbank had repeatedly sounded the alarm, when German house prices increased in the years following the financial and euro crises. The Bundesbank

1085 Author interview (phone), ECB official II. January 19, 2015. 1086 Author interview (phone), ECB official I. December 18, 2014.

299 considered overvalued house prices as a source of financial risk partly caused by loose monetary policy.1087

The ECB initiated its third covered bond purchase program in 2014, and shortly thereafter, launched its first asset backed securities program.1088 The goal of these programs was to ease monetary conditions by providing liquidity for financial markets in times of ultra-low interest rates and deflationary pressures.1089 By January 2015, the ECB had added another EUR30bn in covered bonds and EUR1.8bn in asset-backed securities to its portfolio. Again, the ECB did not show much interest in boosting the housing market. As

Papadia noted, “it is clear that the ECB has no intention to favour the housing sector, which in countries like Germany may already be too lively.”1090 Similarly, a senior ECB official noted that the latest round of covered bond purchases was launched “in the context of QE- like thinking -- that you wanted to increase the balance sheet, inject reserves, and then you’re just looking for assets you can buy.”1091 While the Bundesbank does not fundamentally oppose the covered bond programs, a senior Bundesbank official noted that:

Nobody in the Bundesbank actually believes that this will have much of an

impact … It won’t lead German banks to hand out more loans, so that’s not

helpful. The current covered bond program [CBPPIII] has nothing to do with

the housing market, but it is rather about generating liquidity into the banking

1087 Bundesbank, “Possible overvaluation of residential property in German cities,” 2013. 1088 The European asset-backed securities market amounted to EUR1.5tn in outstanding securities in 2013 (i.e., the U.S. market for mortgage-backed securities was about USD6tn in outstanding securities in 2017). Sources: European Commission; Housing Finance Policy Center; ECB. 1089 ECB, “Decision of the European Central Bank of 15 October 2014 on the implementation of the third covered bond purchase programme,” 2014; ECB, “Decision of the European Central Bank of 19 November 2014 on the implementation of the asset-backed securities purchase programme,” 2014. 1090 Franceso Papadia, “About Elephants and ABS,” Money Matters Blog (July 17, 2014). 1091 Author interview (phone), ECB official II. January 19, 2015.

300 system, to guarantee cheap refinancing for banks in the long run, hoping that

this would stimulate bank lending.1092

This highlights that the housing sector did not play a significant role in implementing the later rounds of bond-buying programs. The difference between the early bond buying programs and the more recent ones is that the former were designed to reactivate the covered bond market that had dried up in times of financial turmoil, while the latter were designed to inject liquidity in financial markets in times of deflationary pressures.

In 2015, the ECB adopted a more aggressive version of quantitative easing of asset purchases modeled after the Fed’s monthly purchase programs.1093 The ECB started purchasing assets in the amount of EUR60bn per month, including sovereign bonds, covered bonds, asset-backed securities, and, later on, public sector securities1094 and corporate bonds.1095 The ECB’s QE program incorporated and extended the already existing covered bond and asset-backed securities programs into its larger bond-buying scheme. According to the ECB, the new QE program was designed to boost inflation to meet its inflation target and to “ease monetary and financial conditions, making access to finance cheaper for firms and households,” so as to stimulate investment and consumption.1096 While the ECB briefly expanded asset purchases to EUR80bn per month

1092 Author interview, Bundesbank official. Berlin. January 9, 2015. My translation. 1093 ECB, Press Release, “ECB announces expanded asset purchase programme,” 2015. 1094 Later in 2015, the ECB adopted a public sector securities purchase program that is part of the larger asset purchase scheme; see ECB, “Decision of the European Central Bank of 4 March 2015 on a secondary markets public sector asset purchase programme,” 2015. 1095 In 2016, the ECB adopted a corporate sector purchase program as part of its quantitative easing program; see ECB, “Decision of the European Central Bank of 1 June 2016 on the implementation of the corporate sector purchase programme,” 2016. 1096 ECB, Press Release, “ECB announces expanded asset purchase programme,” 2015.

301 in 2016, with the goal of raising inflation,1097 it reduced its purchases to EUR60bn given some upbeat economic data in April 2017.1098

While there was little disagreement about the initial, small-scale purchases of covered bonds and asset-backed securities within the ECB, the purchases of government bonds and later rounds of quantitative easing caused a storm within and outside the ECB.

