Every month, The Big Question video series brings together a panel of Chicago Booth faculty for an in-depth discussion. This is an edited excerpt from June’s episode, in which Amir Sufi, Chicago Board of Trade Professor of Finance, Northwestern University’s Matthew J. Notowidigdo, and Mesirow Financial’s Diane Swonk, analyze the housing bust and the more recent recovery. The discussion was hosted by Hal Weitzman, Booth’s executive director for intellectual capital.
Amir Sufi, in your new book House of Debt, you argue that household debt fueled the Great Recession. Are we still suffering from that problem?
Sufi: Research has consistently shown that housing is a main driver of economic activity coming out of a recession. In this recovery, it has not been nearly as strong as after other recessions. So even though housing is now positively contributing to GDP growth, it’s still much weaker than in past recoveries from severe recessions. We have this huge hangover, both in terms of the physical overhang of properties and debt overhang in the household sector. We went through an experience from 2002 to 2007 that was totally unprecedented in terms of the increase in home ownership rates and the increase in leverage in the household sector, and households are still recovering from that. Add to that the growing burden of student debt on younger Americans, the fact that many people have moved back in with their parents, and that household formation is very low.
To what extent does housing, specifically housing debt, drive the unemployment rate?
Sufi: The retail sector tends to be depressed in areas of the United States that had bad housing busts, such as Nevada, California, Florida, and Arizona. That’s driven by workers who used to work in selling goods; and because people are not buying goods any more in those states to the degree they were, you see higher unemployment even today.
Notowidigdo: There are a lot of other things going on in the economy that probably are contributing to this very slow recovery. Housing is definitely an important contributor, but so is rising trade with China, and other structural changes in the economy such as technological change that’s routinizing and automating jobs.
Swonk: You really see the younger, first-time buyers not coming in. First-time buyers accounted for about 28% of existing home sales in the first four months of 2014, down from a 40% norm, in a highly affordable housing market. We also are beginning to see something reminiscent of the Great Depression, of young people no longer just renting because they’re saving for a home, but just renting because that’s where they think they’re going to be.
How should we think about the effect of housing as opposed to other factors, such as secular stagnation?
Sufi: These things are intertwined. Since the 1980s, you’ve seen a fall in real interest rates that’s been pretty dramatic throughout the developed world, to a point where every single economic cycle that we see, we see lower average real interest rates. The housing boom is intimately related to this, because it drove spending from 2002 to 2006. People who didn’t have great income growth were able to spend to get out of that. That was artificial. It wasn’t related to fundamental income productivity growth. When it ended, you saw an even worse downturn than probably you would have seen had that never gone on. So the idea that the economy is struggling to prop up demand and the question of how housing markets interact with demand are very closely related.
Notowidigdo: In the past few recessions we’ve seen an enormous decline in routine jobs, and no sign of those jobs coming back after the recessions end. So we have to look for sources of employment growth in other sectors, such as education, health care, and state and local governments.
If house price growth slows down, is that good because it means people aren’t taking on a lot of debt, or is it bad because underwater homeowners stay trapped?
Sufi: We’ve gotten so used to cheering for higher house-price growth because we think it has these benefits for the economy. But higher house-price growth would price a lot of people out of the market. We don’t see a lot of borrowing against home equity any more, so that channel of consumption growth is no longer there. We’ve seen a reasonably sharp rise in house prices over the last two years, but it doesn’t seem to be translating into really robust construction growth, not enough to bring us back to the steady-state levels that we were at before. We need to rethink the ancillary benefits of house price growth.
Swonk: The problem is you now have many more rentals in neighborhoods that once were almost entirely dominated by ownership. Over the longer haul, what is the collateral damage to having people who don’t put sweat equity or any equity into their homes because they’re renters?
Sufi: It’s still an open question from a research perspective about how big these knock-on effects are when you have high homeownership rates. But if this is a permanent change to a higher renter ratio, the question of how it’s going to affect the economy in the long run is going to be crucial.
Your book makes some pretty radical proposals about how to change lending contracts.
Sufi: Your home equity is much riskier than your lender’s mortgage because you take the first loss. That dynamic not only helps to fuel housing booms, but when house prices crash, it makes it much worse, because usually the people who have the equity cut spending dramatically. Our idea is to promote better risk sharing—mortgage contracts that provide lenders some upside if house prices go up, and, if house prices crash, borrowers would automatically have their principal balances and interest payments reduced. That could help stop big bubbles from forming, and make downturns less painful.
Did the US government tackle the housing collapse correctly?
Sufi: It had a too singular, narrow focus on saving the banking system. You need to provide strong liquidity support, but the view, “Save the banks and we save the economy,” was too narrow. When you start viewing the world like that, it appears to be a zero-sum game: if I help a homeowner, I’m hurting a bank. Our view is that it’s in everybody’s interest to help homeowners because it’s not a zero-sum game. By forgiving and restructuring debt, you could get higher growth, which, ultimately, would be good for the lenders, as well.
Could that have prevented the Great Recession?
Sufi: It would have been much less severe. Probably a recession was inevitable given the excesses in the housing market, but it didn’t need to be so severe.
Notowidigdo: Amir deserves a lot of credit for pointing out the macroeconomic benefits of helping households. Few policymakers were thinking that way during the crisis, and it would have helped a lot. It would not have been sufficient, though, because of these other structural forces in the economy we talked about.
Swonk: There is a limit to what could have been done politically. I agree that they focused on the banks, and banks still aren’t lending. But there is a limit, unfortunately, to what can get done in Washington.
Apart from debt restructuring, what could we do now to help people who are underwater?
Sufi: One obvious thing would be to help underwater homeowners who are solvent on their mortgage payments to refinance into lower interest rates. There’s finally been a lot of success on that front, and we started to see improving durable goods purchases around the same time. I still think there are probably a sizable group of people that, for whatever reason, are not refinancing into the lowest interest rate that they can possibly refinance into. So there may be some room on the policy front for thinking about that. At this point, in terms of things like eminent domain and other policies to write down mortgage debt more aggressively, while in principal I agree we should have done it long ago, it’s not obvious to me there’s a huge bang for the buck, at this point. The people who stayed in their homes have probably adjusted their behavior by now.
Has the moment passed, though? Is rising student debt already building the next crisis?
Swonk: This might be a solution, though, to the next crisis because that change in attitudes among young people about not wanting to buy—that’s because they saw the collapse. If they thought they were more hedged, they might be willing to go back in again. We have to deal with the overhang of student debt. This solution could bring in some of those people who’re struggling on the margins.
Sufi: Think about how student debt works. If you graduated in 2009, through no fault of your own, you were facing an unemployment rate of 20%. When you took on that debt in 2005, you thought for sure, this was going to be good for me. And yet the way debt works is that it doesn’t care that you graduated in this horrible job market. Your interest payment’s the same. Your principle payment’s the same. And renegotiating is almost impossible. It’s crazy to make young Americans bear that risk. The ultimate consequence is young Americans are going to start saying, “Look, it’s not even worth it going to college,” which is a horrible outcome.