Three economists writing for the Federal Reserve Bank of San Francisco's Economic Letter, are theorizing that the explosion of lending, especially mortgage lending, has played a more important role in shaping the business cycle that previously thought.  If they are correct, they say, then economic policy must adapt to this reality.

In their paper, "Mortgaging the Future?" the three, Oscar Jordà vice president in the Economic Research Department of the Bank, Moritz Schularick, professor of economics at the University of Bonn; and Alan M. Taylor professor of economics and finance at the University of California, Davis say that bank lending has quadrupled as a ratio to GDP in advanced economies since World War II.  This lending has been driven to a large extent by the growth in mortgage loans which has in turn allowed households to leverage up.  This "Great Mortgaging" as they call it has also fundamentally changed the nature of traditional banking and profoundly influenced the dynamics of business cycles.

Leverage is risky in that it can multiply small gains and losses into extraordinary ones, for better or worse.  From the mid-1980s until the Great Recession a large decline in inflation and output volatility overshadowed the rapid increase in leverage.  But under what appeared to be calm and moderation leverage continued to build until it erupted along financial fault lines in 2008.  The aftershocks of that global crisis continue even today.

The three look at the channels through which economies have increased lending and the consequences the leverage has had.  The run-up in credit-to-GDP ratios, which stood at about 30 percent in 1945, reached 120 percent just before the 2008 crash and research by Schularick and Taylor found that it was shaped by a boom in mortgage lending.  However the current paper reveals "the outsize role that mortgage lending has played in shaping the pace of recoveries, whether in financial crises or not, is a factor that has been underappreciated until now."

The share of mortgage loans in banks' total lending portfolios averaged across 17 advanced economies including the United States has roughly doubled over the past century-from about 30% in 1900 to about 60% in 2014 but the most dramatic increase occurred since the mid-1980s.

The three liken the core business model of banks today to that of real estate funds in that banks borrow short-term funds to invest in long-term assets linked to real estate.  The maturity mismatch between assets and liabilities increase the fragility of bank balance sheets. While this has helped to drive a wave of mortgage securitization in some countries over the last three decades the bulk of loans remain on bank balance sheets.  Business investment constitutes a much smaller share of banking business today than in the 19^th and early 20^th centuries.

The rise of mortgage lending appears to reflect an increase in leverage rather than in real estate values in many countries including the US.  These high leverage ratios, which Figure 2 shows have nearly quadrupled in the last 105 years, can damage household balance sheets and therefore the overall financial system.

In this country the authors place responsibility for the rise in mortgage lending primarily on the government with large scale interventions into housing markets after the Great Depression.  Some, such as Glass Steagall were designed to control high-risk finance but other policies such as the creation of the Federal Home Loan System, FHA, and Fannie Mae were intended to make basic forms of finance more accessible to the general public.

These interventions intensified during and after WWII with the GI Bill, VA guaranteed loans, and growth in popularity of FHA loans.  Aided by such policies and programs, American homeownership increased from 40% in the 1930s to nearly 70% by 2005, one of the highest rates in the developed world.

So, has the postwar democratization of leverage affected the larger economy?  The authors point to studies that cite debt overhang as a possible cause for slow recoveries from financial crises and say that their own new data "open the door to a new intriguing question: Are all forms of bank lending-particularly mortgage lending-equally relevant in understanding these business cycle dynamics?"  To answer that they used data on 17 advanced economies since 1870, capturing about 200 different recessions, one-quarter of which are linked to a financial crisis.

In retrospective analysis it can be difficult to separate cause and effect, they say, so in examining the effect of bank lending on business cycle dynamics they first used the arrow of time to consider the effect of lending during an expansion on the subsequent recession; that is the future cannot cause the past. Second, they incorporated methods to minimize other factors that might confuse the story.

The two panels in Figure 3 split the data into the pre- and post-WWII periods and for each panel the real GDP per capita is set to 100 at the start of a recession; its evolution in cumulative percent deviations is traced from this point. In the control scenario, shown by the solid lines, both mortgage and nonmortgage lending are set at the average historical levels observed in the expansion. Two alternative scenarios are then considered.  One compares the evolution of GDP per capita if nonmortgage lending in the expansion had grown one standard deviation above average, shown by the dotted lines. In the other scenario, mortgage lending in the expansion is allowed to grow one standard deviation above average instead, shown by the dashed lines. Recessions that are linked to financial crises (shown in red) are separated from those that are not (shown in blue) to avoid conflating the special conditions typical of financial crises. The gray shading shows a 95% confidence region only around the solid blue line for normal recessions to avoid complicating the figure.

The authors say this figure confirms several well-known results and provides some new ones. First, recessions associated with financial crises are deeper and last longer, no matter when they occurred.  Second, it was harder to recover from any type of recession in the pre-WWII era than later. The typical postwar recession lasted about a year. After two years, GDP per capita had grown back to its original level and continued to grow for the next three years. Financial crisis recessions lasted one year longer and only returned to the original level by year five.

More interesting are the two alternative scenarios in which credit in the expansion grows above average. A credit boom in either mortgage or nonmortgage lending makes the recession slightly worse prewar, especially when associated with a financial crisis. "But in the postwar period an above average mortgage-lending boom unequivocally makes both financial and normal recessions worse. By year five GDP per capita can fall considerably, as much as 3 percentage points lower than it would have otherwise been. In contrast, booms in nonmortgage credit have virtually no effect on the shape of the recession in the same postwar period."

The three say they can only speculate on why there is a difference but conclude that "a mortgage boom gone bust is typically followed by rapid household deleveraging, which tends to depress overall demand as borrowers shift away from consumption toward saving. This has been one of the most visible features of the slow U.S. recovery from the global financial crisis."

The paper concludes that much of the recent expansion in bank lending took place through real estate lending, a factor that appears to have the most relevant macroeconomic effects and thus the need to revisit current economic policy.