Former budget director Peter Orszag has said that “a major policy error” was made. And Christina D. Romer, formerly Obama’s top economist, has said that the driving ideas “may have been too limited” and that there needs to be a bigger focus on reducing mortgage debt — a process known as “principal reduction.”
“The new evidence on the importance of household debt has convinced me that we are likely going to need to help homeowners who are underwater,” she said last month. “Many of these troubled loans will need to be renegotiated and the principal reduced if we are going to truly stabilize house prices and get a robust recovery going.”
Why debt matters
Some of the most authoritative research on the role of mortgage debt in the recession and recovery — research reviewed by Obama — comes in part from an economist from Pakistan who started out studying why poor countries struggle to grow.
Atif Mian, now a Princeton professor, came to focus on how finance can destabilize an economy. He saw how foreign money had flooded Latin America in the 1980s and Southeast Asia in the 1990s, leading to borrowing booms and financial crises.
Not long before the U.S. recession, Mian and another young economist, Amir Sufi of the University of Chicago’s business school, saw a similar trend here. “The common link to the emerging market crises,” Mian said, “is that it all starts with leverage.”
The two economists compared what happened in U.S. counties where people had amassed huge debts with those where people had borrowed little. It had long been thought that when property values declined in value, homeowners would spend less because they would feel less wealthy.
But Mian and Sufi’s research showed something more specific and powerful at work: People who owed huge debts when their home values declined cut back dramatically on buying cars, appliances, furniture and groceries. The more they owed, the less they spent. People with little debt hardly slowed spending at all.
This was important because consumer spending makes up the lion’s share of economic activity, and even a small increase or decrease can have a big impact on growth and affect millions of jobs.
From 2006 through 2009, overall consumer spending was flat, according to calculations Sufi completed for The Washington Post. But among the quarter of U.S. counties with the highest debt, it fell 5.5 percent. Without that hit, spending nationwide would have increased by 2.4 percent.
In other words, indebted Americans had an outsize effect, pulling down the rest of the nation’s economy.