Of the various types of financial bubbles, debt-fueled housing bubbles are the most damaging.
Debt is great for an economy as it grows and expands — at least on the surface. Politicians like debt growth because when citizens borrow and spend, it stimulates the economy, and a strong economy helps politicians get reelected.
Lenders like debt growth for obvious reasons: it’s how they make money. Lenders celebrate debt growth along with politicians, but not because the immediate economic boost from economic stimulus but because they ensure themselves a cashflow stream when the borrowers pay their-debt service bills.
Unfortunately, while politicians and lenders celebrated the initial loan and it’s subsequent economic boost, only lenders celebrate the ongoing debt-service payments. Politicians should decry the debt service payments because interest money comes out of the local economy and travels to a lender’s coffers; however, lenders placate politicians through promises of even more borrowing to boost spending and offset the drain caused by debt service.
Unfortunately, this is a Ponzi scheme.
In a lender’s ideal world, as borrowers make more money, they would turn to lenders for increased credit lines so borrowers can immediately increase their spending. In a politicians ideal world, incomes would grow fast enough to service this new debt so the economy never experiences the economic drain of debt service. This unholy alliance of interests puts lenders and politicians in agreement on the benefits of expanding personal Ponzi schemes.
Everything works well until an economic downturn causes millions of personal Ponzi schemes to unravel, like we witnessed in 2008. The presence of these Ponzi schemes makes the downturn worse than it otherwise would be because the pipeline of ever-increasing debt is abruptly stopped, and borrowers are left with nothing other than debt service and repayment. In a world without consumer debt, the booms wouldn’t be as robust, but the busts wouldn’t be as brutal either. (See: Signatory debt is bad; asset-backed debt is good)
In the past, recessions cleansed the financial system of bad debts and wiped out personal Ponzi schemes, reallocating resources to more productive uses, and because the debt-service payments and principal repayments were eliminated, borrowers and businesses were able to spend that money in the economy, providing an economic boost. The cycle of boom and bust constantly cleansed the economy of bad business models and Ponzi schemes, promoting an efficient allocation of resources and strong economic growth overall.
In this last recession, rather than purging the system of bad debt, lenders and the federal reserve officials implemented policies focused on preserving bad debt. Loan modifications preserved trillions dollars of bad mortgage debt that borrowers still struggle with. The policies of lenders and federal reserve that preserved bad debt made the recovery from 2009 through 2014 one of the weakest in modern history, entirely due to lender and federal reserve policy.
The preservation of bad debt is one of the main reasons balance sheet recessions are generally so prolonged, and it’s also why debt-fueled housing bubbles are the most debilitating.
Financial bubbles burst with varying effects depending on the kinds of assets that rose in value in the boom years. Macroeconomists, financial analysts, and policymakers alike are aware of these differences particularly when one compares the disastrous housing market bubble-and-burst that sparked the Great Recession of 2007-2009 compared to the less damaging 2001 “dot-com” stock market recession. But what exactly distinguishes the length and severity of a post-bubble recession?
New research by Oscar Jorda of the Federal Reserve Bank of San Francisco, Moritz Schularick of the University of Bonn, and Alan M. Taylor of the University of California-Davis looks at historical data on economic growth, credit growth, and financial assets to understand the effects of bubbles. Their data set covers 17 countries since the 1870s, including the years directly after the Great Recession, among them the United Kingdom, Germany, France, the United States, and Japan.
They find, unsurprisingly, that the bursting of asset bubbles lead to weaker recoveries on average compared to typical down swings in the business cycle. But there are substantial differences in the effects of different kinds of bubbles when they collapse. Not all bubbles inflate economies in the same way, and when they burst economies react differently.
When you compare the stock market bubble to the housing bubble the biggest differences are caused by the illiquid nature of real estate and the amount of leverage used. The stock market bubble was inflated mostly by equity with only a portion of investors using up to 50% margin. When prices began to crash, brokerages closed the positions out by selling stocks into a very liquid market when the investor’s account hit zero. The investor could lose all their equity, but they couldn’t lose any more than that. A brokerage liquidation prevents the account from falling far below zero.
When real estate prices began to crash, there was no stoploss in the system. Owners watched as the value of their properties fell far below the outstanding balance of their loans, and they were powerless to do anything about it. The forced liquidations that did occur often happened at values far below the outstanding balance on the loan, so banks lost billions as insolvent borrowers walked away. The deflation of this bad debt ravaged the economy, and the lingering bad debt not liquidated still burdens our financial system.
Jorda, Schularick, and Taylor split bubbles into four groups, divided along two lines. The first broad way to categorize bubbles is by the kind of asset the bubble inflates. A bubble might be in equities, such as the high-tech stock bubble in the United States during the late 1990s. Or the bubble could be in housing, which of course took down the U.S. economy and then other leading economies around the world only eight years ago. The second way to categorize bubbles is to see if they happened concurrently with large increases in credit. In other words, were the bubbles financed with debt? So we end up with four kinds of bubbles: equity bubbles without credit bubbles, credit-fueled equity bubbles, housing bubbles with average credit growth, and leveraged housing bubbles.
The three economists find a hierarchy for the effects of bubbles. Bubbles in equity assets that aren’t financed by credit aren’t particularly virulent. In fact, Jorda, Schularcik, and Taylor find that these bubbles don’t make recessions any worse. Or at least, there is no statistical difference. Debt-fueled equity bubbles are more damaging, making recessions more severe and subsequent economic recoveries slower. Yet housing bubbles are even more damaging. Even in the absence of a large credit build up, housing bubbles are quite harmful to the broader economy.
When you consider the extreme leverage and lack of liquidity, it shouldn’t be surprising that housing bubbles are more damaging. Further, participation in a housing bubble is universal among homeowners, and this represents a higher percentage of the population than those who own stocks or bonds. The devastation from a housing bubble is widespread and not contained to the relatively well off who may be invested in other markets.
But when mixed together with credit, leveraged housing bubbles become extremely powerful. The economists find that economies that experience these kinds of bubbles don’t fully recover from the recession until, on average, five years after the bursting of the bubble. Indeed, consider how weak the current U.S. recovery has been or the long depression in Japan after the collapse of a real estate bubble there. These results have obvious implications for macroeconomic policy, particularly when it comes to monetary policy. We should be on the look out for credit-fueled housing bubbles.
Policymakers need to understand these differences and the underlying factors behind them when it comes to housing policy, credit policies more broadly, financial market supervision, and if we think wealth inequality plays a role, tax policy.
Policymakers demonstrated their understanding of these factors in the Dodd-Frank financial reform law. They effectively limited the type and amount of debt available to housing market participants to ensure debt-fueled housing bubbles would be much harder to inflate in the future. It’s one of the few examples of legislators getting the law mostly right.