The Great Recession was one of the most significant events in the last twenty years, but the underlying causes behind it are a central tenet of mainstream macroeconomics: the role of debt-fueled economic growth.
After listening to an excellent podcast on how easy credit helped encourage risk-seeking behavior in the lead-up to the Great Recession, I felt compelled to read the guest’s work on the subject, House of Debt. Atif Mian and Amir Sufi, economics professors at Princeton and Chicago respectively, lay out the case through five years of research that household debt was the central cause behind not only the 2007–2009 crisis, but also most historical recessions.
Published in 2014, this type of hypothesis was initially regarded by many economists as a stretch, but their main idea has gained acceptance over time. Mian and Sufi argue that the role of banks insolvency and deceptive financial instruments like collateralized debt obligations (CDOs) and mortgage backed securities (MBS) seem to be specific conditions of only the Great Recession. Many of the business and economics classes I’ve taken in the past tend to popularize the “bank-lending view”, that the Lehman bankruptcy was the main catalyst to a macroeconomic failure. Take, for instance, this short clip from The Big Short (2015).
Set in time just before the Great Recession, Ryan Gosling’s character successfully convinces a party of hedge fund investors that the collapse of the bond markets would inevitably lead to the destruction of the US housing market. In contrast, the co-authors argue that the causation should be reversed: that debt-seeking behavior normalized in society is the key driver to bank failures and the trigger of most recessions.
This book was intellectually stimulating and presented a compelling case for why the Great Recession was a byproduct of a financial system that incentivizes household debt. The authors examine the different economic quintiles of homeowners and illustrate that the bottom 80% of homeowners had much of their net worth attributed to their home equities. The richest 20%, on the other hand, had the majority of their net worth invested in financial assets and a much smaller portion in home equity. The phrase “a poor man’s debt is a rich man’s asset” rings true, generally speaking, because the financial assets the top quintile possessed typically financed poorer people’s debts (like a mortgage). Thus, poorer people were disproportionately hurt by declining house prices since this destroyed much of their net worth, which was tied up in home equity. The way that modern debt contracts are structured, most homeowners either had the choice of continuing to pay a mortgage that was not tied to the real value of the house or salvage whatever money they had left and desert their houses. This unattractive set of choices lead to mass foreclosures and further declines in house prices. In addition, the decline in spending from these impacted groups compounded the catastrophic damage to the economy.
The policy responses to the Great Recession are also closely examined in the book. According to the authors, the approach the Federal Reserve and other central banks took fundamentally focused on saving the banks, as figureheads like Ben Bernanke, former chairman of the Fed, argued that a failure of these institutions presented an existential threat to modern capitalism. This mainstream “bank-lending view” has distorted the mandate of economic policymaking from preventing bank runs to “behaving as if the preservation of bank creditor and shareholder value is the only policy goal”. Even the Fed’s immediate response to COVID-19 primarily focused on stabilizing the financial markets and issuing massive amounts of bonds to institutions while many Americans were suffering from job losses and mass death.
Where does this leave us today? To learn from past mistakes, Sufi and Mian suggest a fundamental rethink of the role of debt in society. They advocate for pragmatic measures, such as sharing risk between borrowers and lenders and tying the value of a mortgage relative to local housing indexes to avoid mass consumer defaults. However, I am skeptical that such changes will be readily accepted by the gatekeepers of society. This would require the rich and powerful to come to terms with the negative externalities of their income streams, and substantial legislative collaboration in Congress to enact impactful changes to the economy.
Individuals still seem to be incentivized by homeownership as well. As of last year, over 30% of homeowners were equity-rich, meaning their property was worth twice as much as the underlying mortgage. And the housing market is currently acting very strangely, with a record-shattering decline in housing inventory as median house prices in some metros are increasing by 15% in a single year. I think it is long overdue to rethink the ethos of the American dream, from one that champions the white picket fence as the ultimate sign as “having made it” to one instead predicated on economic stability, risk-sharing, and sustainable development based on various types of equity, not just household debt.
Buy House of Debt here, or check it out at your local library.
