Douglas Foster

Govt 490
Final Paper
3-26-15

The borrower is always the slave to the lender. This sentence, roughly taken
from the book of Proverbs in the Bible, was drilled into my head by my grandparents as
I grew up. I was taught that debt was bad, something to be avoided. The negative
effects of debt were recently showcased during the financial crisis that began in 2008
and the subsequent recession. My paper will show that excessively high consumer
debt-to-income ratios result in financial crises and recessions.
The paper will first explain the history and causes of the growth of consumer debt
in the economy. The paper will then cover the effects of high levels of consumer debt on
the economy. The paper will use the example of the 2008 financial crisis to illustrate the
points being made. The paper will conclude by exploring policy implications of the
findings of the paper.
The paper fits into the larger study of the 2008 financial crisis by trying to tie
together the research of many others and to show that debt driven consumption does
not lead to long-term, sustainable growth. This paper contends that borrowers need to
be more responsible with their borrowing, and lenders need to have balance in the type
of lending that they do and not go too far overweight into a single form of lending.The
government also has a role to play in preventing excessive lending and borrowing,
rather than promoting and subsidizing the issuance of new consumer debt.

Increases in debt levels have many causes that come from many different
sources. No single source or cause is fully responsible for debt to income ratios rising to
unsustainable levels. All of the sources and causes work together to create a fragile
financial situation that eventually leads to a collapse. The government, private financial
institutions and businesses, and individual consumers all have a role to play in debt
driven recessions.
Individual consumers make the decision to take out debt, and therefor bear some
responsibility in consumer debt levels rising to unsustainable levels. The decision to
take out debt is not simply a mark of irresponsibility by individuals in the economy
though, there are many factors that lead individuals to take out debt. Increasing
household debt is partly caused by wage stagnation and falling incomes.1 Other causes
of increased levels of household debt are income inequality and increased
consumption. The people on the high end of the income scale set the consumption
patterns for all consumers in the economy. Everyones efforts to consume on the same
level as the richest in society leads to inflation of prices for everyday goods. When
peoples wages do not cover their consumption patterns, they are forced to turn to
alternatives to wage income. The alternative to wages that is used is debt.2 This
substitution occurs on a large scale and causes an explosion in consumer debt.3 This

Weller, Christian, Unburdening Americas Middle Class, Challenge, 55:1 (2012), p. 35, http://
dx.doi.org/10.2753/0577-5132550102.
2

Guttmann, Robert & Plihon, Dominique, Consumer Debt and Financial Fragility, International
Review of Applied Economics, 24:3, (2010), p.272, DOI: 10.1080/02692171003701420
3

Mian, Atif & Sufi, Amir. The Great Recession: Lessons from Microeconomic Data.
The American Economic Review, Vol. 100, No. 2, PAPERS AND PROCEEDINGS OF THE One
Hundred Twenty Second Annual Meeting OF THE AMERICAN ECONOMIC ASSOCIATION
(May 2010), p. 51, http://www.jstor.org/stable/27804962

chain of events comes from somethings that individuals can control, like consumption
patterns, and somethings that they can not control, like wage stagnation. There is some
responsibility that can be placed on consumers for their actions, but not all responsibility
can be laid on this single group.
Private financial institutions and businesses also bear some responsibility for
consumer debt levels rising to unsustainable levels. Businesses tend to shed some of
their debt burden during boom times so that they maintain healthy debt levels.4 When
this happens, financial institutions need to replace the income that previously came from
business loans. Banks turn to consumer lending to take the place of business loans.5
The conditions for wage stagnation are created when the imbalance between business
lending and consumer lending becomes too great.6 The stagnating wages are one of
the factors that lead consumers to expand their debt burden. The loss of business
lending is not the only reason that banks have increased the consumer lending aspect
of their businesses. Securitization has given banks an incentive to increase consumer
lending significantly.7 Data taken from the lead up to the 2008 financial crisis has shown
that an increase in securitization preceded the credit boom.8 Banks ended up increasing

Gutmann and Pilhon. p. 270

Moseley, Fred, The U. S. Economic Crisis, International Journal of Political Economy, 40:3
(2011), p. 64, http://dx.doi.org/10.2753/IJP0891-1916400305.
6

Hyman, Louis, The Debt Bomb, Wilson Quarterly, Vol.36 No.1 (Winter 2012), p. 51, http://
www.jstor.org/stable/41484426.
7

Hyman, Louis, The Politics of Consumer Debt: U.S. State Policy and the Rise of Investment in
Consumer Credit, Annals of American Academy, 644, (November 2012) p. 48, DOI:
10.1177/0002716212452721.
8

Mian and Sufi. (May 2010). p. 52

their investment in mortgage backed securities at the expense of business investment.9

