American consumption habits could lead to an economic downturn as large as the recession in the early 1980s, according to a paper recently released by a Washington University alumnus and an economics faculty member.
The study, co-authored by Professor of Economics Steven Fazzari and Barry Cynamon, who graduated from the University in 2005 with a major in economics, said that the rise in household spending relative to income over the past 25 years has skyrocketed household debt. Fazzari said that debt spending by households has been a large contributor to the long-term economic stability and growth of the past 25 years. However, the large nature of the increase in debt, they wrote, could lead to greater financial fragility and a downturn in consumption strong enough to cause a significant recession.
Cynamon, who is pursuing a Ph.D. at the University of Chicago Graduate School of Business, was out of the country and unable to be reached for comment.
In the study, Fazzari and Cynamon examined the consumption patterns of American households over the past 25 years.
According to the study, one of the causes of the increase in household debt is the influence of media and the influence of friends and family on the spending habits of households.
According to Fazzari, people feel more inclined to make certain financial choices, such as debt spending, when people they know are doing the same thing.
“It’s more of a sense of, ‘Well I can do this. My neighbors are doing this, it’s pretty easy, I don’t really know what the future is going to bring, but everyone else seems to be doing it, so why am I not doing it?’ ” said Fazzari.
Other factors contributing to the debt increase are institutional changes like the Tax Reform Act of 1986, which eliminated tax deductions on all loans except for home mortgage loans. Home equity lines of credit (HELOC), which allow homeowners to take out loans using their houses as collateral, became a popular and easy way to acquire financing with tax-deductible interest.
According to Fazzari, that act, combined with the steady drop in home mortgage interest rates since the early 1980s, made it easier than ever for consumers to acquire home loans for various spending purposes.
But now, with the recent sub-prime mortgage crisis, in which rising interest rates have led to record levels of foreclosure in the United States, Fazzari and Cynamon worry that trouble is ahead for home mortgages, the interest rates for which have generally tumbled since the early 1980s.
“Mortgage rates got very low, so low that it’s hard to imagine that they could get that low ever again,” said Fazzari. “As interest rates fell during economic weakness, people could refinance at lower interest rates, take cash out or at least lower their interest payments. But we may have run the course on that.”
With home mortgage interest rates potentially having bottomed out and household debt having piled up, Fazzari said that financial fragility is now so high that any sudden spikes in interest rates or problems in home or mortgage finance could lead to financial troubles for households and huge drops in household consumption.
Fazzari emphasized that there is a realistic risk that this type of economic downturn could happen. With household consumption comprising 70 percent of gross domestic product, were a downturn to happen, it could mean a recession larger than any since the early 1980s recession, in which unemployment reached a post-World War II high of 10.8 percent. Fazzari did speculate that such a recession could feature a decrease in gross domestic product over several quarters and unemployment as high as eight or nine percent.
The paper’s analysis was qualitative and historical, but not quantitative; therefore it could not offer a precise prediction of the economy’s future. Fazzari described the study as more of a “historical narrative” and said that a quantitative treatment of the subject would be a good topic for future research.
“We’re careful to support [the paper] not so much with formal statistical tests as with observations on the economic events of the last 25 years,” said Fazzari.