How large debts carried by homeowners have led to low consumer spending and is therefore preventing a quick recovery in the American economy
At US Monetary Policy Forum (USMPF) in 2012, an annual gathering organized by the Initiative on Global Markets at Chicago Booth, academics, market economists, and policy makers discussed how a housing market collapse combined with a high level of household debt limits the effectiveness of monetary policy. For instance, though the Federal Reserve has lowered interest rates to help homeowners reduce their mortgage payments and avoid delinquency, banks remain unwilling to refinance mortgages on homes that are worth less than the amount owed on them. The ineffectiveness of this policy suggests that the recession and the weak recovery that followed are as much about the large debts carried by homeowners as they are about a decline in housing wealth.
Economists increasingly have recognised the role played by household debt in generating deep and prolonged recessions. Homeowners with large debts experience the sharpest reduction in net worth when a large asset such as housing loses value. This shock sets off the economic downturn, as highly indebted households drastically cut back on consumption. In theory, households with healthier balance sheets ought to pick up the slack by taking advantage of lower interest rates as monetary policy eases. But as nominal interest rates cannot fall below zero, interest rates effectively remain higher than they should be, exacerbating the recession.
The distribution of debt – the fact that some households are deep in debt while others are not – can turn a housing shock into a grave recession. If everyone carried moderate levels of debt instead, then more households would be able to refinance and fewer would default on their mortgage. The damage to households’ balance sheets would not be so large as to lead to a severe recession, despite a fall in house prices. Empirical evidence supports these arguments. The November 2011 study, “Household Balance Sheets, Consumption, and the Economic Slump” by Sufi with Atif Mian of the University of California, Berkeley and Kamalesh Rao of MasterCard Advisors shows that the dramatic accumulation of household debt in US – combined with the decline in house prices – is the primary reason for the onset, severity, and length of the subsequent consumption collapse. The study is the first to show convincingly at the county and zip-code levels how a shock to households’ balance sheets contributed to the Great Recession of 2007 to 2009 and the slow economic recovery that followed. A SHAKY FINANCIAL POSITION LEADS TO DEEP CUTS An increase in credit supply, partly because of relaxed lending standards, made it possible for more individuals and families to buy a home than ever before in the years prior to the housing crisis. This credit boom put upward pressure on home prices that, in turn, encouraged many homeowners to borrow against the increasing value of their homes.
At US Monetary Policy Forum (USMPF) in 2012, an annual gathering organized by the Initiative on Global Markets at Chicago Booth, academics, market economists, and policy makers discussed how a housing market collapse combined with a high level of household debt limits the effectiveness of monetary policy. For instance, though the Federal Reserve has lowered interest rates to help homeowners reduce their mortgage payments and avoid delinquency, banks remain unwilling to refinance mortgages on homes that are worth less than the amount owed on them. The ineffectiveness of this policy suggests that the recession and the weak recovery that followed are as much about the large debts carried by homeowners as they are about a decline in housing wealth.
Economists increasingly have recognised the role played by household debt in generating deep and prolonged recessions. Homeowners with large debts experience the sharpest reduction in net worth when a large asset such as housing loses value. This shock sets off the economic downturn, as highly indebted households drastically cut back on consumption. In theory, households with healthier balance sheets ought to pick up the slack by taking advantage of lower interest rates as monetary policy eases. But as nominal interest rates cannot fall below zero, interest rates effectively remain higher than they should be, exacerbating the recession.
The distribution of debt – the fact that some households are deep in debt while others are not – can turn a housing shock into a grave recession. If everyone carried moderate levels of debt instead, then more households would be able to refinance and fewer would default on their mortgage. The damage to households’ balance sheets would not be so large as to lead to a severe recession, despite a fall in house prices. Empirical evidence supports these arguments. The November 2011 study, “Household Balance Sheets, Consumption, and the Economic Slump” by Sufi with Atif Mian of the University of California, Berkeley and Kamalesh Rao of MasterCard Advisors shows that the dramatic accumulation of household debt in US – combined with the decline in house prices – is the primary reason for the onset, severity, and length of the subsequent consumption collapse. The study is the first to show convincingly at the county and zip-code levels how a shock to households’ balance sheets contributed to the Great Recession of 2007 to 2009 and the slow economic recovery that followed. A SHAKY FINANCIAL POSITION LEADS TO DEEP CUTS An increase in credit supply, partly because of relaxed lending standards, made it possible for more individuals and families to buy a home than ever before in the years prior to the housing crisis. This credit boom put upward pressure on home prices that, in turn, encouraged many homeowners to borrow against the increasing value of their homes.
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