Given the moderate amounts that the ECB has bought in covered bonds and asset-backed securities, these purchases did not create much controversy.1099 In an interview, an ECB official noted that:

Everybody seemed to be on the same page. They agreed that it was an

important issue to unlock the financial system and mostly discussed some

technical issues during the meetings. These purchases were debated since late

2008 to reduce market turbulences. The SMPs [buying sovereign debt of

distressed eurozone countries] were much more controversial.1100

As the official noted, there was much more disagreement about buying sovereign bonds, triggering heated debates between national central banks, finance ministries, and the media.1101 As the eurozone does not have “euro bonds” equivalent to U.S.

Treasury bonds -- i.e., nontargetable bonds that do not directly support specific sectors or countries -- attempts by the ECB to buy sovereign bonds of its member

1097 ECB, Press Release, “Monetary Policy Decisions,” March 2016. 1098 ECB, Press Release, “Monetary Policy Decisions,” December 2016. 1099 Author interview (phone), ECB official II. January 19, 2015. 1100 Author interview (phone), ECB official III. December 8, 2014. Also see ECB, press release, “ECB decides on measures to address severe tensions in financial markets,” 2010. 1101 For instance, former central bank chief, Axel Weber, and his former German counterpart on the ECB Board, Jürgen Stark, both resigned, in part because the Governing Council agreed on purchasing sovereign debt of distressed countries under the Securities Market Programme (SMP) in 2010, which was terminated in 2012. For a good discussion the politics behind the ECB’s government bond purchase programs, see Lombardi and Moschella 2016.

302 states generated the criticism of both privileging certain countries over others and offering monetary financing for governments.1102 German policymakers, particularly the Bundesbank and finance ministry, have opposed the efforts of the ECB to buy large amounts of government bonds, arguing that such efforts would induce crisis- ridden states to prolong reforms and create moral hazard.1103 In the words of

Bundesbank president, Jens Weidman, “[m]arket discipline is also important against this backdrop so that higher interest rates are ultimately imposed on countries with unsound fiscal policies.”1104 Similarly, the president of the Dutch central bank, Klaas

Knot, said that the ECB’s bond-buying programs could result in financial instability, undisciplined markets, and inefficient allocations of resources:

our non-standard monetary measures could result in an inefficient allocation

of resources. Price signals are being suppressed, and the role of financial

market discipline is weakened. Cheap credit may help unproductive and non-

viable firms to survive for too long … Second, the low interest rate

environment becomes increasingly harmful for financial institutions and

poses risks for financial stability.1105

The hawkish members of the eurozone, such as Germany and the Netherlands, therefore viewed providing monetary assistance for specific countries and sectors, such as housing, as inappropriate policy responses.

1102 Lombardi and Moschella 2016. 1103 Gavyn Davies, “It’s Draghi versus Weidmann on ECB QE,” Financial Times. October 10, 2014. 1104 Frankfurter Allgemeine Sonntagszeitung, “What is to become of our money, Mr Weidmann?” (11 December 2016). 1105 Klaas Knot, “Tilting the Policy Mix in the Euro Area,” Speech delivered at the Finanzmarktklausur Wirtschaftsrat, Berlin, January 26, 2017.

303 This conflict reflects some deeper macroeconomic frictions between the

ECB’s loose monetary policy, including asset-purchase programs, and the German growth model. The German Bundesbank and finance ministry have been the most vocal critics of ultra-loose monetary policy under the leadership of ECB president

Mario Draghi. First, the Bundesbank has argued that loose monetary policy could bring about asset bubbles and financial risk, such as an overheating German property market.1106 Most recently, Andreas Dombret, an executive board member of the

Bundesbank, said that: “[t]he mixture of booming real estate market and low interest rates can become a dangerous cocktail for the banking and savings bank sector.”1107

Second, German politicians across the political spectrum have criticized quantitative easing and ultra-low interest rates for hurting savers, who have collected lower interest on their deposits since the financial crisis.1108 As Germans do not ordinarily tend to put their savings in stocks, but in savings accounts or pension funds,1109

Sigmar Gabriel (SPD), then Vice-Chancellor of Germany, said that “[w]hat the

European Central Bank is doing now is for many savers, for little people, for workers, for pensioners, an expropriation.”1110 For this reason, then German finance minister,

