Bas Bakker and Joshua Felman
The conventional narrative about the great recession that began in the United States in 2007 focuses on the housing price boom and bust and the effects on spending by the middle class, most of whose wealth is concentrated in housing.
The rich have been accorded little, if any, part in the spending boom and bust. The well-to-do play a role, but only as generators of “excess saving” (Kumhof, Rancière, and Winant, 2013). According to that explanation, the spectacular rise in the incomes of the rich that started in the 1980s induced them to lend their increased savings to the hard-pressed middle class, who used the funds to maintain their consumption growth and speculate in real estate (Rajan, 2010).
Initially, all went well, as the real estate boom propelled a construction-based expansion. But by 2007, the music had stopped. The middle class became overextended and ceased buying houses, causing prices to collapse so sharply that many homeowners were suddenly underwater on their mortgages—that is, they owed more to their mortgage lenders than their houses were worth. Some defaulted. Others rapidly increased their saving rates so they could pay down their debts (Mian and Sufi, 2014), curtailing consumption in the process. The result was a deep recession.
But the conventional narrative is incomplete. It was not just the drop in housing wealth that made the Great Recession so deep, but also the decline in financial wealth. Moreover, the rich were not merely passive spectators, but active participants in the consumption cycle. In fact, given the size of their asset holdings, the swings in the spending of the rich were probably a primary motor of the boom and subsequent bust (Bakker and Felman, 2014).
Wealth effects played a key role in the precrisis drop and postcrisis surge in the household saving rate (see Chart 1). Asset prices soared during the boom years, making people feel wealthier, inducing them to increase consumption and reduce their saving rate. When asset prices collapsed during the crisis, wealth effects went into reverse, leading to a fall in consumption (Case, Quigley, and Shiller, 2011).
Mian and Sufi (2014) have argued that the swings in housing prices were particularly critical, because the acquisition of real estate, unlike the purchase of financial assets, is largely funded by borrowing. Accordingly, declines in housing prices created financial difficulties, forcing households to scale back their spending. They argue that this dynamic explains why the Great Recession was so much more severe than the so-called dot-com bust (the collapse in 2000 of stock prices following a three-year boom driven by Internet companies), even though losses in stock wealth were about the same as those in housing wealth later in the decade.
But the explanation may be much simpler. The dotcom bust was mitigated by an increase in nonfinancial assets (mostly housing), while the housing market crash was exacerbated by a drop in financial assets (see Chart 2). In fact, financial assets accounted for $8 trillion of the $13 trillion in peak-to-trough losses in wealth. Put another way, one reason the cutbacks in consumption during the Great Recession were so much deeper than during the dot-com bust was because the overall wealth losses were much larger.
Bakker, Bas B., and Joshua Felman, 2014, “The Rich and the Great Recession,” IMF Working Paper 14/225 (Washington: International Monetary Fund).
Case, Karl E., John M. Quigley, and Robert Shiller, 2011, “Wealth Effects Revisited, 1978–2009,” Cowles Foundation Discussion Paper No. 1884 (New Haven, Connecticut: Yale University).
Kumhof, Michael, Romain Rancière, and Pablo Winant, 2013, “Inequality, Leverage and Crises: The Case of Endogenous Default,” IMF Working Paper 13/249 (Washington: International Monetary Fund).
Mian, Atif, and Amir Sufi, 2014, House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from happening Again (Chicago: University of Chicago Press).
Rajan, Raghuram, 2010, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton, New Jersey: Princeton University Press).