Since 2007, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we face.

The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis. America’s housing stock, at its peak, was estimated to be worth $23 trillion. A 25% decline in housing value would generate a paper loss of $5.75 trillion. With an estimated 1%-3% of housing wealth gains going into consumption, this could generate about a $60-$180 billion reduction in total consumption — a modest amount compared to U.S. gross domestic product of $15 trillion. We should have seen a serious impact on consumption, but there was no a priori reason to believe we were embarking on a crisis of the current scale.

Leverage did increase the riskiness of the system, but it did not by itself turn a housing downturn into a global financial crisis. How leveraged a bank can be depends on many factors — most notably, the nature and duration of its assets and liabilities. In the economy at large, credit relative to incomes has been growing over the last 50 years, and even assuming that credit... To read the complete article, login or sign-up using the form below.