Balance Sheet Crises and Housing: Definition and Occurrence

In the United States, balance sheet crises have occurred as a consequence of a decline in housing market values against fixed mortgage debt. Many household balance sheets are thereby plunged into negative equity, and the lenders suffer parallel balance sheet damage as the underlying value of their mortgage loans declines in step with house prices. Under these conditions, households have strong precautionary incentives to reduce their expenditures and banks to reduce their lending as both sectors seek to rebuild their lost equity and avoid incurring new risks. Although this net-debt-reduction process increases the availability of funds for investment, those channels are simultaneously experiencing expectations of declining returns to new investment opportunities and falling interest rates, even in advance of policy shifts toward monetary ease.

Fortunately, such crises are rare, having occurred in the United States only twice in seventy-eight years – the downturn in 1929 and again in 2008 – culminating in the Great Depression and the Great Recession. Both episodes were preceded by three-year substantial declines in new housing expenditures in 1927–1929 and again in 2006–2008. Perhaps because of their rarity, they are not part of standard macroeconomic or general microeconomic equilibrium models; neither are they part of conventional thinking in monetary and fiscal policy.