For most of the past decade, I’ve been arguing that people have underestimated the role of falling nominal GDP in the financial crisis of 2008, and that falling NGDP was almost completely to blame for the Great Recession itself. Now it looks like I might have been one of those people who underestimated the role of falling NGDP. Ben Southwood sent me a very interesting NBER paper by Stefania Albanesi, Giacomo De Giorgi, and Jaromir Nosal, which argues that the financial crisis was not caused by a surge in subprime lending. Here’s the abstract:

A broadly accepted view contends that the 2007-09 financial crisis in the U.S. was caused by an expansion in the supply of credit to subprime borrowers during the 2001- 2006 credit boom, leading to the spike in defaults and foreclosures that sparked the crisis. We use a large administrative panel of credit file data to examine the evolution of household debt and defaults between 1999 and 2013. Our findings suggest an alternative narrative that challenges the large role of subprime credit in the crisis. We show that credit growth between 2001 and 2007 was concentrated in the prime segment, and debt to high risk borrowers was virtually constant for all debt categories during this period. The rise in mortgage defaults during the crisis was concentrated in the middle of the credit score distribution, and mostly attributable to real estate investors. We argue that previous analyses confounded life cycle debt demand of borrowers who were young at the start of the boom with an expansion in credit supply over that period.

I had previously bought into the conventional wisdom on subprime loans. And here’s how their study differed from previous work in this area:

Mian and Sufi (2009) and Mian and Sufi (2016) identify subprime individuals based on their credit score in 1996 and 1997, respectively. We show that, since low credit score individuals at any time are disproportionally young, this approach confounds an expansion of the supply of credit with the life cycle demand for credit of borrowers who were young at the start of the boom. To avoid this pitfall, our approach is based on ranking individuals by a recent lagged credit score, following industry practices. This prevents joint endogeneity of credit scores with borrowing and delinquency behavior but ensures that the ranking best reflects the borrower’s likely ability to repay debt at the time of borrowing. Our analysis shows that income growth and debt growth are positively related during the credit boom for individual borrowers.

This finding is especially important for the work of Kevin Erdmann. It’s looking more and more like Kevin got the housing crisis right before anyone else. I eagerly await the publication of the book that he is working on.

PS. The fact that the crisis doesn’t seem to have been caused by a surge in risky lending does not mean that our financial system is fine. The system is still riddled with moral hazard, which creates a bias toward excessive debt. It’s just that this problem doesn’t seem to have gotten worse in the lead up to the Great Recession. Something else is to blame—presumably tight money (i.e. falling NGDP)

PPS. I’m sure that people will contest this study—it will be interesting to see how the debate plays out. The stylized facts do seem to point to a surge in subprime lending:

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