A previous post on “Causes of the Global Financial Crisis” provided a detailed summary of the first three chapters of “House of Debt” by Mian and Sufi. This post provides a brief summary of Chapters 4 and 5, in which they present a theoretical framework which explains why leveraged debt leads to high unemployment following a shock to asset prices. The main insight is that the problem is caused by interest-based debt contracts which put most of the risks of default on the weaker party (borrowers), and very little on the stronger party (lenders). Equitable risk sharing between lenders and borrowers would provide a solution.
Background: In the Keynesian Revolution and the Monetarist Counter-Revolution, I have explained how high and persistent unemployment after the Great Depression led to Keynesian insight that government interventions are required to create full employment. This is in conflict with the supply side view, which insists the free markets automatically lead to full employment of all productive resources, including labor. The Reagan-Thatcher era created a counter-revolution against Keynesian theory, and re-implanted the rejected supply side view at the heart of the economic theory. Accordingly, policy responses to the Global Financial Crisis were based on the wrong dogmas. Chapters 4 & 5 of HoD describes the Supply Side view, explains why it is wrong, and then provides an alternative theory to explain the GFC: the Levered Losses framework.
Summary of the first five chapters of HoD: We started this book with a robust statistical pattern. The most severe recessions in history were preceded by a sharp rise in household debt and a collapse in asset prices. Both the Great Recession and Great Depression in the United States followed this script. Even looking internationally, we see that the Great Recession was much more severe in countries with elevated household-debt burdens. The relation between elevated household debt, asset-price collapses, and severe contractions is ironclad.
We then present the levered-losses framework to explain this pattern. The key problem is debt. Debt amplifies the decline in asset prices due to foreclosures and by concentrating losses on the indebted, who are almost always households with the lowest net worth in the economy. This is the fundamental feature of debt: it forces the debtor to bear the brunt of the shock. This is especially dangerous because the spending of indebted households is extremely sensitive to shocks to their net worth—when their net worth is decimated, they sharply pull back on spending. The demand shock overwhelms the economy, and the result is economic catastrophe.
Ch4: The Levered-Losses Theory & The Fundamentals View
The Fundamentals View (or the Supply Side View) is built on Say’s Law: Supply creates its own demand. Output of an economy is determined by the supply side capabilities – how much labor, capital, energy, materials are available for production. Whatever is produced will sell (at some suitable price, which will adjust to ensure that demand for production matches what is being supplied).The fundamentals view has a difficult time explaining severe contractions in advanced economies. Severe contractions are almost never associated with an obvious shock to the productive capacity of the economy. For example, no severe calamity such as war or natural disaster initiated the Great Depression, the Great Recession, or the current economic malaise plaguing Europe. There was no loss of technological capacity. We did not forget how to make cars, airplanes, or houses. And while the price of real estate crashed during each of these episodes, we did not witness a destruction of homes or buildings. Severe recessions are triggered even when no obvious destruction of productive capacity occurs.
Leveraged-Losses Framework: This explains why households sharply pull back on spending, and why this cut in spending is so destructive for total output. This theory also provides data-based explanations for:
- Why doesn’t the economy adjust to lower spending ?
- Why does economic output decline?
- Why do people lose their jobs?
The Leveraged-Losses Theory can be stated as follows. Borrowing Households (BH) have low net worth, and borrow money to buy houses, from Lending Households (LH) which have high net worth. A shock to housing prices wipes out net worth of the BH, putting many BH mortgages under water. That is, the mortgage loan is higher than the value of the house. These households have incentives to default on their loan payments. When they do so, it leads to foreclosures. But fire sales lead to further price declines, which affects many more households, creating a vicious circle.
A second reason for economic catastrophe is that the loss of net worth is concentrated on the low net worth households, which have the highest marginal propensity to consume. These borrowers need to rebuild wealth for retirement, and therefore sharply increase savings. Rebuilding wealth to pre-crisis levels takes a long time, which is why contractions are severed and prolonged. Repayment of Loans creates an additional burden. In addition, it is much harder for these households to borrow. For all these reasons, the contraction in consumption is much higher than it would be if asset price losses were evenly distributed.
