It is a simple question without a concise answer. One common explanation is problems in the banking system precipitated a collapse in credit. This, it goes, then inhibited the operation of businesses, which were forced to cut investment and lay off workers. In this “banking view”, causality runs from banks to business and then on to households via job losses. Though it has become widespread, it has a problem. A look at the data suggests an alternative explanation that deserves at least as much attention as the banking view.





The "Levered Losses" View

In House of Debt, Atif Mian and Amir Sufi reverse this flow of causality and show that over-leveraged households reined in spending well before pressures in the banking system peaked. Businesses then cut spending due not to a lack of credit, but because of poor demand. Tight financial conditions may have later amplified these forces, but it was not their initial cause.

Fact 1: Collapsing house prices had a huge wealth effect

After earning a negligible real return for a century, US home prices doubled in a decade. From their March 2006 peak, prices in most major cities fell 30% over the next three years, wiping $6.0 trillion of wealth from household balance sheets. Americans, on average, were 20% poorer than they had thought.

Fact 2: Housing losses spread unevenly across households

While the net worth of richer households fell about 10%, the wealth of poorer households was almost entirely wiped out. Poorer households bore a disproportionate share of the $6.0 trillion losses due to more asset exposure to real estate and higher leverage.

The Role of Asset Mix: For every $1 of wealth held in home equity, richer households held $4 of wealth in financial assets. Poorer households, in contrast, matched every dollar of home equity wealth with $0.25 of financial asset wealth. As stocks (flat) and bonds (+30%) outperformed home prices (-20%) between 2007 and 2010, the asset mix of poorer households underperformed and wealth inequality widened.

The Role of Leverage: In 2007, poorer households had a leverage ratio approaching 80%, while richer households maintained a ratio near 5%. So for every 1% decline in asset value, poorer households were to experience a 5% decrease in wealth -- substantially more than the 1.08% drop richer households would realize. It was this leverage multiplier that caused the whopping one in four (15.7 million!) homeowners with negative home equity by the end of 2010.

Fact 3: Poorer, more indebted households cut spending more

The uneven housing losses led to uneven spending cuts. On average, US households cut spending by $0.05-0.07 for every dollar of housing wealth lost. But Mian and Sufi show that for every dollar of wealth lost lower-income and more indebted households cut spending by about three times as much as richer, less indebted households.

This is crucial. It shows that, had the wealth losses been equally distributed, the subsequent impact to consumption and output growth would have been less severe. That the losses were borne disproportionately by poorer, more indebted households with the highest marginal propensity to spend exacerbated the downturn.

Fact 4: Household spending fell before Lehman Brothers

Importantly, measures of household spending declined alongside housing prices, providing clear evidence of consumer retrenchment well before pressures peaked in the banking system in September 2008. After cresting in Q1 2006, residential investment fell 40% by Q3 2008, when Lehman Brothers failed. Spending on home-related discretionary items, such as furniture and appliances, slowed dramatically in 2007. By Q3 2008, consumer spending was a full 2.0 percentage point drag on GDP growth.

This timing implicates household spending as the key driver of the recession. It was not until household consumption growth began to slow that business investment started to fall.

Fact 5: Businesses cut spending due to weak demand, not credit

The recession took another leg down in late 2008 as business investment continued to plummet and unemployment began to climb. The banking view points to the failure of Lehman Brothers and subsequent freeze in credit as their causes. Interestingly, credit conditions were not the primary concern for a large segment of American business. A survey measure of thousands of small businesses – precisely those that would be most dependent on bank lending – showed poor sales, not credit, was their largest problem. There is also evidence that lack of credit was neither a constraint for larger, public companies.





Conclusion: Households Caused the Recession

Problems in the banking system certainly worsened the recession, but the banking view overstates their importance. First, consumers cut spending in response to a large wealth shock that was amplified by leverage, especially at the lower ends of the income and wealth distributions. In response to the weakening demand (not insufficient credit), businesses cut investment and laid off workers, thereby further weakening demand and worsening the recession.

Why does this matter now? Understanding the initial causes of the last recession puts the subsequent recovery in context. It was the precarious financial situation for many Americans that kept economic growth anemic. It was their still-high leverage that made households less likely to borrow -- and banks unwilling to lend despite record-low interest rates. This is what capped growth to a level well below that experienced after the Tech Bubble, even though the two events featured similar wealth shocks. Yes, understanding the initial causes of the last recession underscores the importance of considering the distribution of debt, wealth, and incomes in determining the growth impact of a certain economic shock. In this case, uneven debt levels led to uneven wealth effects, uneven spending cuts, and an uneven recovery.





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