Wolfgang Schäuble (CDU), even partly blamed the ECB’s loose monetary policies for the rise of the populist, right-wing, and anti-euro party Alternative for Germany

1106 Bundesbank, “Possible overvaluation of residential property in German cities,” 2013. 1107 Deutsche Welle, “Bundesbank warns of German real estate bubble,” (4 May 2017). 1108 Similarly, the German building societies have criticized the ECB for its low-interest rate policy, which squeezed their profits. See Siedenbiedel and Frühauf, “Bausparkassen sehen sich von der EZB gegängelt,” Frankfurter Allgemeine Zeitung (21 June 2016). 1109 Only 15 percent of all Germans own stocks, whereas the share in the United States is more than 50 percent. Sources: Gallup; Deutsches Aktieninstitut. 1110 Wagstyl, Stefan and Claire Jones, “Germany blames Mario Draghi for rise of rightwing AfD party,” Financial Times (April 10, 2016).

304 (AfD).1111 Third, while quantitative easing programs tend to weaken the euro, which helps export-oriented economies, German exporters view these policies as artificial and detached from market fundamentals. In the words of the head of the federation of

German exporters:

the ECB has opened a door behind which there is a danger of a currency war.

This step also destroys the necessary trust in a stable currency.1112

The German export industry articulated that it would not require monetary stimulus and prefer a stable currency over ultra-loose monetary policy. Quantitative easing that stimulates the German housing market, hurts savers, and creates uncertainty about future currency developments therefore creates frictions with Germany’s export-led growth model traditionally supported by collective bargaining systems, a conservative central bank, and a stable housing market. The Bundesbank president,

Jens Weidmann, made clear “that such an ultra-expansionary monetary policy should not last forever”1113 and has called for an end of unconventional monetary policy and quantitative easing.

In sum, the ECB purchased only moderate amounts of housing-related bonds as part of its quantitative easing programs. This is partly because housing is not a transmission sector for major European economies, such as export-oriented Germany.

Relatedly, the capital markets for mortgages -- covered bond and asset-backed securities markets -- are more fragmented and less developed when compared with

1111 Ibid. 1112 Krohn und Pennekamp, “Der Euro im Sturzflug,” Frankfurter Allgemeine Zeitung (March 12, 2015). My translation. 1113 Frankfurter Allgemeine Sonntagszeitung, “What is to become of our money, Mr Weidmann?” (11 December 2016).

305 their counterparts in the United States, which made effective and large-scale interventions by the ECB more difficult. The most salient conflicts over quantitative easing in Europe revolved around whether the ECB should buy sovereign bonds, but much less about the targetability of certain economic sectors, such as housing.

Conclusion

This chapter has shown that major central banks in advanced economies have supported private housing markets to different degrees during and after the Great Recession. When interest rates hit the zero-lower bound in the late 2000s, central banks resorted to unconventional policy measures of buying large amounts of securities in the open market to bring down long-term interest rates, stimulate bank lending, and generate growth. While the Fed has bought close to two trillion dollars in mortgage bonds to support housing as a major part of its quantitative easing programs, the ECB has purchased housing-related bonds only minimally as part of its own programs. This chapter has shown that the key to explaining these differences lies in the different economic growth models in the United

States and Europe. In the United States, central bankers regarded housing as the key transmission sector to stimulate credit, consumption, and economic growth. The Fed targeted the housing sector, because it was considered to be the source of the financial crisis and able to stimulate the consumption-led growth model. Yet, housing is not a transmission sector in many European economies, most notably not in export-oriented Germany. To the contrary, ultra-loose monetary policy -- and associated house price surges -- are viewed with skepticism in the country, where the larger macroeconomic institutional framework privileges price stability, wage restraint, and savings. Other ECB member banks, such as

306 Dutch central bank, similarly opposed ultra-loose monetary policy, expressing concerns about financial instability and unwanted momentum in the country’s housing market.

Large-scale housing interventions by the ECB therefore do not reinforce the macroeconomic features of major national economies in Europe.

