Friday, June 26, 2009

Housing prices drove borrowing and GDP - link proven

An excellent paper recently came out of University of Chicago by Mian and Sufi called House Prices, Home Equity-Based Borrowing, and the U.S. Household Leverage Crisis.

There has always been a debate on whether housing price increases drove household leverage and spending. Some argue that housing prices and household debt were just correlated, not that one led to the other. People felt good about their future, equities were up, there were more jobs, households borrowed more, and house prices went up driven by optimism (not that house price increase caused more borrowing.)

The way Mian and Sufi got around this is by separating the population into two categories: those who live in areas where housing supply was very limited (inelastic) and areas where new construction could add to the supply (elastic). The inelastic areas saw rapid house price increases that were not related to equity prices, job growth, optimism, etc.

What Mian and Sufi show is that it was the inelastic areas that saw the most borrowing - that is higher house prices were directly responsible for increased borrowing. Furthermore it was the poor credit consumers in inelastic areas who leveraged the most.

First one can see that consumer debt rose much faster than corporate debt,

and consumer leverage far outpaced corporate leverage:

House prices experienced most of the growth in the "inelastic" areas:

Leverage consequently grew most in the inelastic areas as well,

driven mostly by the low credit quality borrower.

Thus the lower credit quality borrower in inelastic areas experienced the high default rates:

Mian and Sufi proceed to show that home equity based borrowing was used mainly for consumption and added 2.3% to GDP every year between 2002 and 2006. This has enormous implications on any recovery from this recession. All other factors aside, over 2% of US GDP has been near permanently taken out, making it highly unlikely that we revert to pre-recession growth levels any time soon.

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