Banks and businesses have to shoulder some of the blame for the financial crisis in
2008 and the subsequent recession, but they do not hold all the blame for the
development of a financial system that was heavily based on consumer debt and did not
invest in businesses enough.
Government policy bears some responsibility for the massive, unsustainable
consumer debt burden. Government subsidies and guarantees have helped drive the
expansion of credit.10 The governments efforts to drive consumption started during the
Great Depression. The FHA was created to increase the availability of credit to home
buyers. The FHA increased the amount of credit available to lend by creating a national
market for mortgages that were resold through the Federal National Mortgage
Association, or Fannie Mae. Fannie Mae sold mortgages to large national financial
institutions and by doing so made their capital available to local mortgage markets.11
They incite investors to buy mortgages by guaranteeing some of the mortgages in case
of default and lowering the risk that was involved in the investments.12 The government
continued driving financial innovation in the 1960s when they created the asset backed
securities market. This market was created in an effort to bring the prosperity of the
suburbs into the inner city. The policy makers did not consider at the time that the
consumption and prosperity of the suburbs was actually a product of good jobs, and not

Hyman (November 2012). p. 46

10Mian
11
12

and Sufi. (May 2010). p. 55

Hyman (November 2012). p. 42-43

Rothoff, K.W. The Incentives Leading Up to the 2008 Financial Crisis. International Journal
of Trade and Global Markets. Vol. 4 No. 4 (2011). p. 346 DOI: 10.1504/IJTGM.2011.042860

a product of the easy credit.13 Government policies continued to drive the financial
markets through the 1990s and 2000s. The government set a goal of having 52% of
mortgages backed by Fannie Mae and Freddie Mac to be from home buyers that were
below the median level of income. This created the move toward subprime loans.
Fannie and Freddie refused to back mortgages issued by firms that did not participate in
the subprime market. This compelled all of the mortgage issuers to start loaning to
subprime home buyers in order to maintain the guarantees on their mortgages that
came from Fannie Mae and Freddie Mac.14 The government has had a hand in all of the
events that led up to the 2008 crisis. The incentives made to increase lending and
consumption played a large role in the over indebtedness of the consumers that led to
the crisis.
The unsustainable growth of consumer debt in the United States prior to the
2008 financial crisis is the responsibility of all of the actors involved in the process.
Some of the actions were voluntary in an effort to make more money, achieve political
ends, or to have a better lifestyle. Some of the actions were done because there was no
other option. All of the actions done by the actors involved combined to create a serious
crisis and recession.
The effects of high levels of consumer debt extend throughout the economy. High
levels of consumer debt does provide a short term bump to the economy, but lays the
groundwork for a recession. Consumers are able to consume at a rate that is beyond
their income. After the bump in consumption, there is a deleveraging process that

13

Hyman (November 2012). pp. 44-45

14

Rothoff. p. 350

occurs. This deleveraging leads to less consumption by consumers and less production
by businesses. The drop in output for the economy creates a recession.
High levels of consumer debt help to lay the groundwork for a recession.
Financial crises are almost always preceded by a sharp rise in leverage and debt based
financing.15 Eight of the past ten recessions were preceded by problems in debt
dependent industries.16 This shows that unsustainable levels of debt are a precursor to
recession. High levels of consumer debt also cause less investment in businesses.17
High levels of consumer debt issued by banks makes the banks more vulnerable to
collapse.18 Failed business loans correlate to bank failures more than business loans.19
These negative effects all precede the high profile event of the recession, but they are
all instrumental in the occurrence of a recession.
Consumer debt helps to provide a short term boost to consumption in the
economy. A bubble is caused by the unsustainable debt to income ratios.20 The GNP of
a country goes up initially as the new borrowing occurs. After this initial boost, the debt

15

Mian and Sufi. (May 2010). p.51

16

Mian, Atif & Sufi, Amir, Household Leverage and the Recession of 2007-09, IMF Economic
Review. Vol. 58, No. 1 (2010), p. 78, http://www.jstor.org/stable/25762071
17

Weller. p. 24

18

Moseley. p. 64

19

Stein, Jerome, US Financial Debt Crisis: A Stochastic Optimal Control Approach. Review of
Economics, Bd. 62, H. 3 (2011), p. 198, http://www.jstor.org/stable/41330838
20

ibid. p. 197

servicing burden increases when the loans have to be repaid. A countrys GNP goes
down at this point.21 The bubble pops and deleveraging occurs.
Deleveraging is the process of reducing the debt burden that is held by an
individual or entity. When debt levels get too high, a deleveraging process is inevitable.
The process is painful economically. When debt cycles into the repayment phase,
consumption drops.22 The drop in consumption during the repayment phase also results
in a lower standard of living for the individuals who have the debt burdens.23 The growth
of mortgage debt correlates negatively to income growth.24 This has problematic
implications for the lenders ability to repay their debts.
The deleveraging process moves into a systemic crisis when debtors cannot pay
their obligations. This happens in the mortgage market when the capital gain on the
house falls below the interest rate paid to service the debt. When households cannot
service their debt, as happened in 2008, the system collapses.25
The deleveraging process also has implications for businesses as well. High
levels of household debt has negatively effected the output of the economy at all times
in the United States since the 1980s when the economy shifted from a production based