This chapter contributes to important studies on the welfare state and central banks in political science. First, this chapter concurs with a body of work on the politics of central bank independence.1114 While central banks are often assumed to be independent entities that can adopt policy decisions with fair levels of autonomy, this chapter demonstrates that policymakers often influence central banks by (i) adopting legislative changes to their charters, (ii) bullying them into policy decisions, and (iii) delegitimizing or undermining their policies in public debates. In the case of the Fed, policymakers have changed -- or threatened to change -- the legal statutes of the Fed and, at times, bullied the central bank into stimulating housing. In the case of the ECB, the German government has openly denounced the central bank’s loose monetary policies, as they would hurt German savers, disincentivize structural reforms in crisis-ridden countries, and contribute to overheating housing markets. Central banks in advanced economies are therefore less independent and more politicized than often assumed.1115

Second, central bank programs that support housing finance have important distributive consequences and should be viewed as part of the public-private welfare state.

Much like fiscal welfare policy in the housing area, large-scale purchases of housing bonds tend to lower the cost of mortgage debt and stimulate housing demand and house prices.

These programs help homeowners get cheaper mortgages or refinance their mortgages at

1114 Fernandez-Albertos 2015; Binder and Spindel 2017; Bernhard 1998; Goodman 1991. 1115 Adolph 2013.

307 better rates, and they contribute to the stabilization or accumulation of housing wealth. But increasing property prices does not benefit everyone and can also contribute to unaffordable rental housing in many communities. The actions of central banks in the housing area may therefore reinforce or exacerbate existing housing inequalities in advanced economies. The social policy dimension of central banking is all the more important in times of fiscal restraint, when policymakers are not able or willing to adopt social programs through fiscal means.1116

1116 Farrell and Quiggin 2017; Blyth 2013.

308 Chapter 7: Conclusion

By now it is clear that housing finance is a major area of advanced economies in which governments intervene. Policymakers in Western societies have long recognized the social and economic importance of housing, but adopted different solutions for financing private homes. This dissertation examined why some countries chose state-based homeownership models with extensive public support for financing private homes, while others relied on market-based solutions with limited public support. To address this variation, this dissertation analyzed the varieties of housing finance policies in the United States and

Germany.

It may come as a surprise to scholars of political economy that the United States and Germany fall on opposite and counterintuitive ends of the housing finance policy spectrum. Where the United States, the land of free market capitalism, embraced a state- based homeownership model, Germany, a social market economy, developed a market- based model. Since the early twentieth century, the United States has subsidized mortgage debt through the primary and secondary mortgage markets and offered billions of dollars in tax breaks for homeowners. To a lesser degree, the postwar German state also supported homeownership, offering large-scale tax breaks and subsidies as part of social housing programs. Yet, over time, policymakers eliminated these longstanding programs. Today, housing finance is much more “socialized” 1117 in the United States than in most other advanced economies, such as Germany.

This dissertation has focused on macroeconomic growth models in explaining the opposing housing finance policy trajectories in the United States and Germany. Existing

1117 Mervyn King, in: McLean (2015, 9).

309 explanations based on power resources, political institutions, culture, and party politics have difficulty capturing this counterintuitive variation. While partly illuminating, they fail to account for the macroeconomic context in which political and economic actors make social and economic policy decisions. It is this macroeconomic context that shapes the political arena in which housing finance battles are fought. In sum, the most important insight of this dissertation is that growth models shape the politics of the welfare state.

More specifically, the interlinkages between economic growth models and housing finance policies shape the policy choices available to political actors. In the United States, the consumption-led growth model has entrenched housing finance policies. As these policies tend to stimulate demand, credit, and consumption, they produce strong macroeconomic synergies with the consumption-based growth model. These synergies helped shape a broad policy consensus among politicians of both parties, supported by interest groups, who viewed these policies as effective growth strategies. The result was the long-term stability and entrenchment of housing finance policies. In Germany, the weak interlinkages between the export-oriented growth model and the country’s housing finance policies made these policies vulnerable to reform. The macroeconomic frictions between the export-oriented model -- partly based on restraining consumption -- and policies that tend to stimulate consumption opened the door for significant partisan conflicts around housing finance policies. Where the center-right favored the stability and expansion of public support for homeownership, so as to promote their family and ownership values, the center-left prioritized public support for affordable rental housing over homeownership.

These conflicts eventually resulted in retrenchment when policymaking power shifted from the political right to the left at the turn of the millennium.

