The debt crisis: Wipeout

DEBT forgiveness, and the redesign of debt contracts to involve more risk-sharing, is the answer to the problem of recurrent financial crises. That is the argument of two economists, Atif Mian and Amir Sufi, in their book “House of Debt” (our Free Exchange column discussed the book here).They argue that economic recessions often follow surges in household debt. They dub their thesis “the levered losses framework”; it is based on the idea that equity losses do not affect homeowners equally. The rich tend to have a lot of equity in their homes; the poorest homeowners tend to have slivers of equity (10-20%). When house prices fall, this wipes out their stake and may force them into foreclosure. The authors illustrate this with some neat statistical analysis of individual areas of America, showing that places where the average equity stake was low suffered significantly more than the rest. One can divide workers into those who serve their local area (shops, restaurants etc) and those who serve the national population (car manufacturers, for example). Places with high leverage saw big job losses in local businesses; areas with low leverage did not. Both areas suffered equally from the effects of the fall in national demand. Furthermore, poorer homeowners tend to have a higher marginal propensity to consumer than the rich; hence their losses had a bigger impact on aggregate …

Link to article: www.economist.com/blogs/buttonwood/2014/09/debt-crisis-0?fsrc=rss

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