Household debt was the primary cause of the 2008 financial crisis, a Chicago Booth economist finds.
Jon Stewart’s no economist, but even an expert could appreciate the comedian’s assessment of the policy response to the 2008 financial crisis. Amir Sufi, Chicago Board of Trade Professor of Finance at Chicago Booth, found himself nodding along as he watched the The Daily Show host address the subject.
Stewart wondered aloud why Congress passed the Troubled Asset Relief Program—the “bailout”—to assist banks but left struggling homeowners to suffer under unmanageable debt. He suggested it should have been the other way around.
“I think that simplistic logic is more or less correct,” says Sufi, whose research led him to the same conclusion as Stewart in House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again (University of Chicago Press, 2014), written with Princeton University economist Atif Mian. The authors argue that spiraling household debt was the root cause of the Great Recession—and should have been the focus of recovery efforts.
Instead, a perception persists among the public and many influential economists that the September 2008 collapse of Lehman Brothers, which the government allowed to fail, was the triggering event of the crisis. After the shock of Lehman’s fall, policy makers focused on rescuing troubled banks to restore confidence in the financial system. Because indebted households received no help, House of Debt argues, consumers were left with much less money to spend, making the recession worse.
As early as 2005, Sufi says, he was struck by what he considered a troublesome trend: Americans were borrowing “aggressively” against their homes to finance spending, creating a fragile economic bubble. As he examined the legitimacy of his hunch, housing values collapsed, and spending dropped accordingly.
The worst damage occurred in places where homeowners had leveraged themselves the most. Worldwide, Sufi and Mian write, “the Great Recession was much more severe in countries with elevated household-debt burdens.” Hence, they continue, “the relation between elevated household debt, asset-price collapses, and severe contractions is ironclad.”
They found that this relationship held true not only in precipitating what became known as the Great Recession but also in many other economic contractions before it, including the Great Depression. “The data are so overwhelmingly consistent and supportive of the idea that household debt levels were what drove decline in economic activity,” Sufi says. Small businesses, for example, reported that a drop in consumer spending was a much bigger problem in 2008 and 2009 than a lack of available credit from compromised banks.
Because of that, he and Mian assert, the policies enacted in the aftermath should have targeted personal debt to stimulate spending. “There’s no way a banking crisis can account for how long this recession was and how severe it was,” Sufi says.
His hope is that the ideas take root enough to prevent the next such bubble before it drags down the economy. For example, he’s currently studying what he calls the “subprime auto boom.” It’s “remarkably similar” to the subprime housing boom that predated the Great Recession, although he adds, “it can’t take down the whole economy” like the housing crisis threatened to do.
If and when such a moment arrives again, however, Sufi believes the growing acceptance of the policy prescriptions in House of Debt could provide a dose of preventive medicine. “A lot of economists and a lot of journalists,” he says, “we’ve swayed them.”
Christina Romer, the chair of President Obama’s Council of Economic Advisers during the response to the crisis, was among those persuaded. She told the New York Times after House of Debt’s publication, “I now think that fiscal stimulus would have been more effective had we also had a more effective housing plan”—although she argued that Sufi and Mian understate the importance of the government’s actions in limiting the scope of the crisis.
Other readers also found some holes in the book’s conclusions. The Economist, for example, noted that “falling house prices and net worth help explain why employment started sinking in early 2008, but not why it went into free fall after the failure of Lehman Brothers.” Still, the article went on, the authors’ “broader point about the danger of debt is correct.”
To mitigate that danger, Sufi and Mian call for a new type of housing debt contract that spreads the risk between the borrower and the lender. Called “shared-responsibility mortgages,” the contracts would include provisions that reduce the principal owed if property values fall, while granting loan originators a percentage of any increase.
In a Financial Times review, former Treasury secretary Lawrence Summers claimed that House of Debt elides the political obstacles to implementing many of their ideas, but added that his objection “detracts only slightly from Mian and Sufi’s accomplishment. All future work on financial crises will have to reckon with the household balance sheet effects they stress.”