310 To illustrate the argument, this dissertation contrasted the housing finance policy developments in the United States and Germany in three important areas: taxation, mortgage debt policy, and central banking. In the early twentieth century, both countries started out with state-based homeownership models in the tax and mortgage areas. Yet, policymakers in the United States fortified and expanded the state-based model, while their

German counterparts substituted the state-based model for market-based strategies during the late twentieth and early twenty-first centuries. The empirical chapters explain these divergent trajectories in each policy area.

When it comes to taxation, chapters two and three show that, while the United

States developed a state-based homeownership tax model, Germany switched from state- based to market-based homeownership taxation. In Germany, strong center-right political forces adopted homeowner tax subsidies in the postwar era, with the dual goals of increasing the housing supply in times of severe shortages and creating a nation of homeowners. While these policies subsequently grew into the largest tax subsidies in the country’s history, they were ill-suited strategies to stimulate the productive activities of the

German export-led economy. To the contrary, when the country’s major housing shortages came to an end, center-left policymakers started viewing homeownership tax breaks as part of larger structural economic problems that contradicted the growth model by contributing to growing deficits (and inequality), diverting funds away from the productive sector, and limiting labor mobility. Their attacks eventually bore fruit in the mid-2000s, when tax breaks for homeowners were eliminated.

In the United States, the story about homeownership tax breaks could not be more different. What became to be known as the popular mortgage interest deduction (MID)

311 grew out of an otherwise little-noticed provision in the U.S. income tax code of 1913 that allowed taxpayers to deduct interest on consumer debt. While the MID was marginal until

WWII, it soon grew in size and importance as the number of homeowners increased and policymakers broadened the tax base after the Great Depression and WWII. At that time, politicians across the spectrum discovered the potential of the MID as a strategy to promote housing demand, house prices, mortgage credit and consumption in the wider economy.

The synergies between the consumption-led growth model and the MID produced a strong bipartisan consensus in favor of policy stability or expansion, which left the mortgage interest deduction essentially untouched for over one hundred years. In light of recent events, it should be noted that the Trump administration and the Republican Congress currently consider reducing homeownership tax benefits, but they are unlikely to eliminate them.1118

The story about mortgage debt subsidies, told in chapters four and five, is similar in that both countries started with state-based models in the mid-twentieth century, but their policy paths diverged over time. In Germany, center-right policymakers adopted social housing policies that included subsidies for homeowners and renters, so as to increase the country’s housing supply in times of severe shortages. Partially, these policies tied in with the country’s postwar growth model, as they helped both keep down the cost of living and stabilize house prices and wage levels in the broader economy. In the immediate postwar years, the political left and right, as well as the federal states, fought about the kind of housing supply that should be subsidized to overcome these shortages --

1118 Conor Dougherty, “Tax Change on Mortgages Could Shake Up the Housing Market,” New York Times (November 2, 2017).

312 homeowners or rental markets. Center-right policymakers grudgingly witnessed that the federal states used their authority to distribute social housing funds disproportionally to the rental sector. When the days of major housing shortages came to an end in the 1970s, the social housing policies decoupled from the growth model in times of well-functioning and affordable housing markets. This made social housing programs vulnerable to reform, when policymakers on the left and right wound down and eventually retrenched them as part of structural economic reforms, austerity measures, and federalism reform, so as to reduce distortive subsidies, balance the budget, and boost export competiveness.

In the United States, mortgage debt policies grew to become the heart of the country’s credit-based consumption model. The depression-era housing finance programs, designed to overcome a full-blown housing crisis, expanded the reach of the American state in the primary mortgage market. As these programs helped stimulate housing demand and credit that helped boost the economy out of the recession, they created strong synergies with the consumption-led growth model. These synergies fostered a lasting policy consensus among both major parties who considered these policies to be effective growth strategies. When climbing interest rates strained the country’s deposit-based housing finance market from the late 1960s until the early 1980s, policymakers stepped in and expanded the American state’s reach in the secondary mortgage market, so as to provide mortgage liquidity and stimulate housing. Increasingly, the U.S. growth model relied on credit-based consumption, which made the country’s government-sponsored secondary mortgage market -- the premier source of mortgage funding -- central to the U.S. economy.

