Practical analysis for investment professionals
29 August 2012

What is Holding Back Economic Recovery in the Developed World?

Why has the economic recovery in the United States been so slow? How can the eurozone solve its crisis?

Unfortunately, neoclassical macroeconomic models don’t do a good job of explaining severe economic downturns because they assume that mediating economic forces, such as wage and price reductions, will offset sharp declines in consumption. Enter finance professor Amir Sufi of the University of Chicago Booth School of Business, who put forward a compelling explanation for the economic woes in both the United States and Europe at last month’s 57th annual Financial Analysts Seminar in Chicago.

His thesis: In the United States, the severe recession that began in 2007 was due to a sharp decline in aggregate demand brought about by a “lethal combination of high U.S. household debt and a collapse of asset prices” — mainly real estate — that reduced the net worth of many U.S. households by as much as 40%–50%. The slow recovery, Sufi contended, is due to frictions in the economy, such as wage and price rigidities, a zero lower bound on interest rates, and weakened household balance sheets resulting from the decline in home prices. (For more details on his analysis, see “What is Holding Back Recovery in the Developed World,” a working paper Sufi published in July along with coauthor Atif R. Mian of Princeton University.)

Europe, too, is suffering from an “aggregate demand and leverage problem,” Sufi told conference attendees, and the problem is exacerbated by the inherent weaknesses of Europe’s single currency and dangerous codependencies between northern and southern European economies.

A Take of Two U.S. Households

Sufi said that the United States is comprised of two types of households: “levereds” and “unlevereds.” From 2001 until 2007, he explained, the levereds were the life of the economic party thanks to their spending on homes, cars, furniture, and other durable goods, which drove GDP growth. Everyone wanted to be like the levereds, because they lived in big houses, drove expensive cars, and owned the newest, state-of-the-art appliances. Unfortunately, the levereds’ lifestyle and spending addictions were primarily fueled by debt. Unlevereds were the “wallflowers” during this period because they generally saved their money, lived within their means, and used debt conservatively.

Consumer spending drove GDP growth until the end of 2007, when the real estate bubble burst and housing prices began to decline. With the punch bowl taken way, and no music to dance to, the levereds left the economic party and, with no access to credit, they were forced to stop spending. In addition, many levereds lost their homes to foreclosure and bankruptcy. Those who remained in their homes found that they owed more on their mortgages than their homes were worth.

During this period, the unlevereds also stopped spending, even though they had been prudently managing their finances. As a result, total aggregate demand in the United States in 2007 and 2008 plummeted. Since 2009, only the unlevereds have rejoined the economic party, and they are making far fewer trips to the punch bowl: Their consumption has not been enough to offset the decline in spending by the levereds. This is precisely why the economic recovery in the United States has been so slow.

So what can policy makers due to stimulate faster economic growth? Unfortunately, lowering interest rates through various monetary policy initiatives is no longer effective. Lower interest rates only benefit the unlevereds thanks to their strong balance sheets, which afford them access to credit. To increase aggregate demand, Sufi contended, the levereds must be helped — either by reducing interest rates on their mortgages or the principal amount that they owe.

The good news is that the U.S. federal government has set up the Home Affordable Refinance Program (HARP, HARP 2) and the Home Affordable Modification Program (HAMP), both of which are designed to help homeowners who are either underwater or in danger of foreclosure. The bad news, however, is that only a small portion of levereds have taken advantage of this program (approximately 1–2 million people out of 15 million).

Using U.S. county-level household debt-to-income ratios as proxies for levereds and unlevereds, Sufi showed the distributional consequences of high leverage. Those counties where the household debt-to-income ratio was the highest — in Florida, Nevada, California, Arizona, and Georgia — are the ones that not only suffered the sharpest drop in home prices but also have the highest proportion of homeowners currently underwater. In addition, these counties have shown the sharpest declines in auto sales and purchases of groceries and durable goods.

