Matthew Gindlesperger/Planet Money Flickr group
Building again in Phoenix, Ariz.
Building again in Phoenix, Ariz. Matthew Gindlesperger/Planet Money Flickr group
During this first anniversary month of the economic crisis, Planet Money will feature economists talking about what they've learned from a miserable year. First up: Atif Mian and Amir Sufi, who teach at the Chicago Booth School of Business.
The dramatic collapse of financial markets in the fall of 2008 captivated the world's attention and sent the stock market reeling. But the collapse of financial markets was a symptom of a more troubling underlying condition: U.S. households dramatically increased their leverage, or debt, from 2001 to 2007. Our research suggests that the historic growth in household debt preceding the financial crisis was the primary driver of the onset and deepening of the current recession.
The central lesson we as economists have learned from the crisis is that an unsustainable increase in household debt is one of the most serious threats to the U.S. economy. Going forward, policy-makers, regulators and researchers must recognize the central role of household financial health in causing economic turbulence if we are to avoid repeating this painful episode. This is not the first time excessive household leverage preceded a severe economic downturn, and the effect of household debt on the economy is not unique to the United States.
Our own research emphasizes three lessons from the recent U.S. household leverage crisis:
First, the availability of cheap mortgages increases the demand for housing, which can push up house prices. In turn, as demand increases and house prices go higher, lenders become overconfident. They then begin offering mortgage credit on even cheaper terms, fueling a violent cycle where household valuations become increasingly unrealistic. In such a credit cycle, the growth in house prices reflects cheap debt, not the underlying earnings power of households. For example, from 2002 to 2005, we find that zip codes where house prices increased the most had the largest percentage of subprime borrowers — borrowers who were experiencing a relative decline in income. Treating house-price growth as independent of mortgage-credit availability — which both regulators and researchers did during the housing boom — is naive at best and dangerous at worst.
Second, the growth in house prices has a real impact on the economy. We find that homeowners extract $0.25 to $0.30 in cash from their houses for every $1 of growth in house price. Our analysis suggests that the home-equity withdrawals are primarily used for consumption or home improvement, which temporarily boosts economic growth. But when a credit-induced housing bubble drives economic growth on the upside, the consequences on the downside will be necessarily painful. For example, the current U.S. economic downturn has been most severe in counties that saw the most aggressive borrowing during the housing boom.
Third, political considerations distort the policy response to a financial crisis. For example, pressure from the financial industry — through lobbying and campaign contributions — helps push legislators to bail out struggling financial institutions. The implications for moral hazard are obvious: during booms, institutions have the incentive to take large bets and structure themselves in such a way as to make their failure unpalatable to regulators during busts. Similarly, the electorate demands action during economic downturns which can promote excessive public spending. Indeed, our biggest worry is that we are simply replacing a private debt problem with a bigger public debt problem.
Going forward, there are two additional questions that are important to answer if we are to fully appreciate the effects of household finance on economic cycles.
First, why does lending for real estate increase so dramatically when credit is flowing freely? The expansion of subprime mortgage lending in the U.S. is the most recent example, but similarly dramatic real estate lending cycles preceded severe economic downturns in Japan and the Southeast Asian countries. We suspect that when the value of collateral becomes artificially inflated, creditors have a harder time putting an accurate price on the risk of real estate lending.
Second, why do households borrow so aggressively when they get access to credit? One potential explanation is that, in normal times, households are constrained from achieving their optimal spending patterns by overly restrictive credit markets. As credit becomes more easily available, they borrow to satisfy their previously unfulfilled needs. For example, a smart high school graduate borrows to pay tuition for college, which helps her earn higher wages in the future.
However, the pattern of boom-bust cycles in household leverage suggests that people borrow for reasons other than their long-term economic well-being. For instance, they may have self-control problems. As credit becomes easier to get, these problems entice them to borrow more heavily, which leads to future regret. The dynamic is even more severe if sophisticated creditors structure financial products to capitalize on this lack of self-control.
The answer to these two questions will have profound implications for our understanding of household debt and economic fluctuations. This is not the first time that household leverage has led to a severe economic downturn; without further inquiry, we fear it will not be the last.