Yet, policymakers did not stop there, as they aggressively expanded mortgage lending to communities and social groups previously excluded from climbing the housing ladder.

313 What started as a tremendously synergetic relationship between the American consumption model and mortgage policies later ended with the financial crisis of 2007-09, including the bailout of the country’s mortgage giants. While the crisis should not be blamed on government policy, it is undeniable that, in their overly aggressive push in extending mortgage lending, policymakers turned a blind eye to the unsound developments in the housing market.

In comparing these cases, it is striking how much both countries differed in their emphases on supply and demand when adopting housing policy. This is indicative of how macroeconomic growth models set the parameters of what policymakers deem as desirable policy objectives. In Germany, policymakers were not primarily concerned with stimulating housing demand, but instead with adjusting housing supply. Stimulating demand does not create strong complementarities with an export-oriented growth model that, to some degree, relies on restraining consumption, wages, and credit, while ensuring price stability in housing markets and the wider economy. This stands in stark contrast with the United States, where stimulating housing demand tends to increase house prices. And as higher house prices stimulate consumption, these policies were seen as effective strategies to promote growth in the U.S. economy. In sum, growth models shape the ways in which policymakers think about the economics of housing policy.

Another striking feature that emerged from the comparison of both countries is the astonishing degree of bipartisan consensus in the United States and the high degree of political conflict in Germany when it comes to housing policy. Policymakers in the two countries not only differed in their assessments about what housing policies mean for supply or demand, but also whether these policies are desirable in the first place.

314 Underlying the remarkable persistence of housing finance policies in the United States was a bipartisan consensus rarely found in other social policy areas in the country. By expanding housing finance support, policymakers have enjoyed the best of all worlds in the context of the U.S. growth model. Such a policy approach aligns the incentives of pleasing homeowners and powerful industries (i.e., housing and banks) with the national interest of stimulating economic growth (i.e., credit and consumption) and the pursuit of the American Dream. It is hard to think of a more powerful cocktail of arguments in favor of a social policy in the United States. Their German counterparts were decidedly more divided over the issue. Where political forces on the left raised concerns about the distributive, environmental, and urban consequences of home finance policies, the forces on the right favored them given their longstanding ownership and family values. While

U.S.-style macroeconomic debates about demand, consumption, and house prices were largely absent in Germany, American policymakers barely acknowledged the distributive and regional concerns found in Germany. In other words, somewhat similar policies were debated very differently in the two countries, as their respective macroeconomic contexts shaped the debates surrounding these policies. While stimulating consumption and rising house prices tends to reinforce the U.S. economy, it does little to promote productive activity in the German economy. The housing policy incentives therefore point in opposite directions -- a factor well understood by policymakers in both countries.

A case in point for how macroeconomic features shape the preferences and policy choices of policymakers is the discussion on monetary housing stimulus in chapter six.

When tax and mortgage policies were not enough to secure a robust housing market, central banks could come to the rescue. The key finding of the chapter is that the Fed adopted a

315 multi-trillion-dollar housing program, while the ECB adopted comparatively timid monetary stimulus for housing during and after the recent crisis. This gets at the core of how different growth models influence economic policy choices. In the credit- and consumption-led U.S. economy, the Fed identified housing as the key transmission sector for economic growth able to stimulate the two key elements of the U.S. economy -- credit and consumption. In contrast, the ECB did not identify housing as a major element of

European growth models. In many European countries, such as export-oriented Germany, neither consumption, credit, nor housing are key for generating economic growth. The ECB therefore adopted a more conservative approach to asset purchases in housing and other private markets, so as to maintain price stability, market discipline, and financial stability.

This dissertation makes important empirical contributions that demystify some common notions about the political economies of the United States and Germany. First, the United States is often seen as a quintessential liberal market economy, with relatively limited degrees of government involvement in the economy. Scholars have rightfully criticized that the American state is much more interventionist than often assumed.1119 This dissertation goes one step further. If we accept the centrality of housing to the U.S. economy -- an assumption rarely questioned after the recent financial crisis -- then we ought to accept that the American state is a constitutive element and important engine of economic growth in the country. Housing and the American state have become inseparable, given the intertwined nature of housing finance policies and the private housing market.

While the recent financial crisis made the presence of the American state in the country’s

1119 Krippner 2011; Prasad 2012.

316 housing market more visible, given the nationalization of Fannie Mae and Freddie Mac, these developments have been in the making for more than half a century.

