Part 3: William Emmons, Why Household Balance Sheets Matter for the Economy

May 23, 2013 | St. Louis Mo.

William Emmons, assistant vice president and chief economist of the Center, discusses why household balance sheets matter for the economy, and explores the current state of American families' balance sheets. He delves into how the financial crisis led to a "balance-sheet recession" and describes why this particular recession was so severe. He explains how the financial crisis led to a large loss of household wealth, which in turn, depressed consumer spending and housing activity and caused businesses to reduce employment and investment. In addition, he details the large loan losses suffered by financial institutions, which reduced their ability or willingness to lend.

Presentation (.pdf)


William Emmons: So, as Ray already suggested, we're thinking about these sorts of specific financial behaviors, actions that in some cases led to problems, and hopefully, we can understand better how we can avoid this kind of situation again. All right, so what I want to cover is why household balance sheets matter for the economy and then drill down a little bit further and give you some of that information that we have generated about exactly how different types of families' balance sheets look today.

Okay. So first, why was this recession so severe? Ray talked about just what a wrenching downturn this was. In some respects it's been compared to the worst recession since World War II, in other respects the worst since the Great Depression. Well, this picture shows the overall economy. This is GDP, the best measure of goods and services, of current production and income, adjusted for inflation and at the level of an individual household, so just the average level of GDP per household.

And I think you can see over this 20-some year period this huge decline that from 2007, 8, 9 that dwarfs anything else in this picture. And if I showed you a longer period, you'd say the same thing. This was a very severe downturn. Well, what we are finding, what we think is compelling is that it had a lot to do with the way households' financial situations evolved.

So the red line here is exactly the same as before. This is the overall level of GDP or economic output. The blue line here shows a measure of household financial strength, the net worth of the average household, again adjusted for inflation. So you can see lots of volatility. You can see the big boom in the stock market here in the late 1990s, a big decline, an even bigger boom in the value of people's assets minus their debts in the 2000s, and that was of course a strong stock market together with very, very strong housing markets. But then it ended. It crashed.

And this decline right there you can see lines up perfectly with that severe drop in the economy. So this is at least circumstantial evidence that this severe shock that was being felt by millions and millions of American families was in fact a big contributor to that severe recession. So how does that work? Well, as Ray suggested, a balance-sheet recession is one in which a large loss of household wealth depresses consumer spending, depresses housing activity. And we saw that. We saw a collapse of housing starts. Auto production, auto sales went way, way down.

So it clearly has the hallmark of being this severe shock to the assets, the wealth, of households. Consequently, businesses, being rational, said, "Why should I invest? Why should I hire aggressively? People aren't spending. In fact they're cutting their spending." But by doing that, by reducing investment, by reducing employment growth, that cuts people's incomes. And of course that makes the situation worse. So you can see a negative feedback loop between businesses adjusting to this shock that households have experienced.

And then another reinforcing element was that many of the losses that people were incurring in terms of defaulting on mortgages directly affected financial institutions. Lenders who owned or made those mortgages felt the pain. And in some cases some of the large institutions failed, for example Washington Mutual. Obviously, they were not lending.

And even other institutions that didn't fail took hits to their capital, so they were less able or willing to lend in some circumstances, which, of course, also reduces the ability of consumers to spend. So you can see these vicious feedback—negative feedback loops that really connect between the loss of wealth into this very, very deep downturn.

Yes? Yeah. Turn on your mic if you would.

Male: Oh, I'm sorry. I was just curious, the blue line. Is net worth typically include home value?

William Emmons: Yes. Great question. I will be more specific about the net worth. It's all of your assets minus all of your liabilities equals net worth. We didn't also mention if you do have a point of clarification, feel free to ask it. We're going to have the discussion at the end, if you can—if questions can wait for that, that would be probably better for more broader questions. But that clarification, yes, this does include housing values, and that's a huge component of that decline.