The Wealth Effect View of the Great Recession: A Behavioral Macroeconomic Model with Occasional Financial Fire Sales

Abstract

Mian et al. (2013, 2014) document that collapsing household net worth significantly and negatively affected employment via consumer spending between 2007 and 2009. To rationalize the underlying transmission mechanism, the popular household leverage view has emphasized tightening consumer credit constraints, which generate the desired consumer response mechanically. This view has recently been challenged as tightening consumer credit can realistically only ac- count for the observed slow recovery of the US economy, but not the abrupt and deep nature of the initial downturn — the Great Recession — itself. This paper thus offers an alternative explanation of the Great Recession, namely that the observed contraction in aggregate demand was mainly driven by households who responded to the 2008 Financial Crisis by voluntarily substituting away from consumption towards savings in the spirit of a classic wealth effect. The primary policy implication of this wealth effect view is that fiscal stimulus may be less effective in combating financial crises than would be implied by the household leverage view.