A new book, “House of Debt” written by Atif Mian and Amir Sufi, economics professors at Princeton and the University of Chicago respectively, is causing a stir in financial circles by providing a non-consensus view of what caused the great recession and the wider lessons that can be learned following the crash. They challenge the big banking view which is that the accumulation of debt in the first instance is not the problem – the problem is that we’ve stopped the flow of debt. The banking view is: “If we can just get the banks to start lending to households and businesses again, everything will be alright. If we save the banks, we will save the economy.
US household debt doubled between the years 2000-2007, from $7 trillion to $14 trillion and the household debt to income ratio exploded, from 1.4 times annual income to 2.1 times over the same period. The real controversy in House of Debt is the authors’ view of what caused the financial crash of 2008. Their argument is that massive accumulation of household debt, in the hands of those who were least able to pay it back, caused consumer spending to fall.
US house prices fell, on average, by 30% from 2006-2009, but in highly indebted/lower net-worth areas, they declined by as much as 50%-60% due to the harmful effects of foreclosure. Because spending habits in poorer households are up to five times more sensitive to changes in their net worth, the decimation in the price of their only financial asset (their home) meant they sharply cut back. The collapse in overall demand overwhelmed the economy and resulted in a severe economic collapse.
Irish household debt as a percentage of disposable income in 2003 was 1.1 times earnings. By 2008, the ratio ballooned to 2.0 times. This was an even bigger percentage rise than the US. The absolute numbers are more staggering. In 2003, total Irish household debt stood at €75 billion. By Q4 2008, it was €204 billion. It took ten years to triple US mortgage debt prior to the 1930’s Great Depression – we almost tripled ours in half the time!