“Taken together, both international and U.S. evidence reveals a strong pattern: Economic disasters are almost always preceded by a large increase in household debt. In fact the correlation is so robust that it is as close to an empirical law as it gets in macroeconomics. Further, larger increases in household debt and economic disasters seemed to be linked by a collapse in spending…

…As it turns out (after analyzing the economic data/evidence), we think debt is dangerous. If this is correct, and the large increases in household debt really do generate severe recessions, we must fundamentally rethink the financial system.”, Atif Mian and Amir Sufi, House of Debt, 2014

“I think ”House of Debt” is a really important book to read if you want to understand the true, root-cause of our recent economic and financial crisis. It analyzes the facts and data and comes to the undeniable conclusion that the global economic and financial crisis in developed countries was caused by excessive household debt (mortgages, credit cards, auto loans, student loans, etc.). Some may say, “That’s what we’ve been saying, it’s the bankers fault!” But that’s not what this book is saying. It makes clear that individual households made their own decisions (“and You caused the Great Recession”) to take on excessive debt, encouraged among other factors by well-intended government incentives that encourage household debt. Fed-created monetary inflation encourages us to spend now and borrow, and not save. Fed-engineered low rates encourage us to borrow more. Government student loans are granted to anyone (because you can’t discharge them in bankruptcy) and are now being restructured (to avoid a looming crisis). Federal mortgages and tax incentives on mortgage interest and capital gains avoidance, encourage us to take on mortgage debt. And many of us have been told time and again by our economic experts, that if we all prudently saved rather than spent, the economy will shrink and jobs will be lost in the short run. In other words, Mr. Mian and Mr. Sufi make clear that our American culture of spending beyond our means by utilizing ever more household debt, was the primary cause of our Great Recession (and also The Great Depression and many other major economic crises around the world). Did the banker’s and Wall Street facilitate this? Certainly. That is their microeconomic role. But the macroeconomic data….a doubling of consumer debt in the U.S. from 2000 to 2007 (to a whopping $14 trillion) and the historical link between excessive household debt and severe recessions (and financial crises) should have been sounding alarm bells at the Federal Reserve and with other top macroeconomists and yet it didn’t. As others have said, Mr. Mian and Mr. Sufi prove that everyone played a part in our economic crisis. With that said, my (and others) view is that given the Federal Reserve’s unique responsibility for financial and economic stability, their access to macroeconomic data like household debt formation (and the economics team to crunch these numbers), and their significant role in encouraging more household debt despite this data (e.g. inflation expectations and low rates/easy money), I think they deserve to be held particularly responsible.”, Mike Perry, former Chairman and CEO, IndyMac Bank

Excerpts from “House of Debt, How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again”, “Chapter 1: A Scandal in Bohemia”, by Atif Mian and Amir Sufi:

“Laid-off workers at Monaco, like millions of other Americans who lost their jobs, deserve an evidence-based explanation for why the Great Recession occurred, and what we can do to avoid more of them in the future.”

“In a “Scandal in Bohemia”, Sherlock Holmes famously remarks that “it is a capital mistake to theorize before one has data. Insensibly on begins to twist facts to suit theories, instead of theories to suit facts.” The mystery of economic disasters presents a challenge on par with anything the great detective faced. It is easy for economists to fall prey to theorizing before they have a good understanding of the evidence…Let’s begin by collecting as many facts as possible.”

“When it comes to the Great Recession, one important fact jumps out: the United States witnessed a dramatic rise in household debt between 2000 and 2007….the total amount doubled in these seven years to $14 trillion, and the household debt-to-income ratio skyrocketed from 1.4 to 2.1……Debt rose steadily (for 50 years) to 2000, then there was a sharp change.”

“…economist David Beim showed that the increase prior to the Great Recession is matched by only one other episode in the last century of U.S. history: the initial years of the Great Depression. From 1920 to 1929, there was an explosion in both mortgage debt and installment debt for purchasing automobiles and furniture….outstanding mortgages for urban nonfarm properties tripled from 1920 to 1929. Such a massive increase in mortgage debt even swamps the housing-boom year of 2000-2007.”