Blindfolds of Neoclassical Theory: Commitment to a methodology that studies equilibrium and ignores the dynamics of convergence ensures blindness to causes of crises. Crises do not occur in a world which transitions smoothly from equilibrium to equilibrium. Classical Economic theory says that the economy should ADJUST to these asset price shocks without loss of output. HoD discusses three such processes which should compensate for a decline in aggregate demand created by a shock in asset prices:
- Reduced consumption leads to increased savings which would lower interest rates. In turn, this would attract investors to borrow and invest, compensating for reduction in aggregate demand by consumers. This mechanism is frustrated by the 0% lower bound on interest rates, also called the “liquidity trap”.
- Lowered demand should lead to reduction in prices, which would compensate to balance supply of goods with the demand. Firms respond to lower aggregate demand by cutting prices and wages. However, a wage cut crushes indebted households who have debt burdens fixed in nominal terms. If an indebted household faces a wage cut while their mortgage payment remains the same, they are likely to cut spending even further. This leads to a vicious cycle in which indebted households cut spending, which leads firms to reduce wages, which leads to higher debt burdens for households, which leads them to cut back even further. This was famously dubbed the “debt-deflation” cycle by Irving Fisher in the aftermath of the Great Depression.
- Another adjustment mechanism is the shift of available productive capacity to manufacture of goods for export, or for other sectors of the economy. However, such shifts are very costly and time-consuming.
To summarize, a collapse in Housing Prices leads to sharp cutbacks in spending by indebted households. This fall in aggregate demand inflicts losses throughout the economy. Supply-siders assume a costless and quick transition to a new full employment equilibrium. Real world experience shows that such transitions are blocked by a large numbers of frictions which are not considered by neoclassical economics. These frictions are discussed in Chapter 5 of HoD
Ch5: Explaining Unemployment
Between 2006 to 2008, about 6 million jobs were lost. This chapter discusses how the levered losses framework explains this unemployment. The authors consider two kinds of jobs. Non-tradeable jobs cater to the local economy (within a state). An example is car dealerships which make sales to residents. Tradeable jobs cater to the entire economy; for example car manufacturers produce for the nation as a whole. We can use the fact that some counties had huge declines in housing prices, while others did not. The graph showing the differences in job-losses provides strong support for the levered losses framework. The graph shows that non-tradeable jobs were heavily affected in counties with high declines in housing prices, but not so much in those where the housing prices did not decline. At the same time, the tradeable jobs were hard hit throughout the economy, whether or not the housing prices declined. This corresponds closely to the predictions of levered-losses.
WHY does economy fail to adjust to these demand shocks? The main frictions which prevent these adjustments to a new equilibrium are: interest rate does not fall, wages do not decline, and workers do not move. Some other hypothesized frictions turn out not to matter:
One is the idea of Skills Mismatch: But the skills mismatch story is difficult to reconcile with the widespread employment decline in the economy. Workers in every industry and of every education level witnessed a large increase in unemployment.
A second idea is: Unemployment Insurance, which reduces incentives to find jobs. Empirical evidence shows that that this has very small effects on the persistence of unemployment.
Massive social costs are inflicted on workers and society by unemployment. A worker laid off in a recession loses income equal to three times his or her annual pre-layoff earnings over the rest of their lifetime. As they point out, this is a staggering amount. And that is only the monetary loss. The non-pecuniary costs—depression, loss of dignity, divorce—may be harder to quantify, but they are almost certainly even larger.
Persistently high unemployment imposes devastating costs on society. Once the levered-losses shock materializes, the sharp decline in spending and the painful increase in unemployment are almost inevitable. One can avoid this problem by replacing the interest-based loans by Islamic style Musharka loans which share risk equitably.
This completes Part I of HoD. Part II deals with the central question: How does an economy get into this levered-losses trap in the first place? Or, in other words, what generates such a large and eventually unsustainable increase in debt? We begin our investigation into these questions in the next chapter. As we will argue, debt not only amplifies the crash. But it also fuels the bubble that makes the crash inevitable. If we want to permanently address the levered-losses problem, we must understand why debt is so toxic in both the bust and the boom.