on 22 February 2015
This is the best kind of economics book. It takes a complex topic and tackles it with an impressive clarity without compromising on rigour.
We were asked to believe after the financial crisis that it was the lack of available credit from banks that was deepening the recession and that saving the banks was the only solution. The authors demonstrate that this was at best a partial solution, and also a sub-optimal one.
The central argument feels intuitively right: if you take on too much debt there will come a point when you realise that you have over stretched your finances and you will have to put the brakes on spending. It is these sudden reductions in consumer demand that cause recessions. Before the last recession, there was a collapse in household spending amongst those who found themselves with too much debt and negative equity. This hit poorer households harder because their spending is highly sensitive to changes in wealth (if you think your home might be repossessed, you are likely to start watching the pennies. If your portfolio of tech stocks loses 30, 40, 50% or more of its value, your daily spending habits probably won't change all that much). Therefore, better to give assistance to people in debt than to save banks. People, especially the less well off, will spend their money and help to create economic growth, but banks will not necessarily lend money even if you bail them out.
Irresponsible lending and borrowing caused the recession to be deeper than it needed to be. Because the mortgage market is the main stage for this drama, that is where the authors propose making interventions. Their big idea is the Shared Responsibility Mortgage. The lender would share the burden of a fall in property prices in the event of negative equity by granting a proportionate decrease in the size of the loan, but would share in the increase in value of the property should the market rise. The hope is that this will encourage responsible lending and borrowing.
Our economies are deeply interconnected and we have a collective interest in stability and sustainable growth. The authors' proposals are an explicit recognition of that interdependence and deserve serious attention.
In this very short and extremely readable book two young professors prove with mathematical rigor (and in plain English) that the recent "Great Recession" was caused by the overindebtedness of America's poorest homeowners. It is truly incredible how much economics they pack into this 187 page book and how much of it you can absorb without stretching yourself. Brief summary of the argument:
1. Always quoting relevant research, but never attempting to talk over your head, they start by explaining how the poorest 20% of homeowners on average lost their entire net worth in the crisis, all while the richest 20% came out unscathed. How come? Simple: 1. The top 20% mainly hold financial assets that were protected by the Fed 2. The top 20% are indirectly the guys holding on to the mortgages that the poorest 20% are still paying or alternatively the US government guaranteed by taking over the obligations of Fannie and Freddie. All the recent talk about inequality? Go no further. The authors have it covered by page 40. Next!
2. They then explain that the poorest 20% have a marginal propensity to consume that is a large multiple of that of the richest 20%, an effect that also works in reverse and explains most of the fall in consumption (and thus aggregate demand) in the economy once their home equity had wiped out their lifetime savings. Yes, I'm confusing wealth effects with income effects here, but only for the sake of brevity. The authors do not! In short, the way you lose your house is you lose your income first (for example, divorce cuts it in half or illness in the family keeps you from working), next you miss payments, then you lose the house, which represented all your wealth to cap it all off. Alternatively, it's all set off when your monthly payment rockets up. And that's how the spending stopped! Charts are provided that measure this impact and irrefutably demonstrate that this process was in full swing, with spending on cars, furniture etc. on its knees a good 2 years before anybody knew the word Lehman.
3. It does not end there. Banks sell foreclosed homes into a weak market, forcing prices lower, which drives everybody's house price down, forcing people's home equity down to below zero who have done nothing wrong. These are people who can make their mortgage payment, and indeed mostly carry on doing so. Meantime, however, they are in negative wealth, with the inevitable negative effects on spending, especially among the poor.
4. Lots of lower spending all-round then forces companies to trim production and triggers unemployment. This was to me the most fascinating part of the book. Through little parables about countries linked through trading etc. the authors demonstrate how lower spending in conjunction with three distinct inflexibilities in the labor market (1. It's easier to fire people than to cut pay 2. It's difficult to move labor around, especially when it's wedded to a house it cannot sell 3. Retraining does not happen instantly) inevitably leads to job losses even in parts of the country or indeed the whole planet where no overleveraging and no housing bubble ever occurred.
I'm probably making a total hash of explaining this here, but the authors don't; they totally rock.
5. Next, they explain how debt not only doomed the poor, it actually triggered the whole housing bubble to begin with. Their work here is, for lack of a better word, forensic. They go state-by-state, nay, ZIP code by ZIP code splitting America by (i) high/low leverage (ii) high/low constraints in expanding city limits (iii) high/low credit score and demonstrate that credit expansion led price house appreciation. NOT the other way round. The analysis is fascinating and totally convincing. Leverage came first, house price appreciation followed. Page 83 is where to look. But, needless to say, higher house prices of course subsequently also led to further borrowing by households who famously "used their house as an ATM."
6. My second-favorite part of the book comes next. It explains how even those who believe homes are overpriced are left with no choice other than to get involved if irrational buyers use leverage: It's pages 110 to 113 and I won't spoil it for you here, it's a total gem of an argument. And it's followed by an equally elegant argument (originally by Andrei Shleifer, the man who best refuted the efficient market hypothesis AFAIC) on who would lend into this type of boom: investors who are misled into doing so by investing in securities specifically designed by the banking sector that provide enhanced yield by dint of over-exposing them to "neglected risks." Like -10% HPA, for example.
And so on... I still can't believe how much they've managed to pack in. In summary, the Great Recession was not caused by the Lehman incident. Contrary to the literature about the "breakdown in financial intermediation" theory promoted by our self-styled saviours, it was caused by debt, and in particular by the overindebtedness of the poor.
