The view is fundamentally mistaken, and reduces to an "overproduction" theory of recession. Overproduction theories are inconsistent with the fundamental economic principle of scarcity.
How can such an error be made? The key problem is the fallacy of composition. What may be true for the individual household and firm is generalized to the economy as a whole. Such composition is a fallacy because what is true for an individual household or firm may not be true for the economy as a whole.
Suppose an individual household borrows money to finance consumption greater than income. For the individual household, this generates a larger stream of consumption expenditure.
Consider now the individual firm that the household patronizes. This additional debt-funded stream of expenditure is an additional stream of sales. This increased demand for the firm's product motivates it to raise both the prices it charges and the volume it sells. The firm's profitability is enhanced.
The individual firm is motivated to expand production to maintain this greater volume of sales. Additional resources, must be utilized, including labor. The firm might even need to offer slightly increased wages to attract more workers.
And so, the individual household's debt-financed consumption generates greater nominal and real expenditure, and an increased nominal and real volume of sales for the individual firm that the household patronizes. The individual firm selling to that household expands production and employment. It enjoys enhanced prices and profitability. Households supplying labor obtain greater employment opportunities and wages from that individual firm.
Surely, a "boom" in the economy is simply that same scenario writ large? Households on the whole borrow more money to fund more consumption. Firms on the whole receive greater volume of sales. Firms on the whole raise prices and production and enjoy enhanced profitability. Workers on the whole enjoy higher wages and employment. (No, this is a fallacy of composition on two fronts.)
Continuing the story of the individual household and firm, the great prosperity of the individual household and especially, the firm that the household patronizes, cannot be maintained because it is being built on unsustainable debt. At some point, the household must slow its borrowing. Perhaps it will begin to worry about being unable to repay all of this debt and will stop borrowing. Or, perhaps it is the lenders that worry about the household's profligacy and cut off additional loans. Regardless, the debt-funded flow of consumption expenditure stops, and only consumption funded by income remains.
Worse, the household may choose to start repaying its debt. Not only isn't it spending on consumer goods beyond its income, it will begin spending less than income, using part of income to repay debt. Again, this could be because the household chooses to reduce its indebtedness, or else, lenders might force this to happen by limiting the extension of new loans as old loans come due. (Later I will discuss some fallacies of composition in banking, where this decision of whether or not to extend new loans to cover old ones or else "bite the bullet" and "liquidate" is the key to macroeconomic disturbances.)
So, the "over-leveraged" household may reduce its flow of consumption expenditure to its income, or go even further, and reduce it to even less than its income and pay off debts.
Now, consider the impact on the individual firm that the individual household was patronizing. The volume of its sales falls. At best, it returns to the level of sales before the boom. The firm may reduce its price a bit in response to the lower demand, but it also reduces its real volume of sales. Since it must pay for the resources used for production, its profitability suffers, perhaps it even suffers losses. It cuts back on production. It uses less resources, including labor. While it might cut employee wages a bit, with less production, it needs less labor and workers lose jobs.
While this could be simply a return to the pre-boom levels of prices, sales, profits, production, wages, and employment, if the household is reducing debt and spending less than income, then the reduction will go further. There is "bust," that clearly follows from the boom. While there were high levels of prices, profits, production, employment, and wages during the boom, funded by easy credit and debt, when those debts need to be repaid, the reduced expenditures by the individual household result in extra low sales, prices, profits, production, wages, and employment at the individual firm it patronizes.
Naturally, then, it must be that the "booms" observed in the economy must end and will generally be followed by "busts." Households on the whole are "over-leveraged," and must reduce their consumption spending at the very least to pre-boom levels. At worst, they cut consumption expenditures even more to reduce debt. Firms suffer reduced sales and respond with lower prices. Profitability and production falls. Perhaps wages fall as well, but so does employment. Surely, this is what causes recessions? (No, there are two fallacies of composition involved.)
