Explaining the Rise of Unemployment

Weak household balance sheets and the resulting aggregate demand shock are the main reasons for historically high unemployment in the U.S. economy.

Unemployment rose dramatically during the Great Recession because highly indebted consumers slashed their spending, according to Atif Mian and Amir Sufi writing in What Explains High Unemployment? The Aggregate Demand Channel (NBER Working Paper No. 17830). They find that shocks to household balance sheets account for 4 million of the 6.2 million jobs lost in the United States between March 2007 and March 2009.

The stage was set for a substantial shock to household balance sheets during the housing bubble. Housing prices rose sharply, but homeowners borrowed even more aggressively. Between 2001 and 2007, household debt doubled from $7 trillion to $14 trillion. Homeowners' debt-to-GDP ratio rose sharply, from 0.7 to 1.0, during the same period. When housing prices collapsed, households were stuck with much higher debt, forcing them to cut back spending, which has shaped the depth and length of the economic slump that followed.

Earlier research by these authors and others had already demonstrated the link between dramatically weaker household balance sheets and plummeting consumer spending. In high-debt U.S. counties, housing prices fell by nearly 30 percent from 2006 to 2010. Households in those counties slashed consumption of durable goods and even cut back grocery spending. In the 10 percent of U.S. counties with the lowest debt-to-income ratios, house prices didn't fall and the fall in consumption wasn't as dramatic. Consumption of durable goods fell 20 percentage points more in high-debt counties than in low-debt counties.

The high-debt counties got that way, at least in part, because of the housing bubble. During the boom, housing prices didn't rise uniformly: the biggest increases came in counties with terrain or regulatory environments that made it more difficult to build new homes. In turn, homeowners in those counties were more apt to boost their debt to unprecedented levels. This finding is important not only because it explains the variability of debt, but also because it points out the absence of a construction boom and bust in many of the most indebted counties.

Mian and Sufi find that employment losses in the non-tradable sector were greater in the U.S. counties with the most highly indebted households than in other counties. In the tradable sector, however, employment losses were more uniform across the United States. The relationship between high debt-to-income ratios and the sharp decline in non-tradable goods purchases allows the authors to estimate the impact of shocks to balance sheets, and therefore on aggregate demand and on nation-wide employment.

"Our main insight is that the relation between demand shocks and employment losses in industries catering to local demand can be used to estimate the effect of aggregate demand on aggregate unemployment," the authors conclude. "We believe that weak household balance sheets and the resulting aggregate demand shock are the main reasons for historically high unemployment in the U.S. economy."

--Laurent Belsie