Next, they train their laser onto the inadequate response of policy makers. In one sentence, the most efficient thing to have done would have been partial debt foregiveness. Period. A chapter is dedicated to how hopeless all other policies (fiscal response, monetary response, you name it) are in comparison. And the blame is laid at the feet of those in charge.
This is so persuasive, that in response Larry Summers took it upon himself to review the book in the FT, lavishing it with praise, but also pointing out 5 (count'em) reasons his hands were tied.
All in the space of 187 pages.
Admittedly, the book could have been even shorter. The authors dedicate a fair few pages to the purpose of debunking the "save the banks, save the economy" theory that informed the policies of the Paulson / Bernanke / Geithner response to the crisis. They needn't have. More people believe in UFOs today than in the importance of Citibank, AIG or Goldman Sachs in our future prosperity, let alone their propensity to hold up the economy through the provision of credit. On the other hand, if you ever bump into somebody who chooses to defend the indefensible, you can always mail him his own personal copy of "House of Debt" and if he is remotely honest or open-minded that should settle the argument.
It's all capped by a rather lengthy proposal regarding Shared-Responsibility Mortgages. I work in the markets and I have no idea who will buy them, especially since the Fed has had to buy the much simpler paper that nobody wanted.
But from where I'm sitting the contribution of the book is elsewhere. It's both the definitive account of what happened to the American economy from 2006 to 2014+ and a powerful punch in the stomach for anyone who advocates the "democratization of debt" as a path to prosperity.
Buy it, read it and lend it to a friend. Spread the word!
on 18 October 2014
I went to listen to these two youngish American professors talk about this book in London and was captured by the originality of their thought and the soundness of their evidence, so I instantly bought a copy. Since the financial crisis, I've read a fair amount about it - books like Sorkin's 'Too Big to Fail', which tells a gripping tale of what happened inside the banks, the insurance companies, the regulators and the Government. The House of Debt is different - it's about the real world in America. It's about the causes of the crash - the creation of an unsustainable bubble of debt that was inevitably bound to burst with a catastrophic impact on the economy. As house prices tumbled the wealth of the less well was destroyed - it was all in housing equity. People were worse off, so they cut back on spending, prices fell further, jobs were lost across the economy, even in areas where house prices did not fall, the economy went into recession and things got worse. The response of the policy makers was plain wrong. Instead of helping the debtors (the borrowers) they helped the creditors (the lenders). The massive transfer of wealth to them did not translate into economic activity and so, even now in 2014, our economies are still sluggish. Transferring wealth by relieving the debt burden on the poor, would have been spent (because of the much greater propensity to consume of the less well off) and much of the subsequent recession could have been avoided.
Stated like that it sounds crushingly obvious, but I hadn't heard that argument articulately so clearly before. And they provide the evidence to back it up. They also provide longer term policy solutions which, although radical, sound as though they might work. Giving loans to people to buy houses, which are secured on those houses, is a one way bet for the lenders with almost all the risk being born by the borrowers. It need not be done like that. If risks were shared (by creating what they call Shared Responsibility Mortgages), the upsides and the downsides would be shared with mutual benefit and, more importantly, social and economic benefit to wider society. There's more in the book, but that's the nub of the argument.
This is a well written, jargon-free book that can be read by anyone with an interest. That's a remarkable achievement for a couple of academic economists.
on 20 October 2014
It is a pretty intense book and I found it heavy going at times, but I did enjoy it. It certainly provided me with a fresh perspective on the Great Financial Crisis.
I found the concept that the modern day banking system is setup so the rich implicitly lend to the poor quite fansinating. Moreover, this effect is amplified with leverage. During a recession the poor suffer considerably because a greater portion of their wealth is tied to debt - the effect of leverage increases the chance of their entire wealth being wiped out. The wealthy on the otherhand have less debt and big deposits which benefit from consirderable protection from the central bank - lender of last resort. Net result - poor indebted are not protected but the wealthy cash-rich are.
The votex effect on foreclosed homes was also interesting. Poor areas where owners often had big mortgages saw a greater incidence of foreclosure. To add to the misery of that local area, foreclosed properties were often sold in firesales as the banks were only interested in getting back the value of the loan. This action lowered the value of homes in the local area and caused even more foreclosures The result was that poor areas were hit hard, while wealthy ones retained most their value. As a home usually makes up the bulk of most people's wealth - the poor suffered considerably.
I guess what struck me is that the authors proved quite convincingly that debt creates inequaility in an economy - especially at extreme levels. Ironically in Europe and North America, households remain highly levered and traditional credit lines have been replaced by less regulated shadow banking.
To be honest I didn't put most arguements in this book to memory, but these points certainly hit home for me.
on 19 August 2014
The idea of this book is remarkably simple - that mortgage debt and in particular the refusal to consider writing some of it off in economic downturns creates and then exacerbates recessions. The research to back this up seems credible. However, the book seems to end midstream - it's half a book really, and has no developed policy recommendations except that the pain of default should be shared between the borrowers and lenders. Seems right in principle, but the knock on consequences aren't really explored - credit might, for example, be more expensive as a result.
on 21 June 2014
I love it when authors explain everything clearly and supplement alternative scenarios with examples. Or when they interpret abstract numbers with analogies. One might find it patronising, I find it extremely useful, even though I knew much of the covered material. Mian and Sufi wrote a wonderful short book backed by years of research and their policy recommendations are not as one-sided as e.g. Piketty's. While they do consider their propositions to be the best amongst those available and their modelling is sometimes rather dubious, I did enjoy the whole thing.
Take it on a vacation, but don't expect it to last long, it is extremely short. The good thing is that it's divided into short chapters (<1 hr each) and then further subdivided, so it's great to read over lunch breaks or just before bed.