America’s early banking crises highlighted the importance of liquid financial markets and lenders of last resort. The Great Depression taught fiscal and monetary policy makers to work to counteract economic fluctuations. And what about the Great Recession? That, according to Chicago Booth’s Amir Sufi and Princeton’s Atif R. Mian, offers ongoing lessons about the significance of household debt.
It’s been a decade since the Great Recession, when countries worldwide saw their economies contract. The event led researchers to analyze the available data for a better understanding the conditions that led to it. Sufi and Mian reviewed dozens of studies from the past decade, and earlier, and built a case for what they call the credit-driven household demand channel, which is the idea that expansions in household credit are an important factor driving business cycles in the economy.
Central to their argument is credit supply, namely that lenders may offer borrowers more or cheaper credit even when borrowers’ income or productivity picture haven’t changed. Looser credit supply boosts household demand, as borrowers use this credit to buy things, the researchers write. This collective action boosts the economy. Industries such as construction and retail see job growth as people spend more on homes and goods.
However, when the credit spigot is shut off because of, say, a banking crisis, households sharply cut their spending, even as interest rates fall. In aggregate, the dramatic drop in spending can make the recession that follows much worse. The more households borrow in good times, the greater the economic contraction, the research suggests.
Booms, Sufi and Mian argue, are clearly tied to busts. Some economists have claimed that financial-sector contractions appear somewhat suddenly, but the pair say that such contractions have roots in financial excesses. Rising income inequality or a global savings glut could lead to excess cash in the system—cash that is then lent freely as its owners seek returns. “Credit supply expansions often sow the seeds of their own destruction, and so we must understand the boom to make sense of the bust,” write Sufi and Mian.
The researchers see the boom-bust pattern repeating itself over time, which suggests that their findings may have implications for the future. In the data, a larger ratio of household debt to GDP predicts a higher unemployment rate, both during the Great Recession and at other times examined, such as the 1980s—and in 30 countries over 40 years. Better understanding the causes of busts could help, among others, economic forecasters trying to anticipate slowdowns.