A new working paper discusses the importance of household debt in the overall cycle of the economy.

In the wake of the Great Recession, it was clear that policymakers and economists alike needed to pay more attention to household debt. The dramatic rise in household debt prior to the recession was, to some at the time and everyone in hindsight, a dangerous sign for the U.S. economy. A decade after the recession began, two economists have pulled together research on household credit and spending to get a better understanding of the forces that drive both expansions and recessions.

Economists Atif Mian of Princeton University and Amir Sufi of the University of Chicago recently released a working paper pulling together the evidence for what they call the “credit-driven household demand channel.” In the paper, Mian and Sufi present the case for the importance of changes in the flow of credit to households in understanding the overall cycle of the economy. The Great Recession is a particularly powerful example of this channel, but the two economists show that the channel played out in Europe and in the United States during the 1980s and 1990s, as well as in the first decade of the 21st century.

Mian and Sufi lay out three “pillars” for the channel. The first is that the expansion of credit to households is due to forces unrelated to changes in technological growth or income growth for households. In other words, the expansion in credit comes from lenders being more willing to lend out money to households, but has nothing to do with their expectations of higher overall economic growth or individual incomes. So, why do lenders increase the supply of credit in these cases? The research isn’t definitive yet, but Mian and Sufi point toward the “global savings glut” and higher economic inequality within the United States as the “financial excesses” that lead to more saving and then more lending.

The second pillar relates to “household demand.” Credit could expand, but its impact on demand and the business cycle depends on where that credit ultimately flows. If it ends up going toward businesses, then that might spur investment and increase productivity growth and the long-run potential of the economy. But what Mian and Sufi, along with their co-authors, find is that in high-income countries, the credit doesn’t go to business but rather to households. The result is that households increase their demand, boosting housing prices, inflation, wages, and employment in nontradable industries such as construction. The credit-driven boost in household demand creates an economic boom.

The researchers’ third pillar holds that household a credit-and demand-driven boom creates the conditions that will make the inevitable recession particularly painful. Once credit starts drying up, the increased indebtedness of households means that consumption in the economy drops dramatically. The higher wages in the nontradeable sector (such as construction) make it harder for the labor market to adjust to this reduced amount of demand. The severity of and potential response to the recession is due to the forces that created the boom before it. In this way, the credit-driven household demand channel means economists and policymakers have to consider both the expansion and the recession together.

What would paying attention to this new channel entail for policy? First, policymakers should be vigilant about increases in household debt. Large increases in household debt, particularly over a short period of time, appear to be a good indicator of a looming recession and a nasty recession. Secondly, a breakdown in the channel may explain why the very low interest rates since the Great Recession haven’t been as stimulative as many expected. If the previous boom was due to credit-driven demand and households are still trying to recover from the last run up in household debt or if the financial sector isn’t as willing to lend, then trying to use credit to boost demand might not be so effective.

The Great Recession revived interest in the sources of fluctuations in the economy. In this new paper, Mian and Sufi present a new approach to this question that puts households and credit at the heart of the story. It’s a story well worth paying attention to.