Essay(2500 words)

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Why are nearly 10 million people still out of work today? Was it because in

September 2008, the U.S. government failed to bail out the insolvent investment

bank Lehmann Brothers? Was it because the two U.S. housing finance giants

Fannie Mae and Freddie Mac guaranteed too many mortgages securitized by

It Wasn't Household Debt That Caused the Great Recession

It was how that debt was disproportionately distributed to America’s most economically fragile communities.

HEATHER BOUSHEY

MAY 21, 2014 | BUSINESS

Reuters

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Lehman and other Wall Street firms to low-income borrowers in the run up to the

housing and financial crises? Or does blame rest with the Federal Reserve’s too-

easy-money policies in the wake of the brief dotcom recession in the early 2000s?

Princeton University professor Atif Mian and University of Chicago Booth School of

Business professor Amir Sufi pin the blame squarely on policymakers, but not for

any of these three reasons, all of which are variously popular with policymakers on

different sides of the political divide in Washington. Instead, in their just-released

book, House of Debt, they argue that the Great Recession was the result of a sharp

fall-off in consumption due to the unevenly accumulated household debt in the first

six years of the 21st century. In that period, mortgage-credit grew more than twice

as fast in neighborhoods with low credit scores than in neighborhoods with high

credit scores, a marked departure from the experience of previous decades. When

the housing bubble popped, the economic consequences were sharply magnified by

the way debt was distributed across households and communities.

How did this happen? Why did lenders suddenly shower less-creditworthy

borrowers with trillions of dollars of credit? Mian and Sufi demonstrate this was

enabled by the securitization of home mortgages by investment banks that did not

seek federal guarantees from Fannie and Freddie—so called private-label

securities, made possible by financial deregulation and the glut of cash in world

markets in the wake of the Asian financial crisis of the late 1990s. That private-

label mortgage-backed securities were at the core of the housing meltdown is no

longer in doubt, but what Mian and Sufi bring to the debate is how an unequal

distribution of debt magnified the economic risks—based on their path-breaking

microeconomic research—and a new framework for considering who is to blame

among policymakers for the still reverberating debacle.

Unfortunately, the two authors don’t provide answers for why so many households

took on so much debt, but they do paint a cautionary tale. This is a critically

important contribution to the policy debate now raging over what Congress and the

Obama administration should do in the way of reforms to the housing-finance

industry. And, it’s important to our understanding of whether and how inequality

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affects economic growth and stability. What they demonstrate is that as the U.S.

housing bubble burst and home prices began to fall in late 2006, the unequal

distribution of debt amplified the decline in consumer spending and the

consequence was an economic disaster. Mian and Sufi’s research leads them to

conclude that the crisis was avoidable if only economists had used the right

framework to see what was happening around them at the time.

“Economic disasters are man-made,” they write in the opening pages, “and the

right framework can help us understand how to prevent them.” By the end of the

book, the reader cannot but be left appalled at the sheer enormity of the policy

failures. It’s not just that 7.4 million workers lost their job during the years of the

Great Recession of 2007-2009 but also that the employment crisis continues to

this day. While jobs are no longer being shed at the rate of 20,000 a day, the share

of the U.S. population with a job fell to a low of 58.2 percent in November 2010

from a high of 63.4 percent in December 2006, but has only increased by a fraction

of a percentage since then, hitting just 58.9 percent in April 2014.

Missing the housing bubble was a massive failure on the part of policymakers. As a

result, our new normal is one where there are nearly 10 million fewer people at

work. This book's contribution helps us understand the important mechanisms

through which this occurred.

* * *

I watched the housing and financial crises unfold from my perch as staff for the U.S.

Congressional Joint Economic Committee. By the time Lehman Brothers failed, the

mantra on Capitol Hill had been articulated by former Treasury

Secretary Lawrence Summers, who said that any recovery package had to be

“timely, targeted, and temporary.” But the stimulus that emerged was not

specifically targeted at homeowners in foreclosure. If Mian and Sufi are correct, the

biggest failure was—and continues to be—leaving families struggling with

mortgages they cannot afford because of the fall in home prices.

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The federal government has provided assistance to a paltry 940,000 struggling

homeowners through the Homeowners Assistance Mortgage Program, in a nation

where 5 million homes have been foreclosed on. This lack of help hasn’t just hurt

those homeowners. Also caught in the downdraft are now destroyed

neighborhoods, ruined communities, and thwarted lives of far too many.

Protecting banks does not necessarily make the economy strong.

So, how did we get here? That’s the focus of House of Debt. Mian and Sufi spent the

past decade compiling and analyzing microeconomic data to test theories about

how the macroeconomy works. They conclude that inequality in wealth and debt

combined with greater availability of credit to marginal borrowers are a toxic

macro-economic combination. They call this the “levered losses” view, arguing

that severe recessions occur when “asset prices collapse and households sharply

pull back on spending,” even with “no obvious destruction of productive capacity

occurs."

