Ask most Americans what caused the Great Recession, and they will likely mention something about subprime mortgages, Lehman brothers, or Wall Street greed. But was any one of these factors really significant enough to bring about the most catastrophic economic event in recent memory? As we will explain, while risky mortgages and questionable financial market practices played an important supporting role in creating the conditions that led up to the economic collapse, there were deeper structural problems—particularly with the way the U.S. economy generated demand growth—in the decades prior to the Great Recession. These underlying problems created conditions that made an eventual crisis almost inevitable (although the timing of such things is nearly impossible to predict in advance). This page explains how consumer debt and financial innovation combined to create a self-reinforcing cycle that encouraged ever-riskier financial practices, ultimately leading to the financial market crisis that finally triggered the Great Recession. In subsequent pages, we peel back the onion that was the Great Recession even further by linking the unsustainable trends in household spending and borrowing to wage stagnation and rising income inequality.
According to the MWM perspective, major movements in the economy are usually associated with changes in demand. By far the largest component of U.S. demand is household consumption. And it was the collapse in household consumption, along with the closely related decline in the demand for new housing construction, that was the proximate cause of the Great Recession.
Why to we argue that demand drives output and employment? Review our Keynesian Basics pages.
To understand why this occurred requires turning back the clock to the mid-1980s. This was the beginning of a long, but ultimately unsustainable, boom in consumer spending. From the end of 1984 until the eve of the Great Recession at the end of 2007, real personal consumption grew almost 37% more than the other components of real GDP. To a large extent, the secular growth of demand depended on the reliable rise in the spending of American households. In an article written before the Great Recession (linked here) Barry Cynamon and Steven Fazzari labeled this period the “Consumer Age.” During this time, U.S. growth was fairly high relative to other developed countries, the long-term trend of unemployment was downward, and the two recessions that occurred in 1990-91 and 2001 were reasonably mild, especially as measured by the drop in GDP.
While strong demand from households generated good macro performance according to the most commonly referenced economic statistics during the Consumer Age, there was a dark side to the rapid rise in consumption spending. Beginning around 1980, income growth declined significantly for all but the top earners. Consumption, however, remained strong among across the income distribution. How could a substantial portion of US households enjoy strong consumption growth after their income growth slowed?
The answer is that they had to borrow more, and they did so to an unprecedented extent. The ratio of debt to income for American households more than doubled from the mid-1980s through 2007 (a rise that followed a 20 year period in which the debt-income ratio was virtually constant). This way of financing the Consumer Age boom turned out to be unsustainable. After the rise in house prices slowed in 2006, lending to the already heavily indebted household sector stalled and consumers cut back their spending on just about everything, especially newly constructed houses. This resulted in a drop in household demand that was larger than any since the early 1930s. This severe decline in demand caused the Great Recession.
As the discussion in the previous section makes clear, housing had a lot to do with the macroeconomic forces that caused the Great Recession. Most of the borrowing that took place during the Consumer Age was mortgage debt. Low interest rates and the expanded availability of mortgage loans—especially “subprime” mortgages which extended credit to borrowers with weak financial records—made home ownership more attractive and attainable for millions of Americans. With the expectation that home prices would keep rising, people not only bought more houses, they also bought bigger houses and accelerated renovations of existing homes. This increase in demand drove home prices upward, validating expectations of rising house prices, making homeowners feel wealthier, and enabling Americans to borrow even more against the equity in their houses.
Americans were content to borrow more and more, but who was on the lending side of all of this debt? As is well-known, there were major innovations in the mortgage lending institutions in the decades preceding the Great Recession. These innovations made it much easier for households to borrow to buy houses and to tap the equity in their homes for other kinds of spending. Many loans were bundled up and sold together as mortgage-backed securities (MBS), which were bought by large investment banks who then repacked them in various ways and sold the mortgage debt of the US household sector to global investors. This process was highly profitable for the financial sector and, as long as home prices were rising, returns for investors were good. The rising desire of wealth holders around the world to obtain a piece of the American mortgage market gave lenders even stronger incentives to push new loans out the door. This reduced interest rates and relaxed credit standards for borrowers even more. More people borrowed, and the deluge of credit fueled even faster growth in home prices. Faster growth of home prices validated everyone’s expectations. Homeowners saw their equity increase, which justified more borrowing. Investors saw the collateral value behind their securities grow which made their investments in the MBS market look even better, encouraging them to pump even more money into the market that was lent out more cheaply to even riskier borrowers. This whirlwind of borrowers and lenders feeding each others’ desires created a classic financial bubble
In 2006, the bubble burst. After some rise in short-term interest rates induced by inflation worries at the Federal Reserve, it became more difficult for borrowers, especially the riskiest borrowers, to refinance. But refinancing was necessary to keep the bubble, and the associated consumer demand going. Many of the risky loans had “teaser” interest rates that allowed very low payments initially but would reset to unaffordable levels after a few years. People took out this like of loan with the expectation that they would refinance, on better terms, before the reset took place. With higher interest rates, this strategy no longer worked. The rising cost of refinancing, or the inability to refinance at any price as credit conditions tightened, forced over-extended borrowers to their back-up plan: sell the house. As more homes came on the market, the rise in housing prices stalled. Over-extended homeowners defaulted on mortgages and investor confidence in mortgage-backed securities plummeted, reducing the availability of mortgage loans even further. More people were forced to sell. Housing prices fell dramatically, leading mortgage balances to exceed home values for many homeowners and forcing them into default.
The housing bubble affected many more Americans than earlier cases of financial-market excess (such as the dot-com bubble of the late 1990s or the bubble in oil-patch real estate of the early 1980s), increasing the severity and pervasiveness of its effects on the US economy. Millions of homeowners defaulted on mortgages or saw much of their wealth evaporate as home prices dropped. In response, consumers tightened their belts: personal consumption spending fell by much more than is typical in recessions. Construction of new homes absolutely collapsed. These massive reductions in demand led firms to cut production and lay off workers, as described in our Keynesian Basics pages. The Great Recession had arrived.
Minsky’s Theory of Instability
These historical events provide a classic example of outcomes predicted by the theory of financial instability proposed by the late economist Hyman Minsky. A summary of Minsky’s ideas and how they help explain the causes of the Great Recession can be found here. **Link to come soon**
These events revealed underlying structural problems in the way that the U.S. economy generated its demand for the roughly 25 years of the Consumer Age. In particular, the Great Recession and its aftermath shows how rising inequality of income can compromise demand and lead to macro stagnation, problems that had been hidden by unsustainable borrowing. This is the topic of the next page of our discussion of the Great Recession and its legacy. Please continue with this **link.
- During the “Consumer Age” period from the early 1980s through 2007, much of U.S. demand growth was generated by the rapid growth of consumer spending financed by unprecedented increases in household debt. The unsustainable rise in debt set the stage for the Great Recession.
- The unprecedented borrowing of American households was facilitated by innovations in mortgage lending that fueled a bubble in home prices. Rising home prices generated more home equity which allowed even more borrowing.
- The housing bubble burst when interest rates rose and refinancing stalled, forcing more homeowners to try to sell. Home prices began to fall. Lenders began to fear default and cut off credit. With refinancing greatly curtailed and home prices declining, over-extended homeowners began to default on their mortgages.
- The resulting financial panic caused demand for consumption and new houses to collapse, the trigger of the Great Recession.