“With this increased willingness to lend to consumers, household spending in the 1920s rose faster than income.”

“(1930s economist) Persons, writing in 1930 was unambiguous in his conclusion regarding debt in the 1920s: “The past decade has witnessed a great volume of credit inflation. Our period of prosperity in part was based on nothing more substantial than debt expansion.” And as households loaded up on debt to purchase new products, they saved less.”

“So one fact we observe is that both the Great Recession and Great Depression were preceded by a large run-up in household debt. There is another striking commonality: both started off with a mysteriously large drop in household spending (larger than could be explained by falling incomes and prices).”

“This pattern of large jumps in household debt and drops in spending preceding economic disasters isn’t unique to the Unites States. Evidence demonstrates that this relationship is robust internationally. And looking internationally, we notice something else: the bigger the increase in debt, the harder the fall in spending.”

“…Reuven Glick and Kevin Lansing show(s) that countries with the largest increase in household debt from 1997 to 2007 were exactly the ones that suffered the largest decline in household spending from 2008 to 2009….they note consumption fell most sharply in Ireland and Denmark, two countries that witnessed enormous increases in household debt in the early 2000s. As striking as the increase in household debt was in the United States from 2000 to 2007, the increase was even larger in Ireland, Denmark, Norway, the United Kingdom, Spain, Portugal, and the Netherlands. And dramatic as the decline in household spending was in the United States, it was even larger in five of these six countries (the exception was Portugal).”

“(Glick and Lansing’s) findings confirm that growth in household debt is one of the best predictors of the decline in household spending during the recession. The basic argument put forward in these studies is simple: If you had known how much household debt had increased in a country prior to the Great Recession, you would have been able to predict exactly which countries would have the most severe decline in spending during the Great Recession.”

“But is the relation between household-debt growth and recession severity unique to the Great Recession? Bank of England Governor Mervyn King argued, “In the early 1990s the most server recessions occurred in those countries which had experienced the largest increase in private debt burdens.”…..Despite a focus on a completely different recession, King found exactly the same relation: Countries with the largest increase in household-debt burdens….Sweden and the United Kingdom, in particular….experienced the largest decline in growth during the recession.”

“Another set of economic downturns we can examine are what economists Carmen Reinhart and Kenneth Rogoff call the “big five” postwar banking crises in the developed world: Spain in 1977, Norway in 1987, Finland and Sweden in 1991, and Japan in 1992….These recessions were triggered by asset-price collapses that led to massive losses in the banking sector, and all were especially deep downturns and slow recoveries…..Reinhart and Rogoff show that all five episodes were preceded by large run-ups in real-estate prices and large increases in current-account deficits (the amount borrowed by the country as a whole from foreigners) of the countries.”

“…Mortiz Schularick and Alan Taylor put together an excellent data set that covers all these episodes except Finland. In the remaining four, the banking crises emphasized by Reinhart and Rogoff were all preceded by large run-ups in private-debt burdens….These banking crises were in a sense also private-debt crises…they were all preceded by large run-ups in private debt, just as the Great Recession and the Great Depression in the United States. So banking crises and large-run ups in household debt are closely related….their combination catalyzes financial crises, and the groundbreaking research of Reinhart and Rogoff demonstrates that they are associated with the most severe economic downturns.”

“While banking crises may be acute events that capture people’s attention, we must also recognize the run-ups in household debt that precede them.”

“Which aspect of a financial crisis is more important in determining the severity of a recession: the run-up in private-debt burdens or the banking crisis?”

“Banking-crisis recessions are much more severe than normal recessions. But Jorda, Schularick, and Taylor also find that banking-crisis recession are preceded by a much large increase in private debt than other recessions. In fact, the expansion of debt is five times as large before a banking-crisis recession. Also, banking-crisis recessions with low levels of private debt are similar to normal recessions. So, without elevated levels of debt, banking-crisis recessions are unexceptional.”

“Even if there is no banking crisis, elevated levels of private debt make recessions worse. However, they show that the worst recessions, include both high private debt and a banking crisis.”