Their story starts with an accumulation of debt—lots of it. After the Asian financial

crisis in 1997, investors were looking for safe havens to park their money. What

they wanted were AAA-rated bonds. What they got were mortgage-backed

securities that were rated AAA but turned out to be junk. As we all now know—but

most of us didn’t know at the time—Wall Street firms in the early 2000s began

slicing and dicing and then reassembling mortgage debt into more and more exotic

and risky mortgage-backed securities in ways that made them look risk-free.

If debt had been more equally distributed then the decline in consumption would have been less dramatic and the recession would have been less devastating.

But, it wasn’t just that there was more securitization. It was that loans made to

riskier borrowers were more likely to be securitized. This both drove the housing

bubble and made the consequences of it popping all the worse. Mian and Sufi point

out that between 2002 and 2005, the growth in mortgage credit and household

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incomes became negatively correlated, that is, credit expanded in areas where

incomes were declining. This makes no sense: How can you pay back a loan if your

income is falling? They point to academic research by Yuliya Demyanyk and Otto

Van Hemert showing the profound consequences: By 2006, loans had become so

disconnected from prudent business practices that “an unusually large fraction of

subprime mortgages originated in 2006 and 2007 [became] delinquent or in

foreclosure only months later.”

As these foreclosures began to pile up, affected households cut back sharply on

spending. Thus, the catalyst for Great Recession had begun two years before the

dramatic demise of Lehman Brothers. In the second quarter of 2006, the collapse

in consumption started with residential investment, which fell by a 17 percent

annual rate. Non-residential investment didn’t begin to fall until late in 2008, but

by then households had already pared back spending sharply.

This fallout from the collapse of the housing bubble was amplified by the unequal

distribution of net wealth. What Mian and Sufi find is that counties with the largest

decline in total net worth—were the ones that cut back most on spending when

house prices declined. As housing prices began falling in 2006, in counties where

net worth had declined most, consumption fell by almost 20 percent, compared to

only five percent for the entire U.S. economy. In contrast, even through 2008,

counties that avoided the collapse in net worth saw almost no decline in spending.

If debt had been more equally distributed then the decline in consumption would

have been less dramatic and the recession would have been less devastating.

Mian and Sufi are part of a new generation of economists who examine detailed microeconomic data to understand the macroeconomy, giving us a deeper understanding of how inequality affects growth and stability. 

Further, they point out that you cannot have a foreclosure crisis—or its associated

sharp fall-off in demand—without debt and the way that debt grew during the early

2000s exacerbated the potential for a foreclosure crisis. Mian and Sufi find that

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about half of the rise in mortgage debt was among people who lived in their homes,

not new purchasers. People took out home equity lines of credit and used the cash

for home improvements, funds for their kids' college tuition, or other types of

consumption. Once the crisis was in motion, about four-in-10 mortgage defaults

were among home-equity borrowers. Thus, the foreclosure crisis was not due to

people reaching to buy homes, but to borrowing against their primary asset. Had

they not ramped up borrowing, falling home prices would not have affected

consumption or led to record-high foreclosures.

Finally, all this subprime mortgage debt that had been structured into AAA-rated

mortgage-backed securities created financial instruments in which no single

investor has the incentive or legal right to restructure the loan, especially for loans

to low-net-worth borrowers. This led to a situation that dramatically reduced the

capacity of homeowners to get relief in form or informal backruptcy and increased

foreclosures. Foreclosures reduce prices more so than principal reductions and thus

amplified the decline in home prices and the loss in wealth.

* * *

Given the troubling rise in economic inequality over the past four decades, this

research could not be more timely. It’s not just the questions they are asking and

the results they are finding, but also the methods they are using. Mian and Sufi are

part of a new generation of economists who examine detailed microeconomic data

and analysis to understand the macroeconomy, giving us a deeper understanding

of how inequality affects economic growth and stability. They have done this by

using detailed, microeconomic data at the county and zip-code level to examine

debt and consumption patterns.

Mian and Sufi’s research shows that the marginal propensity to consume—an

economics term that describes the amount of spending done after receiving an

additional dollar—out of housing wealth depends not just on the value of the asset

but also the debt burden, settling a near-century-old economic debate between two

of the most prominent economists of the 20th century.

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In The General Theory of Employment, Interests, and Money, University of Cambridge

economist John Maynard Keynes argued in 1936 that the distribution of income

mattered for the stability of the macroeconomy. Increased spending, be it from

consumers, government, greater exports, or investment, will multiply as it works its

way through the economy. If additional income goes into the hands of those with a

high marginal propensity to consume then the multiplier for consumption demand

will be relatively larger. But if additional income goes into the hands of those with a

lower marginal propensity to consume then the multiplier on consumption demand

will be relatively weaker.