Finally, what is to be done? Fortunately, once the individual household has paid down its debts to a more sustainable level, consumption expenditure can resume. While it is possible that the individual household will foolishly begin building unsustainable levels of debt, a more responsible expansion is possible--consumption expenditure can instead be funded by current income. The individual firm selling to the individual household, then, will see a recovery of sales, hopefully, on what is now a sound basis. Prices and production recovers, as do employment and wages.
And so, for the economy as a whole, once the households have paid down their debts, consumption spending will recover, and the firms can begin a sound expansion. Prices, profits, production, wages, and employment all recover, and hopefully the economy can prosper on a sound basis. Of course, there is always the danger of excessive lending and borrowing, leading again to an unsustainable boom.
If only, somehow, someone can prevent another orgy of debt financed false prosperity, then a sound and prosperous economy remains possible. Surely, this is the answer to macroeconomic stability? (No, there are two fallacies of composition involved.)
What bothers me most about this "credit cycle" story of economic cycles is that it is inconsistent with perhaps the most important principle of economics--scarcity. The fallacy of composition is exactly the one that so worried Bastiat--"what is seen, and what is not seen." It is similar to the fallacy of the broken window. Someone breaks a shopkeeper's window. Surely, that helps the economy. There is a greater demand for the glazier's product, which then leads to general prosperity. What the shopkeeper with the broken window would have done with his or her funds are ignored. What could have been done with the labor and other resources used to replace the window are ignored.
The market economic system is a spontaneous order. No one directs the economy as a whole, and so, no one really has to understand the macroeconomy. The perspective of the individual firms--producing particular products for profit--has little to do with the what this means for the composition of demand or the allocation of resources across fields of endeavor. It is the unintended consequences of their actions that tend to match the allocation of resources to the demands of household for a variety of goods.
From the perspective of the individual firm, changes in the demand for its product should result in changes in the production of that product and changes the utilization of resources, including labor. However, the role of these signals and incentives in a market economy system are about shifting the allocation of resources in order to match a shift in the composition of demand between different good and services.
An individual firm with greater demand will be able to raise prices and earn more profit. Such a firm can expand the production of its particular product and pull resources, including labor, from firms producing other goods and services. It may need to bid up the prices of at least some of those resources, including labor.
And a firm with lower demand may need to lower prices and suffer reduced profitability or even losses. It is receiving a signal that the resources it is using are more needed elsewhere. It must reduce production and allow those resources, including labor, to be used to produce other goods.
The notion that lower demand for all products signals that all firms should produce less and use less labor is incoherent. It follows from a failure to understand how the individual firm fits into a market economic system.
How does this relate to scarcity? The credit cycle theory, where the changes in demand faced by an individual firm are projected into changes in demand for the entire economy, suggests that the fundamental economic problem is having sufficient demand. While true for the individual firm, for the economy as a whole, the fundamental economic problem is that there are inadequate resources, including labor, to produce all the goods and services in quantities sufficient for everyone to achieve their goals. The market system provides incentives for individual firms to respond to changes in the demand for their particular products so that the market system adjusts the composition of output to reflect the particular goods and services people most want to buy.
So, one fallacy of composition in the "credit cycle" story is that the while a firm receiving additional sales can expand production, the resources, including labor, are being pulled away from the production of other goods and services. The production of those goods fall. Employment of labor in the rest of the economy falls. The increase in production and employment for the individual firm cannot be generalized for the economy as a whole.
Similarly, if an individual firm faces less demand for its product, this is generally a signal that it should produce less and that resources, including labor, need to be used to produce other goods and services. However, the credit cycle theory, that the recession is a time when production needs to be reduced across the board because households don't want to buy because they are using their incomes to pay down debt is incoherent. All firms can reduce production, but they cannot all do so in order to free up resources to producing other things. If somehow profits and losses are signalling everybody produce less because the resources have more important uses, then the market signals are in error and inconsistent with the reality of scarcity. There are plenty of goals and purposes that could be achieved with the products of those resources.
