Understanding the sources of deep recessions is the holy grail of macroeconomics. The
most recent recession has produced a sharp increase in unemployment and a large decline in
GDP (Figure I, top two panels). What factors explain the current economic downturn? This paper
focuses on the role of household leverage. We show that household leverage measured as of
2006 is an early and powerful statistical predictor of cross-sectional county-level variation in
household default, house price, unemployment, residential investment, and durable consumption
from 2007 to 2009. Any realistic macroeconomic theory of the 2007 recession must be consistent
with the time-series and cross-sectional patterns documented in this paper.
The aggregate U.S. evidence highlights the potential importance of household leverage.
The bottom panel of Figure 1 shows the unprecedented increase in the U.S. household debt to
income ratio during the years prior to the recession. In 2007, the household debt to GDP ratio
reached its highest level since the onset of the Great Depression. The initial indicators of
economic difficulty, namely a rise in household defaults and a decline in house prices, were also
related to household leverage. These trends began as early as the second quarter of 2006, a full
five quarters before the initial increase in the unemployment rate. The components of GDP that
initially declined in 2007 and early 2008 were fixed residential investment and durable
consumption—two components that most heavily rely on the willingness of households to obtain
additional debt financing.
...
Overall, our findings suggest that household balance sheets are a crucial component of
explaining macroeconomic fluctuations. The idea that household debt instigates and exacerbates
economic downturns goes back to Fisher (1933), and is reiterated in subsequent research by
Mishkin (1978), King (1994), Leamer (2007, 2009), and Glick and Lansing (2009, 2010)).
Leamer (2007, 2009) points out that eight of the past ten recessions were preceded by substantial
problems in housing and consumer durables. Our paper provides the first micro-level cross-
sectional evidence based on the 2007 to 2009 recession of the link between household balance
sheets and an economic downturn.
Our empirical findings should also serve as a useful metric for guiding theoretical work
on understanding business cycle fluctuations. Standard DSGE models of business cycles often
ignore the role of financial markets (see Tovar 2008). While this has changed more recently (see
e.g. Christiano et al 2007), the emphasis has been on firm and bank level, not household level.
Our work on the other hand points to the potential importance of household balance
sheets in explaining macroeconomic fluctuations. While more research is needed to determine
whether household leverage was a catalyst of the recession or an amplification of other variables,
such as technology or monetary shocks, any explanation of the recession of 2007 to 2009 must
be consistent with the strong correlation between household leverage and subsequent economic
outcomes in the cross-section of U.S. counties.
...
The bottom panel of Figure 4 shows monthly retail sales; as it shows, the drop in durable
consumption (motor vehicles, and furniture and appliances) began very early in the recession.
The drop in auto sales was particularly large—from the fourth quarter of 2007 to the fourth
quarter of 2008, auto sales dropped by 30%. The drop in non-durable consumption both began
later and was far less severe.
Figure 4 shows that the initial part of the economic downturn was driven by declines in
durable consumption and residential investment. This is common in post World War II
recessions (Leamer (2007, 2009)). The early drops in these two GDP components during the
2007 to 2009 recession occurred simultaneously with an extremely large increase in household
defaults. Given the importance of credit in the purchase of durable goods and housing, there is a
suggestive link between deterioration of household balance sheets and the early decline in
durable and housing consumption.
Fig. 4
Fig. 7
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Originally Posted by Dark Sage
