The Great Recession is All About Leverage, Leverage, Leverage

Mike Konczal reads a new IMF report and insists that we pay attention to what it says. We’re not having a long recession because it came in the wake of a financial crisis. We’re having a long recession because households were overleveraged. The financial crisis was just a symptom:

There’s a common wisdom among many elites that prolonged recessions are just what happens in the aftermath of a financial crisis. Most people who argue this derive it from Kenneth Rogoff and Carmen Reinhart’s This Time It’s Different. These arguments have always been a bit difficult to justify. Usually people who invoke them call for inaction, as if there isn’t anything to be done but let the recession run its course.

The IMF report looks at OECD data on housing busts over the past 30 years and compares housing busts with large household leverage ratios with those with low ratios. Busts with large household leverage ratios have much bigger drops in consumptions years out, just like what we see in our recession. What is important is that this holds with or without financial crises.

They don’t discuss it, but this implies that the causation runs the other way; countries that have giant drops in housing values and/or increases in debt-to-income ratios probably create financial crises. But this means that having a financial crisis, like we did, doesn’t change the game; it just amplifies the case for normal demand-side stimulus.

In other words:

It’s not: Financial crisis —> recession

It is: Recession + leverage —> financial crisis

According to NBER, the Great Recession started in December 2007. This is what caused the music to stop and sparked a financial crisis. But even without a financial crisis, households still would have been massively overleveraged, the music still would have stopped, and the housing bust still would have destroyed trillions of dollars of wealth.

Better policy during the aughts could have reduced the size of the recession. Failing that, better policy now could still reduce its length. And although Mike is right that there are people who nonetheless “call for inaction,” he’s wrong to identify them merely as generic “people.” They’re Republicans with a vested political interest in delaying recovery. Precision is important here.