The Biggest Policy Mistake of the Great Recession

Some people, who had studied economic history, predicted the great recession because of the buildup of inequality, which has led in the past to economic depressions.

I notice this article in the Fiscal Times doesn't mention the role of severe inequality until far down in the article, when many people would have stopped reading.

http://www.thefiscaltimes.com/Columns/2014/06/06/Biggest-Policy-Mistake-Great-Recession

BY DAVID DAYEN, The Fiscal Times
June 6, 2014

The popular conception of the Great Recession explains that it stemmed from a financial shock. Housing prices stopped going up, and then Lehman Brothers fell, triggering paralysis in the credit markets. This spilled onto Main Street, and the effects still linger in terms of elevated unemployment and sluggish economic growth.

But this history of the recession can’t be right, say two economics professors who have studied the data. In their new book House of Debt, Amir Sufi of the University of Chicago and Atif Mian of Princeton point out that consumer purchases dropped sharply well before the September 2008 Lehman bankruptcy, and most deeply in places where home prices fell the most. They found that steeper declines in net worth — many homeowners were completely wiped out by falling home prices — led to far sharper reductions in consumer spending, and bigger job losses. But even those with no debt suffer when fire-sale foreclosures drop home prices, and lower overall demand spreads out across the country.

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By reviewing other economic downturns, Mian and Sufi discover two recurring features: a buildup of household debt before the crash, and an extreme decline in consumer spending afterward, as households cut back, hoarding money to pay off those scaled-up debts. The normal channels of fiscal and monetary policy have difficulty dealing with highly leveraged household balance sheets. House of Debt correlates these features of recessions, and really targets debt as the core problem, arguing that it needs to be restructured during crises and prevented during better times.

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This actually helps debtors and creditors, mainly because it brings back the economy faster and reduces the vicious cycle of foreclosures lowering housing prices further. “When there’s a collapse in the economy, it’s a good idea to write down debt,” Sufi said. - See more at: http://www.thefiscaltimes.com/Columns/2014/06/06/Biggest-Policy-Mistake-Great-Recession#sthash.KmSBVITq.dpuf

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A cultural bias against debt has crept into these debates too, blaming homeowners as “deadbeats” who bought “too much home” and ignored the risks (see the famous Rick Santelli rant). But while a 40 percent drop in home prices spares nobody, responsible or otherwise, this perspective also ignores a simple fact: There are two sides to a debt contract. “We blame the homeowner because they paid the price, but the only way that can happen is if a lender lends to the borrower,” Sufi said. “There is responsibility on both sides of the contract.”

Indeed, Sufi and Mian detail in the book how credit growth, particularly to low-income, high-risk households, fueled the housing bubble. Thanks to securitization, lenders could extend shaky credit and then pass off the risk to investors around the world, disconnecting themselves from any price drops. That’s before you get into how they ignored underwriting standards in a rush to lend, and fraudulently sold mortgage-backed securities without divulging the poor quality of the underlying loans. “Lenders should be held accountable for their actions,” Sufi said.

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Underlying the book, which draws on an impressive amount of zip-code level data, is a hidden story about inequality. When the rich take a greater share of income and wealth, it naturally dampens demand, because they don’t spend those extra dollars at the same rate as those of more modest means would. In that situation, Sufi says, “The only way to sustain demand is if the rich finance the consumption of the poor.” This gets linked through the financial system: Essentially, the rich invest in banks, and the poor borrow from them. So debt levels rise, as does the danger of deeper and more protracted downturns.

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Higher wages and broadly shared prosperity would eliminate some of the demand for debt to finance living standards. A cheap public option for higher education would depress student debt. More attractive savings vehicles could prevent the situation where the total net worth for a large chunk of Americans gets tied up in their homes.

Mian and Sufi add a novel solution: contingent debt contracts that share risk between borrowers and creditors. Tying student debt payments to a labor-market index, and tying mortgage payments to home prices, would automatically reduce principal in leaner times, while compensating the creditor with a share of the upside if prices rose.

This, the authors say, would reduce volatility, constrain bubbles, prevent foreclosure crises and lessen the damage of recessions. “The idea that financial firms should never take losses is indefensible,” they write. “We seek to encourage a financial system more equity-dependent and therefore able to absorb losses.”

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