SOCIETY'S HOUSEHOLDS IMPACTED BY THE RECESSION

Society's Households Impacted by the Recession

Society's Households Impacted by the Recession

Chapter I: Introduction

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 deep decline in GDP (Figure I, top two panels). What factors explain the current economic downturn? While a number of reasonable hypotheses have been put forward, an empirically relevant theory must quantitatively explain four facts that collectively define the recession: the sharp rise in household defaults, the fall in house prices, the drop in consumption (especially durables), and the rise in unemployment.

In this study, we focus on the rapid growth in household leverage in the years before the recession, and we find that household leverage growth performs remarkably well in explaining these four facts. 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. Our main results are consistent with the view that the dramatic increase in household leverage from 2000 to 2007 was a primary driver of the recession of 2007 to 2009.

The aggregate U.S. evidence highlights the importance of household leverage. The initial indicators of economic difficulty were a rise in household default rates and a decline in house prices, both of which reflected an overstretched household sector. These trends began as early as the second quarter of 2006, a full five quarters before the initial increase in the unemployment rate. Not surprisingly, the components of GDP that initially declined in 2007 and early 2008 were fixed residential investment and durable consumption—the two components that most heavily rely on the willingness of households to obtain additional debt financing.

While aggregate patterns hint at the importance of household leverage in precipitating the recession, it is difficult to reach definitive conclusions on the link between household leverage and the economy based on aggregate data alone. For example, it is possible that the decline in house prices and the increase in defaults in 2006 reflected an anticipation of future unemployment. Or perhaps the household-leverage component of the recession, while occurring early in the downturn, is far less important than the credit crisis of September and October of 2008. More generally, the linkages across the economy make it difficult to conclude based on aggregate evidence alone what factors contributed to the severe recession of 2007 to 2009.

To overcome these difficulties, we focus on cross-sectional variation across U.S. counties in the severity of the recession. There is a large degree of such variation. For example, Saint Lucie County in Florida experienced an increase in the unemployment rate of 6.6% from 2006 to 2008. In contrast, Harris County in Texas, where Houston is located, had a rise of only 1.2% in the unemployment rate. Our empirical methodology examines patterns across ...