Can more effective management of household debt help foster equitable growth?

In the wake of the Great Recession, policymakers and economists alike need a better understanding of the implications of unfettered private debt. In the last three decades, household debt has expanded dramatically, while wages and income have remained stagnant. This debt, however, was not accumulated evenly across the income distribution.  Barry Cynamon of the Federal Reserve Bank of St. Louis and Steven Fazzari of Washington University in St. Louis show that the vast majority was concentrated among households in the bottom 95 percent of the income distribution.

This is not just a story about debt and inequality, but one with much greater consequences for overall economic stability. Amir Sufi at the University of Chicago and Atif Mian at Princeton University demonstrate that it was exactly this unequal distribution of household debt which helped spark the housing and finance crises that led to the Great Recession of 2007-2009. Between 2002 and 2005, mortgage debt and household income became negatively correlated, leading to expanded debt among those whose incomes were declining.

What happened next is familiar to us all: home foreclosures piled up, and those directly and indirectly affected by falling housing prices cut back sharply on spending. This drop in consumption was not evenly distributed. Sufi and Mian show that while national overall consumption fell by about five percent in the United States, the hardest-hit counties saw consumer spending drop by almost 20 percent. The vast majority of these counties were comprised of low-income homeowners whose wealth was almost entirely tied up in home equity.

In order to better understand the implications of these recent patterns in private consumption and debt accumulation, the Washington Center for Equitable Growth awarded one of its inaugural grants to Will Dobbie, assistant professor of economics at Princeton University. His grant proposal posits that research and evidence from the Great Depression of the 1930s shows that debt forgiveness can help mitigate the most severe effects of a deep recession, especially when targeted at the hardest hit regions. Despite the historical evidence on the efficacy of debt forgiveness as an effective policy lever, little is known about the modern-day effects of debt forgiveness on either the debtors themselves or the economy as a whole.

Dobbie will study the effects of debt forgiveness since 2001. First, he will explore the role of non-profit credit counseling agencies that offer debt management plans to help debtors fully repay their debt within three to five years after negotiating creditor concessions on interest rates and fees.  Second, he will look at for-profit debt settlement companies, which for a fee negotiate with a debtor’s creditors to settle the debt for a fraction of the balance. In both cases, Dobbie will examine the outcomes for debtors and their subsequent financial health, advancing our knowledge on the effectiveness of debt forgiveness programs. Identifying the best ways to reduce household debt may help policymakers advance programs targeted at those that need them most, especially lower income families.

More broadly, Dobbie’s research will help policymakers understand the implications of personal debt accumulation for an individual’s financial health, and the health of the overall economy. Household debt was a primary cause of the Great Recession and recent research suggests that the unequal debt overhang among homeowners is one reason that subsequent economic growth has remained tepid. Developing a better understanding of the effects of individual debt forgiveness could provide an additional tool to prevent future recessions and encourage more robust growth.