Since the Great Recession of 2007, economists have been trying to pin down the forces and fluctuations that rattled the economy so severely. Amir Sufi, Bruce Lindsay Professor of Economics and Public Policy at Chicago Booth, believes he has found the likely culprit: household credit supply. His analysis of historical data shows that sudden, large increases in available household credit lead to a run-up in debt, which consistently predict a subsequent decline in GDP growth, at least over the medium run.
“People think of this as a banking crisis, but that is kind of in retrospect,” he said. The shocks that brought the banks to the brink of failure “are being driven by credit supply.”
Sufi presented this new work, which he pursues with Atif Mian and Emil Verner of Princeton University, at a recent Cocktails & Conversation talk hosted by the Becker Friedman Institute. Their findings suggest that the dramatic rise in available household credit preceding the Great Recession helped to drive up housing prices. Household debt grew not only through an increase in subprime mortgages extended to low credit quality borrowers (the most commonly known story of the Great Recession), but also through increased consumer borrowing against rising home values.
This flood of household credit in the form of easy mortgages and cash-out refinancing led to booms in the construction and retail sectors, which pushed GDP higher. But that boom lasted for only about three to five years before GDP fell sharply, to levels below the pre-boom period. The household credit supply spike, and not solely a jump in consumption, is what amplifies the size of the shock, Sufi said.
“It makes the boom bigger than it would otherwise be and exacerbates the downturn when things turn south,” said Sufi.
In the most recent recession, the finding holds across countries; in fact, Sufi said, the nations that experienced the highest run-up in household debt, like Ireland, Spain, and the US, experienced deeper economic downturns.
The jump in household credit was not just a characteristic of most recent crisis; it occurred over time, driving previous recessions. Sufi’s research examined the household debt-to-GDP ratios for 30 countries over roughly the past 50 years. He found a “statistically powerful” relationship between a higher ratio and lower GDP growth, particularly in the medium run.
Sufi observes that many of the lessons from the Great Recession, could have been learned in the 1980s, which looked like a “mini-2007” where the household sector played a significant role. That episode was more muted because the recession was smaller overall and deregulation played a role as well.
Sufi suggested that it’s possible that credit-driven volatility may yield strong GDP growth over the longer run, but Sufi does not examine that in this current work. He added that most economic forecasters tend to “over-predict” a rise in global GDP growth at the end of these booms, suggesting flawed expectations.
“People don’t understand during credit booms that on average they can end badly,” he said.
Sufi emphasized that the debt run-up resulted from a positive credit supply shock—not a sudden demand for more credit. Credit supply shocks occur when lenders decide to offer more loans based on “reasons unrelated to actual underlying performance of companies or the income of households.” Because these spikes occur when interest rates are low, Sufi rules out increased credit demand as a factor. If lenders were reluctant to expand credit supply, interest rates would have risen. So what causes the supply shock? Possible causes include financial sector deregulation, wealth inequality, commodity price shocks, and fraud.
Sufi’s investigation also reveals what he terms a global household debt cycle. During these types of credit-triggered recessions, linkages across global economies can exacerbate the global effects. When consumption and government spending fall in a recession, nations often look to net exports to cushion the blow, but if many nations are going through the recession at the same time, everyone’s exports are affected. This intensifies the global fluctuations. Countries that are caught in this downturn due to household debt problems get hit hardest and see the sharpest declines in growth when their recessions are correlated with global declines.
It has long been thought that economic roller coasters like these have been driven by firms, not households. Downturns were attributed to the challenges firms ran into accessing credit; booms were thought to occur due to firm growth through increased credit availability or through productivity gains from improved technology.
Sufi argues that the firm channel is actually secondary to the household channel.
“That’s the surprising result because in most of the modeling that thinks about
this credit supply side...the emphasis has been mostly focused on firms,” he said. “We are making the case that maybe it is the other way around.”