Financial journalist and author of the The Devil's Derivatives Nicholas Dunbar reviews House of Debt. The book turn conventional wisdom about the crisis and recession on its head and offers a new explanation of why the situation got so bad and how the 'cure' may have worsened the disease.

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BOOK REVIEW
Curing the
leverage disease
T
he financial 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 fixing the troubled banking
system and restoring its capacity to lend.
But the fitful 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 offers a new explanation of why the
situation got so bad and how the ‘cure’ may have
worsened the disease.
The authors are two respected US economists who
are expert at crunching microeconomic data on
American borrowing patterns and uncovering
explanations for what they see. Their starting point is
the remarkable statistic for US household debt, which
doubled to $14 trillion between 2000 and 2007. Mian
and Sufi argue that this build up of debt was
responsible for the ensuing havoc because of its effect
on borrowers.
To understand this argument, consider mortgage
borrowers versus those who invest in their mortgages
via bank deposits. The borrowers tend to be poorer
than the investors, who have spare cash. As Mian and
Sufi 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 first. 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.
This explains why inequality increased during the
Great Recession. But Mian and Sufi 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, effectively
causing the Great Recession itself. To show causality,
they point out that spending initially fell
predominantly in the areas of biggest housing wealth
declines.
This collapse in spending among leveraged
borrowers was so severe that it amplified the
localised bursting of the housing bubble and made
it contagious. That 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. The 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 off
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. The 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 Sufi point out, it didn’t save
Spain from suffering one of Europe’s deepest
recessions.
Instead of propping up banks, policymakers should
focus stimulus efforts directly on underwater
borrowers to restore their spending ability. Mian and
Sufi have no truck with moralists who argue that
profligate 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). This resembles a standard fixed rate
mortgage with a crucial difference: if a house price
index falls, the principal owed automatically declines,
reducing the repayments on the loan.
Mian and Sufi 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 effort.
Counterfactuals aside, the idea of loss-absorbent
debt is a hot topic right now. In a sense, Mian and
Sufi’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.
The elusive recovery (absent in the eurozone) means
that Mian and Sufi’s ideas should get a serious hearing
among policymakers.
Nicholas Dunbar is a
financial journalist and author
of The Devil’s Derivatives
Book review by Nicholas Dunbar
House of Debt
by Atif Mian and Amir Sufi
43Winter 2014