Economic Fluctuations and Growth.

• Author: Gertler, Mark
• Position: Program Report

Over the last decade, research in the Economic Fluctuations and Growth (EFG) Program has responded to important macroeconomic challenges. This report emphasizes four areas in which there have been significant developments. First, the global financial crisis has prompted research on the sources and propagation of financial crises, as well as on policy responses. Second, the general decline in business dynamism and lackluster productivity have reignited interest in economic growth analysis. Third, the surge in income and wealth inequality has generated new work on macroeconomic determinants of inequality. Fourth, with respect to methodology, there has been a growing recognition that so-called "representative agent" models are not sufficient for addressing many key macroeconomic issues. This has led to the development and increased use of heterogeneous agent models. This report summarizes recent research in each of these areas.

1. The Great Recession, Financial Crises, and Policy Responses

   Researchers affiliated with the EFG program have analyzed both the financial crisis and the policy responses extensively. Roughly one tenth of recent EFG working papers have been devoted to these issues.

   Theoretical and empirical work on financial crises predates the Great Recession. This work emphasized the role of borrower balance sheets in constraining credit access when capital markets are imperfect. It then associated financial crises with a kind of "adverse feedback loop" in which declines in real activity weaken borrower balance sheets, which in turn further depress spending and real activity. The emphasis was on borrowing frictions faced by nonfinancial firms. However, the evidence from the recent crisis suggests that the key conduits of financial distress were mainly highly leveraged households and highly leveraged shadow banks. While nonfinancial firms eventually felt the brunt of the financial distress, it was a dramatic buildup of leverage in the housing and shadow banking sectors that made the economy vulnerable to financial collapse.

   There is now a rough consensus that there were two main channels of financial distress. The first, which we call the "household balance sheet channel," features the impact of declining house prices on households' net financial positions, and in turn on their credit access and spending. The second, which we term "the banking distress channel," features the effect of weakening of bank balance sheets on credit intermediation. (1) Of course the two channels are interrelated, as the sources of the financial distress in banking stemmed from losses on mortgage-related securities that eventually led to a full-scale panic.

   * The Household Balance Sheet Channel

   Partly because of how the data was unfolding in real time during the crisis, much of the early research emphasis was on the household balance sheet channel. The origins of the crisis involved an extraordinary housing boom, featuring a dramatic run-up in home prices and mortgage debt. Among the factors triggering the boom were: a secular decline in mortgage rates due to a combination of declining long-term interest rates and innovation in mortgage finance, relaxation of lending standards, and widespread optimism about housing prices.

   What we have learned to appreciate since is that the pre-crisis housing boom was not unique to the 2007 U.S. experience. Across both countries and time, it is typical for run-ups of both household debt and housing prices to precede major financial crises. For example, Oscar Jorda, Moritz Schularick, and Alan Taylor document that the run-up in household mortgage debt occurred across countries as a precursor to the recent global financial crisis. (2) Arvind Krishnamurthy and Tyler Muir, in related work, find that not all household debt booms lead to crises, but that those accompanied by increasing credit spreads are more likely to do so. (3)

   What initially triggers the crises that follow a run-up in household debt, including the recent one, is a contraction in house prices. According to the household balance sheet channel, the drop in house prices weakens the balance sheets of households highly leveraged with mortgage debt. In turn, there is a significant decline in household spending.

   The descriptive evidence suggests that a household balance sheet channel was a key conduit of financial distress during the Great Recession. The left panel in Figure 1 shows the behavior of household debt to income (the blue line) versus debt to assets (the gray line) over the period 2004 to 2012. The right panel shows house prices (the blue line) and consumer durable consumption (the gray line). In each panel the shaded band is the recession and the solid vertical line is the date of the Lehman bankruptcy. Preceding the crisis there is a roughly 20 percent runup of household debt as a percentage of income. The debt-to-assets ratio remains stable until 2007, reflecting that home prices increase along with debt. However, as home prices decline starting in early 2007, the household debt-to-assets ratio sharply increases. The weakening of household balance sheets, in turn, leads to a sharp drop in spending on consumer durables.