Second, Germany is often praised for its resilient, affordable, and high-quality rental market. Scholars and commentators are quick to claim that the country followed a grand design of creating a nation of renters, while neglecting policy support for homeowners.1120 This dissertation adds nuance to this narrative. The powerful Christian

Democrats did adopt large-scale tax subsidies for homeowners in the postwar era, with the goal of rebuilding the country as one of homeowners. The homeownership tax allowance, in particular, became the largest tax subsidy in the country’s postwar history. Similarly, social housing policies were designed to allocate the majority of funds to homeowners -- but failed to do so, as the federal states privileged the rental market on the ground. This dissertation concentrated on one major factor that prevented the creation of a German homeowner nation -- the absence of strong interlinkages between homeownership policies and the country’s export-oriented growth model, which made these policies vulnerable to subversion and retrenchment. That the country developed what today is considered a stable, high-quality, and affordable rental market was not envisioned by the powerful Christian

Democrats, who dominated much of the political scene in postwar Germany.

This dissertation also makes a number of theoretical contributions. First, macroeconomic growth models are fundamental, but underexplored, determinants of the welfare state. Scholarship on the welfare state has often treated the preferences of political parties as fixed, both across time and space. Instead, this dissertation has shown that macroeconomic growth models shape the preferences of political actors when pursuing

1120 Kofner 2014; Voigtländer 2009.

317 social and economic policies. Center-left parties in one country might therefore be supportive of home finance policies, while their counterparts in another country might oppose such policies. What is perceived as viable social policy often hinges upon the macroeconomic context. This is precisely why Republicans and Democrats in the United

States agreed on supporting housing finance markets, while the Christian Democrats and

Social Democrats in Germany disagreed over the issue. Growth models set the parameters and interests of what policymakers are willing to promote in the social policy area.

Relatedly, scholarship emphasizing the paramount role of interest groups in shaping social policy miss the growth model dimension.1121 This oversight is important, as macroeconomic features shape the capabilities of interest groups in influencing social policy. One key finding of this study is that, while interest groups in the housing area were not inherently powerful, they were often empowered by larger macroeconomic features. In the United States, housing groups were able to voice their policy concerns -- loudly and clearly -- as they reverberated the powerful economic arguments of boosting credit, consumption, and growth. Yet, their direct influence in the tax and mortgage areas is also more limited than often assumed, as these housing groups promoted what policymakers wanted to get behind in any case -- a strong housing market and economic growth. In

Germany, the influence of housing groups in shaping home finance policies was much weaker than in the United States. The macroeconomic context made it difficult for housing groups to sell and defend these policies as growth strategies, which limited their influence in the policymaking arena. Housing groups also did not speak with a single voice in

Germany’s political economy of housing in which homeownership and rental markets are

1121 Howard 1997; Hacker and Pierson 2010.

318 on an equal footing. In sum, macroeconomic features shape the influence and power resources of interest groups in the housing and other social policy areas.

The second contribution relates to the growing literature on the public-private welfare state. All three policy areas discussed in this dissertation -- taxation, mortgage debt, and even central banking -- are quintessential elements of the public-private welfare state.

The very essence of these policies is to offer public support for private markets in providing human welfare, including in the housing area. Yet, many of these policies do much more than merely supporting private markets. Fundamentally, these policies are often constitutive of private markets -- policies without which private markets could collapse -- as the case of the American secondary mortgage market has demonstrated. On the flip side, relying on private markets for social outcomes, even if they receive generous public support, makes ordinary people and policymakers vulnerable to the performance of these markets. This can leave policymakers in a bind given their stakes in the functioning of these public-private relationships.

