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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