The financial crisis that began in 2007 was accompanied by a Great Recession which in Europe may have never really ended. Until now, policymakers have acted on the basis that to bring about recovery in the wider economy meant fixing the troubled banking system and restoring its capacity to lend.
But the fitful pace of recovery (only just taking hold in the US and absent in Europe) has raised questions about the wisdom of this policy, which entrenched high unemployment levels and increased inequality. Published in May, ‘House of Debt’ is a book that throws the conventional wisdom about the crisis and recession on its head and offers a new explanation of why things got so bad and how the cure may have worsened the disease.
The authors are experts at crunching microeconomic data on American borrowing patterns and uncovering explanations for what they see. Their starting point is the remarkable statistic for US household debt, which doubled to $14 trillion between 2000 and 2007. This build up of debt was responsible for the ensuing havoc because of its effect on borrowers, Mian and Sufi argue.
To understand this argument, consider mortgage borrowers versus those who invest in their mortgages via bank deposits. The borrowers tend to be poorer than the investors, who have spare cash. As Mian and Sufi put it, a poor man’s loan is a rich man’s asset.
However, the risk distribution is highly asymmetric because mortgage holders have a senior claim on property while the borrowers’ equity claim is junior, and gets wiped out first. When US house prices fell from late 2006 onwards, losses were concentrated among the poorest segment of the population who had levered exposure, while the richest segment ““ the savers ““ were cushioned.
That explains why inequality increased during the Great Recession, but Mian and Sufi don’t stop there. Using economic analysis that reads like a detective story, they show how the evaporation of poor peoples’ wealth led to a collapse in spending, effectively causing the Great Recession itself. To show causality, they point out that spending initially fell the most in areas of biggest housing wealth declines.
This collapse in spending among leveraged borrowers was so severe that it amplified the localised bursting of the housing bubble and made it contagious. That mechanism caused the Great Recession to spread from areas dominated by the housing bubble ““ such as southern California ““ to places like Indiana or Tennessee that produced products that Californians suddenly stopped buying. The result was chronic unemployment across the US.
So what are the lessons for policymakers? Mian and Sufi highlight the error of former Fed chairman Ben Bernanke who in 2005 argued that the housing boom was the outcome of strong “fundamentals” in the US economy and hence nothing to worry about. Had Bernanke done the zipcode-level analysis pioneered by Mian and Sufi he might have spotted the negative correlation between mortgage credit growth and income growth, a worrying signal that contradicted the comforting message of the aggregate data.
Such errors during periods of growth are accompanied by equally damaging mistakes during downturns. Consider the ‘bank lending view’, according to which shoring up ailing banks and boosting their lending is said to lead to economic recovery. It turns out that the lack of credit from banks was never a constraint on businesses or a reason that workers were laid off during the recession.
Yet policymakers shied away from allowing borrowers to modify underwater mortgages out of fear that doing so would damage banks and prevent lending. The most egregious example of this was in Spain, where the law permits banks to chase borrowers for loan arrears even after repossessing their homes. As Mian and Sufi point out, that didn’t save Spain from suffering one of Europe’s deepest recessions.
Instead of propping up banks, policymakers should focus stimulus efforts directly on underwater borrowers in order to restore their spending ability. Taking a stance that is logical but politically naïve, Mian and Sufi have no truck with moralists who argue that profligate borrowers got what they deserved in the crisis.
To prevent credit bubbles happening again, they propose a new contract, a ‘shared responsibility mortgage’ (SRM) that resembles a standard fixed rate mortgage with a crucial difference: if a house price index falls, then the principal owed automatically declines, reducing the repayments on the loan.
If SRMs had been in place when the US housing bubble burst, Mian and Sufi claim that the decline in housing wealth would have been $2.5 trillion less than it was. Of course, one could also argue that the prevention of wholesale fraud in home loans and securitisation before the crisis might have had a similar impact with less effort.
Counterfactuals aside, the idea of loss-absorbent debt is a hot topic right now. In a sense, Mian and Sufi’s proposal is a granular-level analogue of fellow economist Anat Admati’s campaign to make bank balance sheets more absorbent by increasing equity capital ratios. Unfortunately, aside from some reforms like bank bail-ins and CoCo bonds, policy still remains over-focused on traditional lending as a means of stimulating economic growth.
Consider the UK for example, where the Bank of England has provided £47 billion of funds to banks as part of the Funding for Lending Scheme (FLS). This was intended to support small to medium-sized enterprises but the vast majority of the £2.4 billion lent out by the banks has gone to large businesses instead. After the scandal of interest rate swap mis-selling, it shouldn’t be a surprise that SMEs are reluctant to take the loans that banks are supposedly pushing at them. What SMEs need is loss-absorbing equity, not debt.
Policy failures like this show why, six months after its publication in the US, Mian and Sufi’s book deserves a wider hearing.
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If mortgages track the house price down, presumably they track it up too. House prices rose 18% in London this year. The poor suffer enough trying to get (small pieces of) equity in the housing market. Paying an extra 18% would be a sair fecht, as the Scots sometimes say. It might have some of the economic consequences the authors are trying to avoid, perhaps.