“Taken together, both international and U.S. evidence reveals a strong pattern: Economic disasters are almost always preceded by a large increase in household debt. In fact the correlation is so robust that it is as close to an empirical law as it gets in macroeconomics. Further, larger increases in household debt and economic disasters seemed to be linked  by a collapse in spending.”

“So an initial look at the evidence suggests a link between household debt, spending, and severe recessions.”

“…many intelligent and respected economists have looked elsewhere. They argue that household debt is largely a sideshow…not the main attraction when it comes to explaining severe recessions….Those economists who are suspicious about the importance of household debt usually have some alternative in mind.”

“Perhaps the most common is the fundamentals view, according to which sever recessions are caused by some fundamental shock to the economy: a natural disaster, a political coup, or a change in expectations of growth in the future…..But most severe recessions we’ve discussed above were not preceded by some obvious act of nature or political disaster….(or) Severe recessions results when these high expectations (say, from a technology advance) are not realized. People lose faith that technology will advance or that incomes will improve, and therefore they will spend less. In the fundamentals view, debt still increases before recessions. But the correlation is spurious…it is not indicative of a causal relation.”

“A second explanation is the animal spirits view, in which economic fluctuations are driven by irrational and volatile beliefs…..For example, during the housing boom before the Great Recession, people may have irrationally thought that house prices would rise forever. Then fickle human nature led a dramatic revision of beliefs. People became pessimistic and cut back on spending. House prices collapsed, and the economy went into a tailspin because of a self-fulfilling prophecy. People got scared of a downturn, and their fear made a the downturn inevitable. Once again, in this view household debt had little to do with ensuing downturn. In both the fundamentals and animal-spirits mind-sets, there is a strong sense of fatalism: a large drop in economic activity cannot be predicted or avoided. We simply have to accept them as a natural part of the economic process.”

“A third hypothesis often put forward is the banking view, which hold the central problem with the economy is a severely weakened financial sector that has stopped the flow of credit. According to this, the run-up in debt is not a problem; the problem is that we’ve stopped the flow of debt. If we can get banks to start lending to households and businesses again, everything will be all right. If we save the banks, we will save the economy. Everything will go back to normal. The banking view in particular enjoyed an immense amount of support among policy makers during the Great Recession….If we save the banks he (President Bush) argued, it would help “create jobs” and it “will help our economy grow.” There is no such thing as excessive debt…instead, we should encourage banks to lend even more.”

“The only way we can address…and perhaps even prevent…economic catastrophes is by understanding their causes. During the Great Recession, disagreement on causes overshadowed the facts that policy makers desperately needed to clean up the mess.”

“We must distinguish whether there is something more to the link between household debt and severe recessions or if the alternatives above are true. The best way to test this is the scientific method: let’s take a close look at the data and see which theory is valid. That is the purpose of this book.”

“We now have the microeconomic data on an abundance of outcomes, including borrowing, spending, housing prices, and defaults. All of these data are available at the zip-code level for the United States, and some are available even at the individual level. This allows us to examine who had more debt and who cut back on spending…and who lost their jobs.”

“As it turns out, we think debt is dangerous. If this is correct, and large increases in household debt really do generate severe recessions, we must fundamentally rethink the financial system.”

“A financial system that thrives on massive use of debt by households does exactly what we don’t want it to do…it concentrates risk squarely on the debtor. We want the financial system to insure us against shocks like a decline in house prices. But instead, as will show, it concentrates the losses on home owners. The financial system actually works against us, not for us. For homeowners with a mortgage, for example, we will demonstrate how home equity is much riskier than the mortgage debt held by the bank, something many homeowners only realize when house prices collapse.”

“But it’s not all bad news. If we are correct that excessive reliance on debt is in fact our culprit, it is a problem that potentially can be fixed. We don’t need severe recessions and mass unemployment as an inevitable part of the business cycle.”

“We hope that the end result of this book is that it will provide an intellectual framework, strongly supported by evidence, that can help us respond to future recessions…and even prevent them. We understand this is an ambitious goal. But we must pursue it. We strongly believe that recessions are not inevitable….they are not mysterious acts of nature that we must accept. Instead, recessions are a product of a financial system that fosters too much household debt.”

Posted on June 9, 2014, in Postings. Bookmark the permalink. Leave a comment.

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