21

Kim, Yun K., Household Debt, Financialization, and Macroeconomic Performance in the
United States, 1951-2009, Journal of Post Keynesian Economics, 35:4 (2013), pp. 677-678,
http://dx.doi.org/10.2753/PKE0160-3477350408.
22

Backman, Jules, Are We Too Deep in Debt? Challenge, Vol. 4, No. 1 (October 1955), p. 13,
http://www.jstor.org/stable/40717001.
23

Scott, Robert and Steven Pressman. Household Debt and Income Distribution. Journal of
Economic Issues. Vol. 47 no. 2 (June 2013) p. 324. DOI 10.2753/JEI0021-3624470204
24

Mian and Sufi. (May 2010). p. 52

25

Stein. p. 199-201

model to a financial services based model.26 The fall in consumption that happens
during the deleveraging causes businesses to invest less in production.27 The lack of
investment in production and consumption causes negative effects for employment as
well.28
Excessive levels of consumer debt also has negative effects for the recovery
from recessions. The deleveraging process makes less credit available from banks for
any purpose.29 When levels of consumer debt are higher, the process of deleveraging
takes longer to complete, so the negative effects of the process linger.30 Less money
available for consumption and investment leads to slower growth. Lower productivity
leads to less jobs available for people to earn the wages necessary to consume at
higher levels. The cycle continues until consumers are fully deleveraged and no longer
crushed by the burden of their debt.
Deleveraging is a necessary process after a massive expansion of debt. The
deleveraging of consumers causes a large amount of economic pain. The shockwaves
of consumers deleveraging expand through the entire financial system, and put the
economy into a recession that is very difficult to recover from.

26

Kim. p. 689

27

Weller. p. 37

28

Mian, Atif & Sufi, Amir, Household Balance Sheets, Aggregate Demand and Unemployment,
The Pakistan Development Review, Vol. 50, No. 4, Papers and Proceedings PARTS I and II The
27th Annual General Meeting and Conference of the Pakistan Society of Development
Economists Islamabad, December 13 - 15, 2011 (Winter 2011), p. 292, http://www.jstor.org/
stable/27804962
29

Guttmann and Pilhon. p. 281

30

Weller. p. 25

The 2008 financial crisis is the most recent example of the negative effects of
high levels of consumer debt. The crisis started in the mortgage market and spread to
the entire economy. This portion of the paper will describe how excessive levels of
consumer debt contributed to the crisis.
The economic expansion of the 2000s relied on consumer debt as its main
driver.31 Financial innovation and deregulation led to an increase in home based debt
during the boom. Low interest rates through the period led investors to seek higher
yields through mortgage backed securities. This increased the securitization of
consumer debt and the proliferation of many different financial vehicles. Global trade
imbalances led the countries that had excess capital to invest in the American mortgage
market, and tied the entire world to the ability of the American consumers to pay their
mortgages.32 The stage was set for a global crisis to erupt as soon as there was a
shock in the United States mortgage market. The deleveraging process that was
described in the previous section of this paper began occurring and the crisis began.
The crisis hit some areas of the country harder than others. Counties in the
United States that had a higher level of growth in household leverage had longer and
more severe recessions than counties that did not experience the same high growth in
indebtedness. These counties also experienced a high level of borrowing form credit
cards at the start of the recession as consumers attempted to maintain their lifestyles.
High levels of growth in household indebtedness can explain many of the negative
visible negative effects of the recession. Household defaults, falling home prices, and

31

ibid p. 36

32

Gutmann and Pilhon. pp. 273-275

falling auto sales were far more common in the counties that had higher levels of
household leverage and credit card borrowing at the start of the recession.33 This
example shows how strongly household debt levels correlate to recessions.
This paper has focused on the negative effects of household debt, but there are
positive aspects to it as well. Credit availability allows people to buy durable goods that
are very expensive without dropping their consumption levels for years beforehand.
Credit allows people to consume more and to stimulate companies to produce more.
Companies hire more people to expand production. The jobs created allow more people
to consume and the consumption starts a cycle of employment. Debt can benefit society
when it is used in moderation, but recessions occur when the levels of debt rise too
much.
This paper has implications for individuals, private financial institutions, and
government policy. All three have a role to play in consumer debt driven recessions, and
all three can change their behavior to help prevent the conditions that lead to
recessions.
Individuals are the ones who take on the debt, and behavior changes by them
can go a long way toward preventing a financial crisis like the one seen in 2008.
Consumers need to adjust their consumption patterns to their current financial situation.
There are many times when credit is used for items that are necessary, but there are
other times when it is used frivolously. Responsible use of credit and maintaining a
healthy debt to income ratio can go a long way to preventing financial crises and
shortening the recessions that follow the crises.

