When the economy´s macro-foundations “crack”!

Thomas Cooley and Co. apply their RBC theoretical framework, where monetary policy plays (almost) no role in driving the economy:

Our usual goal in these posts is to describe where the US is in its now 7-year recovery from the recent recession. However, we ask a different question in this post (one that has been the central focus of many economists since the crisis started): why was the downturn in the labor market so deep?

And argue that:

Compared to past recessions, the increase in unemployment during the Great Recession was the worst since the Great Depression. The unemployment rate more than doubled from mid 2007 to late 2009. Even compared to recent recessions, this crisis was particularly severe. What factors led to such a severe recession? In my job market paper,“Consumer Credit, Unemployment, and Aggregate Labor Market Dynamics”,  I study the role of  households’ ability to access and use consumer credit when they become unemployed and ask if this relationship, at the household level, can help us explain the depth of the recent recession.


The Role of Consumer Credit

The Great Recession was unique in many respects, but a feature that continually stands out has been the response of household debt and borrowing. The credit boom of the late 1990s led many households to increase their reliance on debt to finance consumption and investment. The ratio of debt-to-income increased from around 0.6 in the 1980s to nearly 1.2 at the peak of the boom in 2007. During the crash, both debt and borrowing fell at rates never seen before as the unemployment rate doubled. Debt-to-income currently stands around 0.95.

Not only was the pattern in unemployment and borrowing similar in the aggregate, we also see them linked if we look across regions of the US. For instance, counties that had the largest increase, and subsequent fall, in borrowing during the Great Recession also tended to be the counties that experienced the largest declines in employment or increases in unemployment (see an excellent non-technical summary of this work here). These facts have led to a new emphasis on research into how problems in household financial markets might exacerbate recessions.

And conclude

The evidence above highlights two aspects of why the fall in household borrowing between 2007 and 2009 corresponded closely with the increase in unemployment. First, the complementarities between the household credit market and the labor market run down to the household level. It became more difficult to borrow precisely for households that demanded it the most, the unemployed. Second, this relationship affected the incentives for firms to hire, which exacerbated the initial causes of the recession.  Accounting for the relationship between borrowing and unemployment at the household level is important in understanding the trends we see aggregate data.


I fail to reject the null that nominal household credit market debt does not Granger cause nominal personal consumption expenditures and private residential fixed investment, but I reject the null that nominal personal consumption expenditures and private residential fixed investment does not Granger cause nominal household credit market debt at the 1% significance level.

In other words U.S. household sector spending provides statistically significant information about future household sector lending, but not the other way around. As I said, the finding that spending precedes lending at the macroeconomic level is fairly robust across a variety of contexts, so anytime I see anyone jumping to the conclusion that lending causes spending merely based on their correlation, it causes me to cringe.

On the other hand, there are strong theoretical reasons why we might expect spending to precede lending. At the macroeconomic level everyone’s spending is someone else’s income. The ability and willingness to take on debt arguably is income constrained. Thus we might expect to see changes in income and spending precede changes in lending.

And in fact if it is monetary policy which is the cause of nominal income and spending, as I strongly believe to be the case, then increased lending is not the key to boosting the U.S. economy. Rather increased lending is simply one possible consequence of an adequately expansionary monetary policy.

And the chart below helps put things in perspective, with the huge hole in spending in the present cycle leading to the “rocket-fashion-rise” in unemployment, leading to increased delinquencies and tightening credit conditions!


This is a clear example of an instance where the economy´s Macro-foundations were not supportive of good microeconomic outcomes!

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