Although spending in levered counties as measured by sales-tax revenues has been recovering, Sufi said, it remains significantly below 2006 levels. These statistics contrast sharply with data from unlevered counties in states such as Texas, New York, Connecticut, Kansas, and Arkansas, where housing prices, auto sales, and purchases of durable goods also declined — but less severely. These counties are home to fewer households whose mortgages are underwater. And spending as measured by sales-tax revenue has returned to pre-recession levels. Although auto sales in both levered and unlevered counties are recovering, Sufi said, they remain about 40% below 2006 levels in the levered counties and down 20% in unlevered counties.

With regard to the impact of high leverage on employment, Sufi distinguished between nontradable and tradable employment. Nontradable employment refers to jobs catering to the local economy, such as restaurant, retail, and hotel jobs. Tradable employment refers to manufacturing jobs that produce goods for the national economy. During the recession, nontradable employment declined in both levered and unlevered counties as households reduced their spending on durable goods. The decline in levered counties, however, was much more severe. Although nontradable employment has increase since 2010, the gap between nontradable employment in levered and unlevered counties remains very large. Tradable employment also declined precipitiously across both types of counties but is recovering more quickly in unlevered counties (although it is still significantly below 2006 levels).

Understanding the Eurozone Crisis

The same framework can be applied to the eurozone crisis. In this model, the levereds are Portugal, Italy, Ireland, Greece, and Spain, collectively known as the PIIGS, and the unlevereds are mostly Northern European countries such as Denmark, Finland, and Germany.

Prior to 2007, the levereds ran large current account deficits as they financed their real estate and construction booms with debt. The unlevereds and their banks were all too happy to lend to the levereds since the latter used the funds to purchase goods and services that drove current account surpluses in unlevered countries and stimulated domestic economic growth.

When the music stopped in 2007, and asset prices (read: real estate prices) collapsed, it was the levereds that had no chairs — and a whole lot of IOUs.

Sofi demonstrated that a correlation exists between current account deficits, household debt-to-income ratios, and unemployment: Those countries that had the highest current account deficits prior to 2007 now have the highest unemployment rates, while those counties with the lowest household debt-to-income levels have the lowest current unemployment rates.

Unfortunately for Europe, Sufi finds that the aggregate demand and leverage problem in the eurozone is more intractable than in the United States for several key reasons, including the lack of an integrated fiscal policy and no Europe-wide deposit insurance, large productivity differences between countries, and the European Central Bank’s less aggressive use of monetary policy tools. Nonetheless, Sufi’s solution for addressing Europe’s economic woes is similar to the one he suggests for the United States: Simply put, the only way to solve the European debt crisis is to renegotiate the sovereign and private debt of the levered countries with losses borne by the unlevereds — that is, their mostly northern European bank creditors. “Bank bailouts” financed with local government debt are destined to fail, he contended, because they impose huge burdens on taxpayers in those countries and worsens economic decline.

Banks in northern European countries that loaned money to Spanish and Irish banks “need to step up to the plate,” Sufi said, by admitting that they made mistakes and — more importantly — by taking losses on their loans.


Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Michael McMillan, CFA

Michael McMillan, CFA, is director of ethics education at CFA Institute, where he is responsible for creating, sourcing, and developing educational content for CFA Institute members and investment professionals in the area of ethics and professional standards. Previously, he was a professor of accounting and finance at Johns Hopkins University’s Carey School of Business and George Washington University’s School of Business. Prior to his career in academia, McMillan was a securities analyst and portfolio manager at Bailard, Biehl, and Kaiser and at Merus Capital Management. He is a certified public accountant (CPA) and a chartered investment counselor (CIC). McMillan holds a BA from the University of Pennsylvania, an MBA from Stanford University, and a PhD in accounting and finance from George Washington University. Topical Expertise: Financial Statement Analysis · Standards, Ethics, and Regulations (SER)

2 thoughts on “What is Holding Back Economic Recovery in the Developed World?”

  1. Seems like a statement of the obvious – the more leveraged you are, the more you lose when things go down. Not sure what’s new here, other than perhaps explaining the obvious to Chicago economists.

  2. Duaa says:

    I believe the statement was about the behaviour of the levered and unlevered during the crisis. You are right about losing more when levered but you will lose more when unlevered behave the same. I think the explanation is convincing and worth studying it more.

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