Text size

Why do we have booms and busts?

The traditional view blames “shocks” to “productivity” or “technology.” In other words, recessions are what happens when workers and machines somehow become less efficient at turning resources into economic output. Our research instead suggests that changes in credit supply are a crucial driver of economic cycles. Moreover, these changes primarily affect borrowing and spending by households, rather than businesses.

Credit-driven household demand has been an important driver of economic fluctuations in many places over the past half-century. We have found that a large and sudden rise in the ratio of household debt to gross domestic product consistently predicts slower growth. The experience of the United States from 2000 to 2010 wasn’t an anomaly, but instead followed a pattern seen across the world throughout recent history.

The problem starts when the financial system extends credit on increasingly generous terms, even though the outlook for borrowers hasn’t improved. For example, the rapid rise of the private-label mortgage securitization market from 2003 to 2006 in the United States enabled low-credit-score home-buyers to speculate in the housing market.

Expansions in credit supply generate a predictable sequence of events. Fueled by easy lending, household debt increases suddenly and substantially. Since much of this borrowing is used to buy real estate, house prices often rise significantly.

But after a few years, lowered credit standards result in mounting defaults. Lenders respond by tightening credit supply, often quite rapidly. This depresses household spending, which had been inflated during the boom by cheap credit. Increasing defaults eventually trigger a banking crisis, which amplifies the economic downturn. What follows is a large rise in unemployment, that “great menace to our social order.”

This narrative can explain a number of historical episodes. To name a few: the United Kingdom and the U.S. during the 1980s; Thailand in the 1990s; Greece, Ireland, Spain, and the U.S. during the first decade of the 21st century; and Brazil from 2005 to 2016. Prognostication is always dangerous, but it is reasonable to conclude based on current evidence that Australia, Canada, and Turkey are in the middle of this oft-repeated cycle.

The consistency of this sequence is difficult to explain in most models that rely on rational actors. The standard theory is that indebtedness should only rise in anticipation of future growth. It makes sense to boost spending by borrowing if rising incomes will eventually lower debt service costs relative to earnings. Yet the data show that an increase in indebtedness consistently predicts slower future growth and lower incomes.

A decade after the financial crisis, billionaire investor Warren Buffett explains what was behind the 2008 mayhem, what we can do to limit the damage and opportunities missed last time.

These predictable cycles can likely be explained by behavioral biases such as extrapolative expectations—people over-estimate the probability of continued prosperity during good times. We have found that private-sector and government forecasters systematically over-predict growth in gross domestic product in the midst of an economic boom fueled by easy credit. Other researchers have found that a large rise in the private debt-to-GDP ratio of a country systematically predicts a crash in bank-stock prices.

None of this is sufficient to explain the boom-bust sequence. To understand that, we have to understand what drives changes in credit supply. Why does the financial system suddenly decide to provide credit on easier terms? Our preliminary thesis is that, at certain moments in history, there is a rapid inflow of funds into the financial system. That money has to go somewhere, regardless of whether there are any worthwhile investment projects in need of financing. Lenders respond by searching for new borrowers. Households often get the bulk of the additional credit, rather than firms or governments, perhaps because housing is thought to provide better collateral.

One version of this is Ben Bernanke’s global savings glut: East Asian governments hoarded dollar-denominated assets to prevent a repeat of the 1997-98 crises. However, there are other historical episodes that also fit the bill. Economic historians blame the Latin American debt crisis of the early 1980s at least in part on the rise of the price of oil in the 1970s. That created windfall profits for producers and generated huge flows of “petrodollars” from the Middle East into the financial systems of the U.K. and the U.S. Large British and American banks then recycled those dollars into aggressive lending in Latin America. Scholars of the Great Depression and the Great Recession note that both were preceded by sudden increases in income inequality. This mechanically led to an influx of money into the financial system because the highest-earning households save much of their income.

Newsletter Sign-up This Week's Magazine This weekly email offers a full list of stories and other features in this week's magazine. Saturday mornings ET. PREVIEW

Atif Mian is a professor of economics, public policy, and finance at Princeton University, and director of the Julis-Rabinowitz Center for Public Policy and Finance at the Woodrow Wilson School. Amir Sufi is the a professor of economics and public policy at the University of Chicago Booth School of Business. Mian and Sufi are the authors of House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It From Happening Again.

Email: editors@barrons.com