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New book points to household debt as cause of recession

May 19, 2014

During the Great American Recession of the 21st century, more than 8 million people lost their jobs and more than 4 million homes were lost to foreclosure. In the years immediately preceding the recession, Americans doubled their household debt to $14 trillion. According to the new book "House of Debt" (University of Chicago Press, 2014), these events were directly related.

Authors Amir Sufi of the University of Chicago Booth School of Business and Atif Mian of Princeton University argue with convincing evidence that the dramatic rise in debt followed by a significant drop in household spending were key factors leading to the most recent economic crash as well as the Great Depression some 80 years ago.

Though the banking crisis may have played a smaller role, Sufi and Mian use actual data to argue that current policy is too heavily biased toward protecting banks and creditors, and increasing the flow of credit is counterproductive in a debt-heavy environment.

Sufi explains in this video both the historical and contemporary context of debt and financial crises.

"Excessive household debt leads to foreclosures, causing people to spend less and save more," Sufi explains. "Less spending means less demand for goods followed by declines in production and huge job losses. The only way to break that cycle is directly attacking debt."

Housing debt is only part of the problem, according to Sufi. Even now, elevated levels of student debt continue to hold back the economic recovery. When many students entered college in 2006, they had no idea that when they graduated four years later it would be nearly impossible to find a job, so they borrowed for tuition on the assumption they would earn sufficient income to repay the loan, but that hasn't been the case.

"House of Debt" also offers compelling answers to the question of how we can prevent these crises in the future, including avoiding another bubble-and-bust episode, by moving away from inflexible debt contracts. Similarly, recent college grads should be protected if they face a dismal job market upon completing their degrees by making student loans contingent on measures of the job market at the time the student graduates.

Lender flexibility is key in avoiding future financial meltdowns. Borrowers in bad situations, the authors conclude, require more options, not fewer.

Sufi and Mian offer economic commentary on their blog, "House of Debt." Their recent entries are available here.