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House of Debt
How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again
- Read in 15 minutes
- Contains 9 key ideas
Synopsis
When we bailed out the banks during the Great Recession, we didn’t actually address the real factors that caused the economic downturn. The actual problem lay with excessive mortgage lending to those who couldn’t afford it, which led to heavy debts and, eventually, huge collapses in consumer spending. To avoid the consequences of this boom-and-bust cycle in the future, the authors propose new ways of restructuring debt and stimulating the economy.
Key idea 1 of 9
Severe recessions are caused by a huge build-up of consumer debt, followed a large drop in household spending.
What causes severe recessions? Some economists and analysts think they’re triggered by natural or political disasters. Others think these economic crises arise when irrational beliefs infect public consciousness.
But this is rarely true. Events like the Great Recession are, in fact, caused by high household debt.
From 2000 to 2007, US household debt essentially doubled in size, reaching $14 trillion. Likewise, the ratio of debt owed to income earned also jumped to an unprecedented level, from 1.4 to 2.1.
Similarly, household debt was also the key factor during the Great Depression. In the 1920s, the ratio of consumer debt to income more than doubled, while urban mortgage debt tripled.
These large debt loads cause severe consumer spending cuts, and intensify the harsh effects of a subsequent recession.
In fact, there’s a clear correlation between the amount of household debt before a recession and the amount of spending cuts observed during the downturn.
This was borne out by multiple studies showing that across Europe and Asia, increases in household debt in the decade leading up to the recession correlated to declines in spending after 2007.
For example, Ireland and Denmark both had greater jumps in household debt than the United States, and also more severe cuts in household spending.
Thus we can predict the severity of a recession by looking at data about consumer debt, and gauging likely cuts in consumer spending.
As we’ll see, these household debt increases are devastating to the economy, because without these elevated levels of debt, banking-crisis recessions are unexceptional. In fact, banking-crisis recessions with low levels of private debt are similar to normal recessions.
Key ideas in this title
- Severe recessions are caused by a huge build-up of consumer debt, followed a large drop in household spending.
- Declines in housing prices disproportionately affect the poorest borrowers.
- During a recession, indebted households cut their spending, affecting jobs across the whole economy.
- Banks fueled the housing bubble by granting mortgages to borrowers who couldn’t afford them.
- Complex financial instruments hid dangerous lending practices and fraudulent activity.
- Bank bailouts aren’t the best solution for debt-driven crises.
- Debt forgiveness will boost a recession-addled economy more effectively than government spending and stimulating inflation.
- A shared risk mortgage structure could prevent the next recession.
- Final summary
