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BOOK REVIEW

Curing the leverage disease

The � nancial crisis that began in 2007 was accompanied by the Great Recession which in Europe may never have really ended. Until now, policymakers have acted on the basis that bringing about recovery in the

wider economy meant � xing the troubled banking system and restoring its capacity to lend.

But the � tful pace of recovery (only just taking hold in the US and absent in Europe) has raised questions about the wisdom of this policy, which caused high unemployment and increased inequality.

Published in May, House of Debt turns on its head the conventional wisdom about the crisis and recession, and o� ers a new explanation of why the situation got so bad and how the ‘cure’ may have worsened the disease.

� e authors are two respected US economists who are expert at crunching microeconomic data on American borrowing patterns and uncovering explanations for what they see. � eir starting point is the remarkable statistic for US household debt, which doubled to $14 trillion between 2000 and 2007. Mian and Su� argue that this build up of debt was responsible for the ensuing havoc because of its e� ect on borrowers.

To understand this argument, consider mortgage borrowers versus those who invest in their mortgages via bank deposits. � e borrowers tend to be poorer than the investors, who have spare cash. As Mian and Su� put it, a poor man’s loan is a rich man’s asset.

However, the risk distribution is highly asymmetric because mortgage holders have a senior claim on property while borrowers’ equity claims are junior and get wiped out � rst. When US house prices fell from late 2006 onwards, losses were concentrated among the poorest segment of the population who had leveraged exposure, while the richest segment, the savers, were cushioned.

� is explains why inequality increased during the Great Recession. But Mian and Su� don’t stop there. Using economic analysis that reads like a detective story, they show how the evaporation of poor people’s wealth led to a collapse in spending, e� ectively causing the Great Recession itself. To show causality, they point out that spending initially fell predominantly in the areas of biggest housing wealth declines.

� is collapse in spending among leveraged borrowers was so severe that it ampli� ed the

localised bursting of the housing bubble and made it contagious. � at mechanism caused the Great Recession to spread from areas dominated by the housing bubble, such as southern California, to places like Indiana and Tennessee which produced products that Californians suddenly stopped buying. � e result was chronic unemployment across the US.

So what are the lessons for policymakers? Consider the ‘bank lending view’, according to which shoring up ailing banks and boosting their lending is said to lead to economic recovery. It turns out that the lack of credit from banks was never a constraint on businesses or a reason that workers were laid o� during the recession.

Yet policymakers shied away from allowing borrowers to modify underwater mortgages out of fear that doing so would damage banks and prevent lending. � e most egregious example of this was in Spain, where the law permits banks to chase borrowers for loan arrears even after repossessing their homes. As Mian and Su� point out, it didn’t save Spain from su� ering one of Europe’s deepest recessions.

Instead of propping up banks, policymakers should focus stimulus e� orts directly on underwater borrowers to restore their spending ability. Mian and Su� have no truck with moralists who argue that pro� igate borrowers got what they deserved in the crisis, a stance that is logical but politically naïve.

To prevent credit bubbles happening again, they propose a new contract: a ‘shared responsibility mortgage’ (SRM). � is resembles a standard � xed rate mortgage with a crucial di� erence: if a house price index falls, the principal owed automatically declines, reducing the repayments on the loan.

Mian and Su� claim that the decline in housing wealth would have been $2.5 trillion less than it was if SRMs had been in place when the US housing bubble burst. Of course, one could also argue that the prevention of wholesale fraud in home loans and securitisation before the crisis might have had a similar impact with less e� ort.

Counterfactuals aside, the idea of loss-absorbent debt is a hot topic right now. In a sense, Mian and Su� ’s proposal is a granular-level analogue of fellow economist Anat Admati’s campaign to make bank balance sheets more absorbent by increasing equity capital ratios.

� e elusive recovery (absent in the eurozone) means that Mian and Su� ’s ideas should get a serious hearing among policymakers.

Nicholas Dunbar is a fi nancial journalist and author of The Devil’s Derivatives

Book review by Nicholas Dunbar

House of Debt by Atif Mian and Amir Sufi

43 Winter 2014