Welfare Implications of the Transition to High Household Debt∗

Aggressive deregulation of the mortgage market in the early 1980s triggered innova-tions that greatly reduced the required home equity of U.S. households. This allowed households to cash-out a large part of accumulated equity, which equaled 71 percent of GDP in 1982. A borrowing surge followed: Household debt increased from 43 to 62 percent of GDP in the 1982-2000 period. This paper uses a calibrated general equi-librium model of lending from the wealthy to the middle class to evaluate the welfare effects of this reform quantitatively. We find that the “indirect ” effects of endogenous interest rate and other relative price changes dominate the “direct ” effect of relaxing the constraint. In our baseline experiment, the borrowing household’s welfare falls even though the reform directly relaxes a constraint on its trade. The saving household’s welfare rises substantially. ∗We are grateful to Erik Hurst and Richard Rogerson for their discussions of an earlier version of this paper and to audiences at the Federal Reserve Banks of San Francisco, Cleveland, and New York. Yaniv Ben-Ami provided expert research assistance. The views expressed herein are those of the authors, and they do not necessarily represent the views of the Federal Reserve Bank of Chicago, the Federal Reserve System, or its Board of Governors