become insolvent. thus, household leverage and financial institution leverage render the financial sector more sensitive to downward movements in the price of land. this kind of sensitivity decreases the stability of the financial system and so increases the potential for the kind of crisis we endured in 2007 - 09. on to my final point : the u. s. tax system encourages household leverage and bank leverage, even though both are potentially destabilizing. let ’ s start with household leverage. think about a family that wants to buy a $ 300, 000 house. it has sufficient financial assets in stocks and bonds to cover half of the cost. will it use these assets to fund half of the house price and take out a mortgage of $ 150, 000? or will it take a more levered position : make a $ 60, 000 down payment, and borrow the remaining $ 240, 000? it ’ s not possible to answer this question with certainty for any given household. but we know that the tax system provides an extra incentive for any given household to take out the larger loan. under the current tax code, the household can deduct from its gross income any interest payments it makes on the extra $ 90, 000 of mortgage debt. this means that the household ’ s after - tax interest rate on its mortgage is lower than it would otherwise be, making mortgage financing more attractive. it is in this sense that the mortgage interest tax deduction undercuts financial stability. bis central bankers ’ speeches in making this argument, i should note that only about one - third of u. s. tax returns itemize deductions and are therefore affected by the tax code ’ s leverage inducement. however, over 60 percent of those households that make over $ 50, 000 do itemize, as do over threequarters of those households that make over $ 75, 000. 5 and – contrary to some misconceptions – the mortgages of these relatively upper - income households are certainly relevant as we think about the impact of the fall in land prices. according to a recent online survey, just over 20 percent of mortgage - holding adults with incomes over $ 50, 000 – and a similar fraction of those with incomes over $ 75, 000 – believe that they are “ underwater ” on those mortgages. 6 this fraction is pretty much the same as the percentage for all households. 7 next, i turn to financial institution leverage. consider a financial institution that needs to raise an extra million dollars.

is with this in mind that i ’ d like to offer the following contributions. of course, many fed leaders have made these kinds of suggestions in the past, and i ’ m sure that they will do so in the future. in minneapolis, my predecessor, gary stern, and my current head of supervision, ron feldman, did their part by writing a book in 2004 called too big to fail. the book identified a host of incentives within the u. s. financial system that encouraged large banks to take on risks that could prove destabilizing. their book has proven to be distressingly prescient. i will follow in stern and feldman ’ s footsteps by focusing on ways in which our current tax system provides incentives for financial institutions to make destabilizing choices. my focus today is on the use of debt as a form of financing – that is to say – on leverage. i will be making three points. • first, the sharp and largely unanticipated fall in u. s. residential land prices after 2006 was the main cause of the financial crisis of 2007 - 09. for example, section 1074 of the act mandates that the secretary of the treasury submit recommendations to congress about possible changes to government - sponsored housing finance. earlier this year, the secretary fulfilled that mandate. bis central bankers ’ speeches • second, household and financial institution leverage exacerbate the sensitivity of the financial system to declines in land prices and so reduce financial stability. • third, the u. s. tax system promotes leverage on the part of households and financial institutions. my conclusion is that congress should modify the u. s. tax system to reduce the incentives for destabilizing activities by banks and households. as i have already indicated, my arguments will hinge throughout on what economists call incentive effects. one of my big surprises since taking this job is that there is a lot more scepticism among policymakers about the relevance of incentive effects than i would have thought. basically, my point today about tax incentives is that if the tax system reduces the cost of one activity versus another, then people will do more of the first. i can restate this idea even more prosaically by saying that if apples fall in price relative to bananas, people will buy more apples, and fewer bananas, than previously. this proposition about choices is entirely obvious if one is willing to assume – as i generally do – that people behave in a purposive, goal -