Borrowing against the increase in home equity by existing homeowners was responsible for a significant fraction of the rise in US household leverage from 2002 to 2006 and the increase in defaults from 2006 to 2008. Instrumental variables estimation shows that homeowners extracted 25 cents for every dollar increase in home equity. Home equity–based borrowing was stronger for younger households and households with low credit scores. The evidence suggests that borrowed funds were used for real outlays. Home equity–based borrowing added $1.25 trillion in household debt from 2002 to 2008, and accounts for at least 39 percent of new defaults from 2006 to 2008. JEL: D14, R31

Crises and sharp economic downturns, while undesirable, provide economists with a unique opportunity to test and hone economic theory. Indeed, some of the most influential advance ments in economic thought, including Milton Friedman’s monetarist tradition, John Maynard Keynes’ fiscal theory, and Irving Fisher’s debtdeflation hypothesis, emerged from analysis of the Great Depression. The current economic malaise, which we refer to as “The Great Recession,” provides another watershed moment to reevaluate our core economic beliefs. However, in contrast to our peers in previous crises, we are fortunate to have access to large-scale microeconomic datasets and advancements in computational capacity. These advantages allow for a more rigorous analysis of the current recession and therefore a more informed understanding of its origins, propagation, and consequences. Our purpose is to highlight how a micro-level analysis of the Great Recession provides us with important clues to understand the origins of the crisis, the link between credit and asset prices, the feedback effect from asset prices to the real economy, and the role of household leverage in explaining the downturn. We hope that our discussion also serves as an example of the useful ness of incorporating microeconomic data and techniques in answering traditional macroeco nomic questions. I. What Were the Origins of the Credit Cycle: Credit Demand or Credit Supply?

We develop a tractable framework for deficit and debt dynamics. A “free lunch” fiscal deficit—one that raises spending without higher future taxes—is sustainable without zero lower bound (ZLB) only when R < G − φ, where φ is the sensitivity of the interest rate to the debt level. With the ZLB, both high and low deficits can increase debt, as the latter weaken demand and reduce nominal growth at the ZLB. A rise in income inequality expands fiscal space outside the ZLB, but contracts it at the ZLB. Calibrating the model, we find little space for “free lunch” policies for the United States in 2019, but significant space for Japan.

We examine the effects of constituents, special interests, and ideology on congressional voting on two of the most significant pieces of legislation in US economic history. Representatives whose constituents experience a sharp increase in mortgage defaults are more likely to support the Foreclosure Prevention Act, especially in competitive districts. Interestingly, representatives are more sensitive to defaults of their own-party constituents. Special interests in the form of higher campaign contributions from the financial industry increase the likelihood of supporting the Emergency Economic Stabilization Act. However, ideologically conservative representatives are less responsive to both constituent and special interests.

Dynamic Inefficiencies in Insurance Markets: Evidence from Long-Term Care Insurance by Amy Finkelstein, Kathleen McGarry and Amir Sufi. Published in volume 95, issue 2, pages 224-228 of American Economic Review, May 2005