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Roots of the 2008 Crisis

by David Beckworth

House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again, by Atif Mian and Amir Sufi (Chicago, 192 pp., $26)

The “Great Recession” of 2007–09 was the most severe economic crisis since the Great Depression of the 1930s. The net worth of households fell $13 trillion, the stock market declined more than 50 percent, and 8 million jobs were lost. The severity of this recession led many to question why it happened and what could be done to prevent it from happening again. Atif Mian and Amir Sufi provide answers to these questions in an accessible and engaging manner, and anyone wanting to better understand the Great Recession should read this book.

Mian and Sufi make the case that it was the large run-up in household debt between 2000 and 2007 that set the stage for the crisis. During this time, household debt doubled, to $14 trillion, rising at a pace far faster than the growth of household income. Most of the debt was in the form of mortgages. When house prices started falling, the debt became unbearable and households were forced to start paying down or defaulting on their debt. This deleveraging by households led to a sharp collapse in consumption, which in turn ushered in the Great Recession. The authors note that rapid debt accumulation and deleveraging also occurred in other countries during the same period — and occurred in the U.S. economy during the Great Depression. According to the authors, then, this boom–bust cycle in debt is the key to understanding the recent crisis.

They are not the first ones to make this observation, but they give an original explanation as to why the run-up and subsequent deleveraging of the debt was so problematic. They provide evidence that it was the distribution of debt that made it so harmful. Specifically, they show that most of the run-up in household debt occurred for individuals in the middle- and lower-income brackets, whose only significant asset was their home. Consequently, their net worth — assets minus debts — was low going into the crisis and highly susceptible to swings in housing prices. Higher-income individuals, by contrast, had less debt and a more diversified portfolio of assets, and therefore were not as dependent on housing to maintain their net worth. When housing prices fell 30 percent, this wiped out the net worth or equity of many middle- and lower-income households. They were now holding mortgages worth more than their homes and could no longer use them as collateral to borrow money. For many, it also meant their retirement investment was gone. As a result, they had to cut back on spending, and this further reinforced the downward spiral of falling home prices and deleveraging.

Mian and Sufi note that this understanding can explain why the 2001 recession was comparatively so mild: It was associated with a stock-market crash that mostly affected rich individuals who had very little debt. Their net worth was not destroyed by the stock-market crash. The 2007–09 recession, on the other hand, was tied to a housing-market crash that affected many middle-income Americans who were carrying a lot of debt. The authors provide evidence that supports this view for the early part of the recession: The U.S. counties whose residents were most indebted and had the largest net-worth declines were also the ones with the greatest pullbacks in spending and increases in unemployment in 2007 and 2008. Middle- and lower-income households saw far larger percentage drops in net worth than richer ones did during this period.

The authors conclude that, given this uneven distribution of household debt and its implications for changes in net worth, the severe effect the sharp drop in home prices had on the economy should not come as a surprise. Given the disparate distribution of assets and debt, the Great Recession was almost inevitable. This conclusion, however, prompts an important question: Why should the decline in debtors’ spending necessarily cause a recession?

Recall that for every debtor there is a creditor. That is, for every debtor who is cutting back on spending to pay down his debt, there is a creditor receiving more funds. The creditors could in principle provide an increase in spending to offset the decrease in debtors’ spending. But in the recent crisis, they did not. Instead, households and non-financial firms that were creditors increased their holdings of safe, liquid assets. This increased the demand for money. This problem was exacerbated by the actions of banks and other financial firms. When a debtor paid down a loan owed to a bank, both loans and deposits fell. Since there were fewer new loans being made during this time, there was a net decline in deposits — and therefore in the money supply. This decline can be seen in broad money measures such as the Divisia M4 measure. These developments — an increase in money demand and a decrease in money supply — imply that an excess money-demand problem was at work during the crisis.

The problem, then, is as much about the excess demand for money by creditors as it is about the deleveraging of debtors. Why did creditors increase their money holdings rather than provide more spending to offset the debtors? This important question does not get the discussion it deserves in the book, but Mian and Sufi do briefly bring up a potential answer: the 0 percent lower bound (ZLB) on nominal interest rates.

The ZLB is a floor beneath which interest rates cannot go. This is because creditors would rather hold money at 0 percent than lend it out at a negative interest rate. This creates a big problem, because market clearing depends on interest rates’ adjusting to reflect changes in the economy. In a depressed economy, firms sitting on cash would start investing their funds in tools, machines, and factories if interest rates fell low enough to make the expected return on such investments exceed the expected return on holding money. Even if the weak economy means the expected return on holding capital is low, falling interest rates at some point would still make it more profitable to invest in capital than to hold money. Similarly, households holding large amounts of money assets would start spending more if the return on holding money fell low enough to make household spending worthwhile. This is a natural market-healing process that occurs all the time. It breaks down when there is an increase in precautionary saving and a decrease in credit demand large enough to push interest rates to 0 percent. If interest rates need to adjust below 0 percent to spur creditors into providing the offsetting spending, this process will be thwarted by the ZLB.

It is the ZLB problem, then, rather than the debt deleveraging, that is the deeper reason for the Great Recession. Mian and Sufi do not acknowledge this point, but their evidence actually is consistent with it. Their findings that the most indebted, low-net-worth areas were hit hard while the less indebted, higher-net-worth areas were relatively unscathed up through the end of 2008 fits well with the fact that the recession was mild until the last quarter of 2008. From this period on, all households were adversely affected — and it was during this subsequent period that the ZLB became a problem.

Moreover, research by Luigia Pistaferri and Itay Sporta Eksten of Stanford University shows that most of the actual decline in consumption from late 2008 to mid 2009 occurred in higher-wealth groups. Consistent with this finding, they also show, using survey data, that the top income groups became the most pessimistic during the crisis. Consequently, the Mian and Sufi account makes sense only for the mild stage of the recession.

Still, the authors note, correctly, that the debt crises are associated with economies’ hitting the ZLB. They argue, therefore, that it is important to avoid debt crisis in the future. They propose that we do this by changing debt contracts so that lenders share in both the risk and the return borrowers face. They specifically call for a risk-sharing mortgage, in which the lender would share in house-price gains but would reduce the loan principal if house prices fell. That way, both lender and borrower share in the upside as well as the downside of the home investment. This effectively would make the mortgage like an equity investment for the lender. If adopted, this proposal would mean that a collapse in housing prices would not destroy the net worth of ordinary Americans. It also would nicely align incentives up front: Lenders would be more careful in choosing to whom they lent, and this would minimize the chances of housing boom–bust cycles’ occurring in the first place. Others have made similar suggestions for student loans. There is much to like in these proposals to make debt more like equity.

Mian and Sufi have produced an interesting book that provides a unique explanation of why debt was so important to the crisis, and their risk-sharing mortgage is an innovative proposal for avoiding future debt crises. Though they undersell the importance of the ZLB in creating the Great Recession, the authors do make a solid case that these crises are not inevitable. Better policies — such as more risk-sharing in debt contracts — arguably could prevent them from happening. Let’s hope policymakers are listening.

– Mr. Beckworth, formerly an economist at the U.S. Department of the Treasury, is an assistant professor of economics at Western Kentucky University and the editor of Boom and Bust Banking: The Causes and Cures of the Great Recession.

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