Two decades later, University of Chicago economist Milton Friedman

hypothesized that although rich households appear to consume less, they have a

pretty clear sense of what their standard of living will be on average year after year

and they adjust their savings to keep themselves at that level. In good years, when

they get an income bonus, they will save a more while in bad years, they won’t save

as much—or will borrow—to maintain that average standard of living.

Yet neither Keynes nor Friedman had access to the kinds of data now at the

fingertips of Mian and Sufi. Thus the Keynes-Friedman debate was theoretical, not

grounded in empirical reality. Now, Mian and Sufi provide a definite “yes” to the

question of whether we could have prevented the Great Recession—and the

conclusion isn’t pretty. They argue that policymakers could have seriously

mitigated the damage, pointing out that debt forgiveness would have been much

more effective that the policies implemented because it would have targeted

households with the largest marginal propensity to consume. This is a failure on a

massive scale and more economists need to follow the lead of Mian and Sufi and

look deep into the data to understand what we got wrong.

Mian and Sufi’s argument hinges on the conclusion that it was the supply of credit

that drove the bubble and the heightened debt burdens, rather than increased

demand from consumers. They discuss some reasons why people may have wanted

to borrow more, such as the idea that people who expected higher incomes were

borrowing constrained, but come down on the side that people were just acting

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irrationally—given that the massive increase in borrows during the credit boom was

among borrowers with declining incomes, not those with rising incomes. From this,

they conclude that “whatever the reason, however, consumers who were offered

more money by lenders took it.”

Were people behaving irrationally? And, what (really) does that mean? The late

1990s saw the strongest labor market in decades. The typical male earner saw his

annual earnings finally grow, after over a decade-and-a-half of inflation-adjusted

declines; women’s employment rates hit an all-time high of 58 percent; and the

typical family income grew by an average annual rate of just under 2 percent. The

middle was (finally) back, so it may have been the case that people were optimistic

that the recession of 2001 would not just be short and shallow, but that the

recovery would look like the late 1990s.

But looking closely at the data reveals another pattern. One thing that did not

happen during the recession of the early 2000s was a rise in government

borrowing. The cash seeking a safe haven from the Asian financial crisis had to go

somewhere, but the federal government wasn’t in the mood to borrow. So those

dollars flowed willingly into the mortgage-backed securities being peddled as AAA-

rated bonds. And the greater the demand, the more Wall Street packaged up their

dodgy securities containing more and more subprime loans extended to those least

able to afford credit.

The last few decades of the 2oth century also saw a number of marked changes for

families. Women increased their labor supply steadily from the 1960s through the

high employment years of the early 1990s. By the late 1990s, however, that long-

term rise in employment rates had stalled. The United States went from being an

economy that had one of the largest shares of women in the labor force to number

18 among 35 developed-economy member nations of the Organisation for

Economic Co-operation and Development.

A variety of reasons have been presented for the sudden end in the growth of

women’s employment beginning in the first decade of the 21st century and

continuing today. The mainstream media play up the idea that women are “opting

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out” of careers in favor of motherhood, a story line developed in large part by

journalists who either live in more wealthy neighborhoods and thus see this

happening or write for publications that cater mostly to these wealthy

neighborhoods. Yet empirical research finds that women, like men, found it harder

to find and keep jobs due to the lackluster economic recovery after the recession of

2001. As families sought to cope with the slow-job growth economy in the 2000s

and a labor market that still does not provide the kinds of supports and protections

working parents need, many turned to increasingly-readily-available credit as a way

to cope.

Now, of course, such easy credit is no longer available. Neither is a robust jobs

market. It may be true that it doesn’t matter why people took on more debt prior to

the Great Recession, as Mian and Sufi contend, but today the lessons learned then

are critically important. The story that emerged in the early days of the Great

Recession was that too many people borrowed too much to afford fancy houses.

That’s not what Mian and Sufi’s data show. They show that the boom in debt

occurred among borrowers that couldn’t qualify for a government-backed

mortgage. That the private sector sought them out in the tens of millions to offer

loans they were demonstrably unable to repay—without worry because these

lenders very quickly diced up those loans and sold them to supposedly savvy

institutional investors—created the housing bubble that exploded into the twin

crises that led to the Great Recession.

This activity produced a bubble—one that anyone could see and one that

policymakers blithely passed off as either non-existent or unimportant—to the

detriment of our entire economy. Subsequent reforms to our financial system give

policymakers more tools to police housing finance, yet the continuing over-reliance

on debt and a lack of good jobs leaves families at risk and exposes our economy to

the whipsaw of another debt-fueled credit bubble. Mian and Sufi deserve credit of

another kind for detailing how ensnared the American Dream is in this tangled web

of debt finance—and how exposed the vast majority of us are to the broader

economic consequences.

ABOUT THE AUTHOR

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HEATHER BOUSHEY is the executive director and chief economist at the Washington Center for Equitable Growth.