Piling on household debt also causes crashes

Six years after Lehmans, and the mainstream view remains that it was the banks that done it. While the behavior of some banks -- especially the large ones that ended up bust -- was certainly a contributory factor, it is simplistic to think that this was the only, or even the main, cause of the economic meltdown.

If we are to learn lessons from that financial crisis, it's important to understand how our own behavior – collectively, of course – was also a causal factor.

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As the crisis progressed, there were economy-wide recessions in a number of countries that led to large-scale losses by banks. The real-estate bubbles in Ireland, the U.K. and Spain, for example, were a big driver.

Of course, you could say that bad lending decisions by banks exposed them to greater risk. And econometricians will have a hard time proving which was the tail and which was the dog: the banks or the housing market. But it's worth examining how personal finances make a bad situation worse.

On both sides of the Atlantic, a stand-out feature of this crash was the long time taken by economies to come out of recession. In previous downturns, starting with 1929 but also 1980-81 and (in the U.K.) 1990-91, the return to recovery was much quicker – within 12 months. However, six years on from the latest crisis and we are still not in recovery mode in some parts of the euro zone (although the euro itself is a factor here). Why the sluggish performance?

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The bull market during 2002-2008 didn't just affect banks' mindsets. Individual households were also swept up, and in several countries household debt rose every year during that period. It seemed everyone wanted to get involved. Once the crash occurred, the real problem was that this excessive personal debt became a drag on any further spending and hence output overall was affected. At the small business level, the picture was the same – in the US lending to small and medium-sized businesses was still rising in 2008 even while banks' cost of funding was blowing out due to Lehmans.

Personal debt levels are a significant factor in any recession because, once the downturn strikes, individuals look to pay down debt as the prospect of unemployment, loss of orders and the like increases. So as households rein in spending and stop borrowing, a bad situation is made worse and economic output fails to recover. The banks were heavily criticized for not doing enough to boost small business lending. But, to be fair to them, the demand just wasn't there: individuals and SMEs were in no mood to borrow more money in the environment prevailing in 2009-2012.

Banks like the U.K. lender Northern Rock were quite rightly vilified for making available 100 percent loan-to-value mortgages, and the yet more risible 125LTV loan, but no-one is forced to borrow under such terms.

We have to look at ourselves too.

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Now of course, we've turned the corner haven't we? The U.K. housing sector, especially in London and the South East, looks like it's already overheating, the Bank of England has commented on it and the government's need to subsidize house purchases for first-time buyers (when will they ever learn?) and we may well be only another five-six years away from the next crash.

When it comes to learning lessons, the best place to start is at home.

Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking(John Wiley & Sons 2012).