33

Mian and Sufi. (2010). pp. 75-102

Financial institutions issue debt, and need to change some behaviors as well.
Bank lending patterns help to create the conditions that lead people to over
indebtedness. Banks need to diversify their lending more so that they are not so
exposed to consumer debt. The fragility that overexposure to consumer debt gives to
banks is a serious problem that needs to be addressed. Business lending is safer for
the banks and has positive economic implications.
The government also needs to reform its behavior in regards to consumer debt.
Policy makers need to put less emphasis on debt as a way to prosperity and more
emphasis on access to good jobs. Government policy supported an unsustainable
growth in consumer lending for too long in the hopes that it would reduce inequality.
Debt is not a replacement for wages. The government also needs to end the efforts to
engineer the markets to meet government goals. This ended in disaster in the case of
subprime mortgages and should not be tried again.
There is more research to be done on this topic. There is no accepted ideal ratio
of debt to income for consumers. An explicit number would go a long way to inform
consumers of how much debt they can take on safely, and allow for a sustainable debt
market to grow that does not have the serious risks that consumer debt markets contain
at this time.
This paper has shown who brought the debt driven economy into being, what the
effects of an economy reliant on consumer debt are, and has given an example of the
catastrophe that can occur when consumer debt gets out of control. The final conclusion
of this paper is that excessive consumer debt drives recessions. Consumer debt, like
many other things in this world, is good in moderation. When debt is overused, it can

become a millstone around the neck of the economy and drag everybody down into
recession. Many efforts need to be made, from many different angles, to ensure that
consumer debt does not get out of control as it did in 2008.

Bibliography
Backman, Jules, Are We Too Deep in Debt? Challenge, Vol. 4, No. 1 (October 1955),
pp. 11-15, http://www.jstor.org/stable/40717001.
Guttmann, Robert & Plihon, Dominique, Consumer Debt and Financial Fragility,
International Review of Applied Economics, 24:3, (2010), pp. 269-283, DOI:
10.1080/02692171003701420
Hyman, Louis, The Debt Bomb, Wilson Quarterly, Vol.36 No.1 (Winter 2012), pp.
44-51, http://www.jstor.org/stable/41484426.
Hyman, Louis, The Politics of Consumer Debt: U.S. State Policy and the Rise of
Investment in Consumer Credit, Annals of American Academy, 644, (November
2012) pp. 40-49, DOI: 10.1177/0002716212452721.
Kim, Yun K., Household Debt, Financialization, and Macroeconomic Performance in
the United States, 1951-2009, Journal of Post Keynesian Economics, 35:4
(2013), pp. 675-694, http://dx.doi.org/10.2753/PKE0160-3477350408.
Mian, Atif & Sufi, Amir, Household Leverage and the Recession of 2007-09, IMF
Economic Review. Vol. 58, No. 1 (2010), pp. 74-117,
http://www.jstor.org/stable/25762071
Mian, Atif & Sufi, Amir. The Great Recession: Lessons from Microeconomic Data.
The American Economic Review, Vol. 100, No. 2, PAPERS AND
PROCEEDINGS OF THE One Hundred Twenty Second Annual Meeting OF THE
AMERICAN ECONOMIC ASSOCIATION (May 2010), pp. 51-56, http://
www.jstor.org/stable/27804962
Mian, Atif & Sufi, Amir, Household Balance Sheets, Aggregate Demand and
Unemployment, The Pakistan Development Review, Vol. 50, No. 4, Papers and
Proceedings PARTS I and II The 27th Annual General Meeting and Conference
of the Pakistan Society of Development Economists Islamabad, December 13 15, 2011 (Winter 2011), pp. 285-294, http://www.jstor.org/stable/27804962
Rothoff, K.W. The Incentives Leading Up to the 2008 Financial Crisis. International Journal of
Trade and Global Markets. Vol. 4 No. 4 (2011). pp. 343-349 DOI: 10.1504/IJTGM.
2011.042860
Scott, Robert and Steven Pressman. Household Debt and Income Distribution. Journal of
Economic Issues. Vol. 47 no. 2 (June 2013) pp. 323-331. DOI 10.2753/
JEI0021-3624470204
Stein, Jerome, US Financial Debt Crisis: A Stochastic Optimal Control Approach.
Review of Economics, Bd. 62, H. 3 (2011), pp. 197-217,

http://www.jstor.org/stable/41330838

Weller, Christian, Unburdening Americas Middle Class, Challenge, 55:1 (2012), 23-52,
http://dx.doi.org/10.2753/0577-5132550102.