By Amir Sufi
In the midst of a downturn, good macroeconomic policy requires a solid understanding of the headwinds facing the economy. Unfortunately, policy makers often are more interested in their ideological biases than in facts. As a result, the debate has degenerated into sterile arguments: Those on the right are convinced that government intervention is holding back a robust recovery. The left argues that we need more public spending.
We need to move beyond this hackneyed debate, and doing so requires a reframing of the discussion. The optimal policy response can only be formed if we know why the economy remains weak. And in making the diagnosis, it is crucial to check ideology at the door and instead be guided by the data.
And the data tell a compelling story: The main factor responsible for both the severity of the recession and the subsequent weakness of the economic recovery is the deplorable condition of the U.S. household balance sheet.
Here are the facts:
The household balance sheet is in worse condition than at any other point in history since the Great Depression. From 2001 to 2007, debt for U.S. households increased to $14 trillion from $7 trillion, and the ratio of household debt to gross domestic product was higher in 2007 than at any time since 1929 (and we know how that turned out).
The rise in home values during the boom disguised the over-levered household sector; the subsequent decline in house prices revealed just how bad the debt binge was. Mortgage defaults and foreclosures reached levels that were unprecedented in the past 30 years, as far back as the data go.
Weakness in household balance sheets has hammered the economy. Atif Mian of the University of California, Berkeley, and I have shown that the recession began as early as the end of 2006 in areas of the country with elevated levels of household debt. Further, employment, auto sales, and residential patterns in these highly levered areas remained mired in a severe recessionary environment through the first quarter of 2011. California, Arizona, Nevada, and Florida account for 30 percent of the employment losses during the downturn, even though they accounted for only 20 percent of jobs before the recession.
By contrast, areas of the country that avoided the housing boom and the resulting sharp increases in household debt experienced a very short recession — one that started in the fourth quarter of 2008 and was over by the second quarter of 2009. The recovery in these areas is in full swing.
The good news is that there is a renewed appreciation among academics for the importance of household leverage in understanding downturns. For example, Robert E. Hall of Stanford University argued in his 2011 American Economic Association Presidential Address that elevated household leverage was essential in understanding the current slump.
The basic argument, laid out in a series of studies, is this: When highly indebted households experience a shock to their credit availability that necessitates deleveraging, their decline in consumption and efforts to pay back debt push interest rates down. In a well-functioning flexible-price economy, interest rates would decline to the point where households with healthy balance sheets would be induced to increase their consumption, thereby making up for the reduced purchases of the over-levered households.
But what happens if real interest rates need to fall dramatically -- even go negative -- to boost the economy? The existence of currency prevents the nominal interest rate from going below zero, which effectively limits real interest rates from getting low enough unless the economy experiences substantial inflation. So even though interest rates for financially healthy individuals are historically low, they need to get even lower to induce those consumers to buy a car or remodel their kitchen. In such an environment, the economy will be stuck in an equilibrium where household demand for goods and services is depressed by a real interest rate that isn't sufficiently low.
Many economists use this framework to justify fiscal stimulus, but they may be missing the point. In both the data and the theory, the critical problem is the high level of debt in the household sector. So why doesn’t macroeconomic policy directly combat this problem?
There are historical precedents. After the panic of 1819, when cotton price declines decimated the net worth of farmers, state legislatures intervened with debt moratoria. In 1933, the U.S. Congress abrogated gold clause provisions in corporate debt contracts, dramatically reducing principal obligations by companies. So what is different today?
The differences are both political and practical. First, financial institutions that would most likely lose from any mandatory principal reduction or debt moratoria are more politcally powerful than in the past. In fact, the original mortgage relief legislation passed in the summer of 2008 was formulated in part by the industry, and, not surprisingly, didn't include any mandatory writedowns of principal. It was supposed to help 400,000 homeowners, but there were only 312 applications from October to December 2008. The secretary of Housing and Urban Development called the program a "failure."
Which brings us to the practical: a successful principal writedown program must be targeted at households whose consumption behavior would be materially changed. Unfortunately, such a program is difficult to design. What is more likely to happen is that all underwater homeowners would line up for relief. This would lead to government expenditures far larger than most taxpayers would accept.
Solving the household debt problem won't be easy. But recognition is the first step toward a solution. If policy makers would acknowledge the drag on the economy from excessive household debt, a fix may present itself. I’m certainly open to suggestions. Just don't forget to bring data to support your proposal.
(Amir Sufi is professor of finance at the University of Chicago Booth School of Business. The opinions expressed are his own.)
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