6. Why Damage to Balance Sheets Matters for the Economy
Prior to the Great Recession, many respected economists were not worried about the management of household balance sheets and the role balance sheets played in macroeconomic performance. This may have been due to the lack of recent historical evidence suggesting that household balance-sheet failures, such as high concentrations in housing or high levels of debt, actually harmed the economy. At the same time, many economists believed that consumer credit markets were reasonably competitive and efficient so that most households' balance sheets were in pretty good shape. In short, policymakers thought that any household balance-sheet problems would largely work themselves out on their own without harming the economy. If some families reduced their spending while they struggled with weak balance sheets, others likely would take up the slack, contributing to reasonably steady overall growth.
It has come as somewhat of a surprise, therefore, that many economists now are calling the Great Recession of 2007-09 a "balance-sheet recession" and that balance-sheet failures of the type described above are seen as important contributors to the downturn and weak recovery. Two key aspects of the current economic cycle explain this description: (1) wealth effects and (2) defaults and deleveraging.
Wealth effects. Economists long have sought to estimate how much a one-time, unexpected change in the value of households' assets might affect their spending, both in the short term and in the long term—what are called "wealth effects." Economists Karl Case, John Quigley and Robert Shiller found, first, that housing-wealth effects are much larger than financial-wealth effects (stocks, bonds, mutual funds). They estimated that, in recent years, an unexpected, one-time increase of 1 percent in housing wealth led to an increase of 0.08 to 0.12 percent in consumer spending each year afterward.3 In contrast, the same increase in financial wealth was followed by a less than 0.03 percent permanent increase in consumer spending.
Second, they found that consumer spending reacts much more strongly to declines than increases in household wealth. In particular, an unexpected decline of 1 percent in house prices results in about a 0.10 percent permanent decline in consumer spending, while a 1 percent increase in house prices results in only about a 0.03 percent increase in consumer spending.4 Applying these estimates to the actual declines in housing wealth experienced between 2005 and 2009—about 35 percent after inflation adjustment—the authors estimate that consumer spending ended up on a path about 3.5 percent lower than otherwise would have been expected, or roughly $350 billion less than it would have been in 2010.
Based in part on studies like this, some macroeconomists analyzing the Great Recession and subsequent weak recovery believe that negative household wealth effects played an important role.5 They describe the huge declines in asset values and net worth as one of the shocks that threw the economy into recession. Skeptics might argue that the asset-price declines themselves merely reflect anticipated deterioration elsewhere in the economy and, therefore, are not themselves fundamental causes of the downturn. These questions merit further study.
Defaults and deleveraging. There are two distinct but related ways in which the liability side of household balance sheets may have harmed the economy in recent years—namely, through defaults and deleveraging.
Defaults that discharge debt in excess of acquired collateral value result in a loss to the lenders; it is the concentration of losses at highly leveraged financial institutions that appears to give loan defaults their macroeconomic significance. An early, and remarkably accurate, analysis of likely mortgage defaults and their effects on financial institutions, mortgage lending and the economy as a whole by economist Jan Hatzius predicted a huge reduction of 2.6 percentage points in real GDP growth in both 2008 and 2009 from a baseline of about 2.5 percent annual growth. Thus, Hatzius predicted roughly zero growth for the two years. As it turned out, real GDP fell 0.3 and 3.1 percent in those years, somewhat worse than he predicted.
Another body of research suggesting that large-scale defaults can have significant harmful effects on economic growth includes the work of Carmen Reinhart and Kenneth Rogoff, well-known for their book, This Time Is Different. They studied both banking crises and government debt defaults in many countries over a long time span and concluded that losses on loans or bonds can amplify economic weaknesses when the losses damage financial intermediaries, impairing the economy's credit-creation mechanisms.
There is a substantial amount of empirical evidence documenting the contours and extent of household "deleveraging"—households paying down their debts and rebuilding their savings—in the wake of the crisis. The International Monetary Fund combined an examination of current levels of household debt in 36 countries with an analysis of previous episodes of excessive household debt. The IMF confirmed that household debt can become so large and burdensome that it hampers economic growth; the organization also concluded that policy responses that involve debt restructuring can alleviate some of the burdens on the economy. In earlier work, economists at the McKinsey management consulting firm stressed the need for countries to avoid the buildup of excessive household debt in the first place.6
Economists Atif Mian, Amir Sufi and their co-authors wrote a series of papers documenting the cross-sectional diversity of the housing and credit boom and bust at the county level. They showed that large precrisis increases in debt-to-income ratios were strong predictors of early and sharp corrections in house prices. Soon thereafter, those counties with the sharpest declines in house prices also experienced surges in unemployment and mortgage defaults, while auto sales and building permits plunged. Mian and Sufi also estimated that roughly two out of every three (4 million out of 6.2 million) jobs lost between March 2007 and March 2009 were indirectly attributable to weak household balance sheets.
Further, economists Karen Dynan and Wendy Edelberg found that individual households that had high leverage before the crash subsequently decreased their spending more than low-leverage households. A significant contribution of Dynan and Edelberg's work was to disentangle the two sides of households' balance sheets in harming the broader economy.7 They document an independent debt-overhang effect: Households with greater leverage decreased spending more, even when holding constant the change in net worth across different households.
3. See Table 7 in Case, Quigley and Shiller. [back to text]
4. See Table 8 in Case, Quigley and Shiller. [back to text]
5. For example, Federal Reserve Bank of St. Louis President James Bullard observed, "A better interpretation of the behavior of U.S. real GDP over the last five years may be that the economy was disrupted by a permanent, one-time shock to wealth." See Bullard. Federal Reserve Gov. Sarah Bloom Raskin highlighted the importance of wealth inequality for understanding the recession. See Raskin. [back to text]
6. See Croxson et al. [back to text]
7. The issue is that Mian and Sufi cannot rule out the possibility that the boom and bust together represented a huge positive wealth effect followed by an equally large negative wealth effect; in other words, they cannot verify an independent role for the liability side of the balance sheet in propagating the economic shock because they do not observe individual households' balance sheets. [back to text]