Did excessive centralization help inflate the housing bubble?

Paul Krugman's column this morning describes a contrast between two sorts of institutional barriers to regulation, one of which exacerbated the housing bubble and one of which prevented it. Although Krugman does not note the point, the contrast is an object lesson in the benefits of federalism and the costs of centralization. Krugman notes that lax zoning in the Midwest prevented a bubble in housing prices: "permissive zoning and abundant land make it easy to increase the housing supply, a situation that prevented big price increases and therefore prevented a serious bubble." But Krugman also notes that the federal government's -- specifically, the Office of the Comptroller of the Currency's -- preemption of state laws against predatory lending exacerbated the crisis in Georgia, where banks tumbled over each other making risky loans to homeowners using their homes as piggy banks.

In short, federal de-regulation exacerbated the housing bubble, while subnational de-regulation mitigated it. Fans of decentralization will suggest that the relationship between centralization and dysfunction is not coincidental: There is a political economy underlying both stories that suggests caution in seeking centralization of power to avoid externalities. I'll explain in more detail after the jump, but the quick moral of the story is that zoning restrictions and preemption of state banking regulations are both driven by economic self-interest of narrowly focused groups -- homeowners seeking to drive up the value of their homes with restrictive zoning and banks seeking maximum latitude to lend money free from subnational restrictions. Decentralization undercuts the power of the first group, while centralization increases the power of the second group. In both cases, advocates of centralization applauded the centralized control of zoning or banking while ignoring the interest-group perversities that centralization fosters.

First, consider the interests underlying zoning restrictions. It is a familiar point in the economics of housing that zoning restrictions drive up housing prices. Although, as Michael Schill has noted, it is difficult to tease apart the efficient effect of zoning on quality (thereby pumping up demand) and inefficient effect on supply, there is powerfully suggestive evidence (nicely summarized here by Edward Glaeser and Joseph Gyourko) that regulatory barriers to housing increase housing costs without providing much of an improvement in quality. As Bob Ellickson argued back in 1977, homeowners have every incentive to behave like oligopolists when it comes to their down payments, imposing severe restrictions on new housing to boost the value of their biggest investment.

Commutersheds with lots of municipalities can help impede such monopolistic designs: Dozens -- sometimes even hundreds -- of suburban municipalities, jammed cheek by jowl in a single commutershed, prevent any single jurisdiction from controlling the housing supply. The Midwest has an ample supply of such zoning-busting jurisdictions thanks to Thomas Jefferson's system of six-by-six mile townships: Counties in states of the old Northwest Territory are subdivided into thousands of little squares, each with control over zoning --and each willing to welcome a subdivision that their neighbors exclude.

That's how decentralization deflates the housing bubble through competition. But how did centralization pump it back up through preemption? As with zoning, there is a political economy underling the OCC's aggressive preemption of state laws attacking predatory lending. The OCC generates fees when banks obtain a national charter, and banks benefit more from national charters when these charters enable their subsidiaries to be free from state regulation. As my colleague, Rick Pildes, noted on Balkinization, the SCOTUS may have exacerbated the financial crisis by allowing the OCC to bestow the boon of deregulation on banks through preemption of state predatory lending rules. Federal efforts to reverse the OCC's stance on state laws, led by Barney Frank, were bogged down in the mire of congressional inertia celebrated by Madison in Federalist #10.

Some folks ceaselessly defend centralization as a way of preventing subnational actors from imposing external costs on their neighbors. My colleagues, Sam Issacharoff and Catherine Sharkey, for instance, described SCOTUS as purveying this sort of externality-suppressing preemption: In the Court's mind, as described by Issacharoff and Sharkey, states were just burdening a national market with disuniform, externality-imposing, parochial laws. Likewise, zoning reformers ceaselessly call for regional control over zoning to prevent uncoordinated land-use regulation.

What these cheerleaders for preemption forget is that the centralized regime will not be run by impartial experts but by self-interested actors: Removing the constraints of decentralization might solve the externality crisis only by creating a much larger "internality" crisis -- the crisis of a small group of self-seeking insiders (hence, the term "internality") who use their control over the commanding heights of a commutershed or nation to reap the rents from a monopoly on a valuable resource. Of course, the answer is not simply dismantling national power: As nicely argued by Mason, Kulick, and Singer, the costs of subnational protectionism in banking are too high. But one can call for a limited national ban on subnational protectionism without simply stamping out state law across the board.

Fortunately, the seductions of suppressing externalities through centralized reform may have worn thin with its former fans. As Arthur Wilmarth notes, the SCOTUS's decision in Cuomo v. Clearing House Ass'n suggests that the justices are feeling a little abashed at how their aggressive defense of preemption in Watters v. Wachovia Bank might have exacerbated the financial crisis. Likewise, one might note that the housing bubble popped the loudest in states like California and Florida with aggressive state- or regional-wide review of local zoning: Defenders of regional control of zoning should take note and curb their enthusiasm for state-wide control of zoning until they figure out how to insure that state agencies do not unduly suppress the housing supply.

In short, it is not enough to cite an externality as a justification for centralization: One must balance the costs of this externality against any increase in agency costs fostered by the monopolization of land and power that centralization tends to promote.