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Piling on household debt also causes crashes

Piling on household debt also causes crashes Moorad Choudhry

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Six years after Lehmans, the mainstream view remains that it was banks that caused the crash. While the behavior of some banks, especially the large ones that ended up bust, was certainly a contributory causal factor, it is simplistic to think that this was the only, or even the main, cause of the economic meltdown. If we are to learn lessons from that experience, it’s important to understand how our own personal behavior – collectively, of course – was also a causal factor.

In a number of countries, there was an economy-wide recession that led to large-scale losses by banks; for example, the real estate bubbles in Ireland, the UK and Spain, was a big driver. Of course, one could say that bad lending decisions by banks exposed them to greater risk if the market did collapse, and econometricians will have a hard time proving either way which was the tail and which was the dog in this two-way relationship. But it’s worth examining how personal finances make a bad situation worse.

On both sides of the Atlantic, a stand-out feature of this crash was the long time taken by economies to come out of recession. In previous downturns, starting with 1929 but also 1980-81 and (in the UK) 1990-91, the return to recovery was much quicker – within 12 months. However this time, six years later, we are still not in recovery mode in some parts of the eurozone (although the euro itself is a factor here). Why the sluggish performance?

The bull market during 2002-2008 didn’t just affect banks’ mindsets. Individual households were also affected, and in several countries household debt rose every year during that period. It seemed that everyone wanted to get involved. Once the crash occurred, the real problem of the ongoing slump was that this excessive personal debt became a drag on any further spending and hence output overall was affected. At the small business level, the picture was the same – in the US for example, SME lending was still rising in 2008 even as banks’ cost of funding was blowing out due to Lehmans.

Personal debt levels are a significant factor in any recession because, once the downturn strikes, individuals look to play down debt, fearing unemployment, loss of orders and the like. So, as they rein in spending and stop borrowing, a bad situation is made worse and economic output fails to recover. The banks took it in the neck after the crash for not doing enough to boost small business lending - but to be fair to them, the demand just wasn’t there, individuals and SMEs were in no mood to borrow more money in the environment prevailing in 2009-2012.

Banks like the UK institution Northern Rock quite rightly were vilified for making available 100% loan-to-value mortgages, and the yet more risible 125LTV loan, but no-one is forced to borrow under such terms. We have to look at ourselves too.

Now of course, we’ve turned the corner haven’t we? In the UK, the housing sector (especially in London and the South East) looks like it’s already overheating. The Bank of England has commented on this and the government’s need to subsidize house purchases for first-time buyers (when will they ever learn?!) and we may well be only another 5-6 years away from the next crash.

When it comes to learning lessons from the crash, the best place to start is at home.

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