   With aggregate data, however, it is difficult to identify causality. Aggregate housing prices could be responding to the decline in real activity, as opposed to influencing it. In a series of highly influential papers, Atif Mian and Amir Sufi use cross-sectional data to identify the household balance sheet channel. (4) They first show that regions which experienced the largest run up in home prices and mortgage debt in the years prior to the crisis suffered the largest drops in home prices and real activity once the crisis hit. For the crisis period, they estimate cross-sectional regressions that relate some measure of real activity--for example, consumption or non-tradable employment--to the decline in household net worth, where the latter is measured by the rate of decline in home prices weighted by household leverage at the beginning of the crisis. They identify exogenous variation in household net worth using an instrumental variable based on local land supply elasticity. Because the regression is cross-sectional and time effects are removed, it is not possible to identify the aggregate effects of the household balance sheet channel. Nonetheless, the results provide persuasive evidence of the existence of a household balance sheet channel. (5)

   The empirical work on the household balance sheet in turn motivated a vast theoretical literature that modifies macroeconomic models to allow for balance sheet constraints on households. As with models developed before the crisis, these models feature adverse feedback loops between borrower balance sheets and real activity, but they put households, rather than non-financial firms, at center stage. One interesting auxiliary finding is that the tightening of balance sheet constraints on household borrowers not only reduces household spending, it also pushes down interest rates, helping account for how household financial distress could move the economy into a liquidity trap, where the zero lower bound on the nominal interest rate binds. (6)

   * Banking Distress and the Real Economy

   The mirror image of the sharp increase in household indebtedness portrayed in Figure 1 was a sharp increase in the leveraging of the banking system, particularly the shadow banking system that operated outside the direct regulatory control of the Federal Reserve. The right panel in Figure 2, on the next page, illustrates the behavior of the liabilities of broker/dealers--the investment banks that were the main actors in the shadow banking sector. The growth of the shadow banking sector financed the sharp increase in mortgage-related securities, a product of the housing boom described earlier. Importantly, while the assets held by these institutions were mainly long-term, the liabilities were mostly short-term. With the benefit of hindsight, this maturity mismatch made them vulnerable to panic. The downturn in house prices portrayed in Figure 1 not only weakened household balance sheets, it induced losses in mortgage-related securities held by both shadow and commercial banks. The highly lever-aged and lightly regulated shadow banking sector was particularly vulnerable. The losses on mortgage-related securities led to panic in markets for wholesale short-term funding, culminating in the failure of Lehman Brothers and the investment banking collapse. (7) The collapse in broker/dealer liabilities portrayed in Figure 2 was the product of these events.

   The role of the banking distress channel demonstrates that the weakening of bank balance sheets over the crisis induced a contraction in intermediation, raising the cost of credit and thus weakening real activity. As with the household balance sheet channel, the aggregate data provide some suggestive support. The left panel in Figure 2 plots GDP growth against a measure of financial distress, the excess bond premium (EBP) developed by Simon Gilchrist and Egon Zakrajsek. (8) The EBP measures the spread between the rate of return on corporate bonds and on similar maturity government bonds, but with the default premium removed. The latter adjustment implies that increases in the EBP reflect elevation in the cost of credit as opposed to signals of increasing default. As Figure 2 shows, the beginning of the recession features relatively modest declines in output growth and increases in the EBP. In the summer of 2008, the recession appeared similar to the relatively mild downturns of 1990-91 and 2001-02. However, as Figure 2 makes clear, closely correlated with the Lehman collapse is a sharp increase in the EBP along with a sharp contraction in GDP growth. This broad connection of banking disruption, rising credit costs, and declining real activity is highly suggestive of a banking distress channel.

   Once again, to establish causality it is...