The final contribution takes the discussion into the realm of international political economy. As scholars and commentators have voiced growing concerns about the global imbalances of world capital flows,1122 this dissertation sheds light on how the interlinkages between growth models and housing finance policies play into these imbalances. In the

United States, the government-sponsored Fannie Mae and Freddie Mac attracted significant capital inflows from abroad, because investments in their mortgage-backed securities -- enjoying the backing of the U.S. government -- were deemed safe and risk- free investments. While capital inflows from abroad stimulate the U.S. housing market,

1122 Obstfeld 2012; Roach 2014.

319 they also reinforce global imbalances, as foreign surpluses help finance U.S. mortgage credit and consumption. The flipside of these developments can be found in Germany’s export-oriented economy, which has produced trade surpluses in most years in its postwar history. Yet, reducing the country’s surplus by increasing consumption is a tall order.1123

Consumption-oriented policies, such as tax breaks for homeowners, do not produce synergies with the growth model and are therefore much more limited when compared to their American counterparts. The larger point is that macroeconomic growth models entrench some policies and economic activities over others, which then goes on to affect the imbalances of capital flows in the global economy.

Any study limited to two countries and one major policy area is subject to scrutiny when it comes to the generalizability of its findings. It is certainly impossible to generalize the long-term, intricate policy processes in both countries, given the very nature of exploring within-case variation that takes into account feedback effects and temporality.

Yet, my theoretical framework does provide a set of portable and testable propositions based on general variables that can be applied to other advanced economies -- growth models as the independent variable and housing finance models as the dependent variable.

The argument of this dissertation might then serve as a starting point to explore how growth models entrench housing finance policies in other countries or policy areas.

This dissertation was completed at a time when most advanced economies experienced growing inequality and housing affordability crises. It is fair to say that public support for homeownership -- tax breaks and mortgage subsidies, in particular -- tend to reinforce these developments. In many countries, most notably the United States, housing

1123 Jacoby 2017.

320 finance policies disproportionately favor those able and willing to climb the property ladder, but not those left behind in the increasingly unaffordable rental markets of metropolitan areas on both sides of the Atlantic. In times of rising student debt and stagnant wages, when ordinary people are often overburdened with paying rent, policymakers in advanced countries might shift resources away from homeownership to those in dire need of affordable housing. However, given the macroeconomic context from which these policy arrangements emerged, and by which they have been sustained, this study also provides answers to why countries might have a hard time switching housing policy paths.

321 Bibliography

Author interviews

Germany:

Author interview, Bundestag member I (CDU). Berlin, June 22, 2015.

Author interview, Bundestag member II (SPD). Berlin, September 9, 2015.

Author interview (phone), Bundestag member III (SPD). May 14, 2015.

Author interview (phone), Bundestag member IV (SPD). September 25, 2015.

Author interview (phone), Bundestag member V (SPD). May 7, 2015.

Author interview (phone), Bundestag member VI (SPD). October 27, 2015.

Author interview (phone), housing ministry official. North-Rhine Westphalia, December 22, 2015.

Author interview (phone), representative of Deutscher Städtetag I, December 11, 2015.

Author interview (phone), representative of Deutscher Städtetag II, December 11, 2015.

Author interview (phone), representative of GdW - Bundesverband deutscher Wohnungs- und Immobilienunternehmen, January 18, 2016.

Author interview (phone), representative of Haus & Grund (H+G), January 14, 2016.

United States:

Author interview, former FHFA official. Washington D.C., July 25, 2014.

Author interview, former Freddie Mac official, Washington, D.C., September 6, 2016.

Author interview, former Treasury official. Washington, D.C., July 9, 2014.

Author interview, former White House official I. Washington, D.C., September 3, 2014.

Author interview (phone), former White House official II. August 8, 2014.

Author interview, former White House official III. Washington, D.C. July 16, 2014.

322

Author interview, NLIHC representative. Washington, D.C. August 5, 2014.

Author interview, Ginnie Mae official. Washington, D.C., March 8, 2016.

Author interview, HUD official. Washington, D.C. August 1, 2014.

Author interview (phone), policy staffer, House majority leader, Eric Cantor (R-VA). September 1, 2014.

Author interview, Treasury official. Washington, D.C., August 1, 2014.

Author interview, former member of the House of Representatives (R). Berlin, August 6, 2015.

European Central Bank, Federal Reserve, Bundesbank:

Author interview, Bundesbank official. Berlin. January 9, 2015.

Author interview (phone), ECB official I. December 18, 2014.

Author interview (phone), ECB official II. January 19, 2015.

Author interview (phone), ECB official III. December 8, 2014.

Author interview, ECB official IV, Frankfurt, March 30, 2015.

Author interview, Fed economist. Washington, D.C., September 10, 2014.

Author interview, Fed official. Washington, D.C., July 10, 2014.

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