A collective large run-up in household debt leads to severe recessions


Armed with clear and powerful evidence, Atif Mian and Amir Sufi reveal in House of Debt how the Great Recession and Great Depression, as well as the current economic malaise in Europe, were caused by a large run-up in household debt followed by a significantly large drop in household spending.
Though the banking crisis captured the public's attention, Mian and Sufi argue strongly with actual data that current policy is too heavily biased toward protecting banks and creditors. Increasing the flow of credit, they show, is disastrously counterproductive when the fundamental problem is too much debt. As their research shows, excessive household debt leads to foreclosures, causing individuals to spend less and save more. Less spending means less demand for goods, followed by declines in production and huge job losses. How do we end such a cycle? With a direct attack on debt, say Mian and Sufi. More aggressive debt forgiveness after the crash helps, but as they illustrate, we can be rid of painful bubble-and-bust episodes only if the financial system moves away from its reliance on inflexible debt contracts. As an example, they propose new mortgage contracts that are built on the principle of risk-sharing, a concept that would have prevented the housing bubble from emerging in the first place.
 
 
"Now, a second mortgage doesn't sound very nice," he says. "You know, if you already have an aversion to debt, a second mortgage is kind of like, 'Okay, I already have handcuffs on, and now you're going to put, you know, ankle cuffs on me.'"
For most of America's history, debt was something to be avoided. But in the past hundred years, the country's relationship to debt has drastically changed. Companies, even the government, began to urge people to borrow money, linking that borrowing and subsequent spending to a healthy economy. One way they convinced Americans to buy into this idea was through re-branding. In the 1980s, for example, second mortgages became known as "home equity loans."
"There was a systematic effort to actually invent this term home equity," Sufi says. "And the idea was, well, it's your equity in your home. You have every right to borrow against it. It's not a bad thing to borrow against that equity."
 
But in their book, House of Debt: How They (And You) Caused The Great Recession And How We Can Prevent It From Happening Again, Sufi and co-author Atif Mian argue that the buildup of household debt is the single most important driver of severe recessions. This is counter to the traditional argument that the breakdown of financial institutions causes recessions.
 

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