The theory of recovery, where the households pay down their debts out of current income, and then, once that is done, can begin to consume an amount equal to their income, hopefully now on a sustainable level, is also based upon a fallacy of composition. The income of an individual household can be treated as being independent of its expenditures. However, if all households decrease expenditures, so that all firms suffer reduced sales and respond by reduced production, then the income earned by the households will decrease as well. The notion that the total of everyone's income needs to fall so that everyone will be able to pay down their debts is incoherent. Again, if the market economic system is creating signals and incentives for this to occur, then those signals and incentives are in error.
This last fallacy of composition--that the individual debtor can reduce expenditure out of income and pay down debts, but that all debtors cannot reduce expenditure and pay down debts, is just an aspect of the second fallacy of composition involved in the "credit cycle" story.
The individual household can borrow and expand its consumption expenditures beyond its income. An individual household might become "over-leveraged" and need to slow the pace of borrowing. Perhaps it will even need to reduce consumption below income and repay debts.
Surely, then, it is possible for all households to expand consumption above income? Surely, if we look at the ratio of household debt to income, this will show that "the" household is "over-leveraged" so that aggregate consumption must slow. Perhaps consumption must even fall below income so that "the" household, can pay down its debts.
No, this is a fallacy of composition. It is a fallacy because for every borrower there is a lender. Credit transfers funds from lenders to borrowers. Credit shifts the allocation of resources away from producing what the lenders would have purchased to what the borrowers want to purchase.
Take the simplest scenario. The consumption of some households is less than income--they save. The consumption of other household is greater than income--they dissave. The households that save lend to the households that borrow to fund dissaving. Even if the amount borrowed and lent each year is small, it is possible for these amounts to accumulate and grow quite large. It is even possible for total household debt to grow to a multiple of the total income of all the households. If it were the same households that were saving and lending to the same households that are borrowing and consuming, then the wealth of the savers would be an even larger multiple of their income than the aggregate debt/income ratio. And, of course, the households that have been borrowing to fund their orgy of consumption would be more "over-leveraged" than all the households together.
Various individual households have been borrowing, and the individual businesses patronized by those households "boom." However, the funds that those households were spending came from the households that were saving and lending. The various firms that they would have patronized sell less. Of course, it could be the very same firms that the borrowers patronize, and there is no impact on the prices, profitability, volume of sales, production, employment, or wages of any individual firm. But, of course, there might be a shift in the composition of demand between firms and industries. There may be a shift in the allocation of resources, including labor, throughout the economy. However, the supposed "boom" for the firms is simply a fallacy of composition. Where the lenders would have spent the funds--what is unseen--is ignored.
Consider the supposed "bust" from the credit cycle. It is certainly correct that a single household can be "over-leveraged" and can choose or be compelled to slow borrowing, or even repay debt. However, for every borrower there is a lender. For every debtor there is a creditor. If a household chooses to slow its pace of borrowing and expand consumption more slowly or even reduce consumption, the question remains, what happens to the funds of whoever would have made the loans? In the more extreme situation, where the borrower repays the loans, what happens to funds that are repaid?
In the simple scenario, where some households have lent to other households and the debts of some households are matched by the wealth of other households, then one possible answer is quite simple. When wealthy households who were lending now confront "over-leveraged" borrowers, so they can not, or will not, lend more, then they simply stop saving and spend their incomes on consumer goods and services.
Similarly, if the "over-leveraged" households choose to reduce their debts, or must reduce their debts, the households that are their creditors can simply spend more than their incomes on consumer goods and services. The wealthy households can now dissave, not by going into debt, but by spending accumulated wealth on consumer goods and services. This process could conceivably continue until debt falls to zero, the the aggregate level of household debt to household income is zero. While the individual firm selling to a household paying down its debt will sell less, the firms selling to the households receiving and spending those debt repayments will sell more.
The simple scenario of consumption loans between households is a good place to start, but there are, of course, other scenarios. From a nationalist perspective, it is possible for households in one nation to borrow from foreign lenders. However, this result in no "boom" for domestic firms. The result of borrowing from the foreigners is imports. Further, while foreign producers may "boom" from all of their exports, what would have the lenders have done with the funds if they hadn't lent them out. Similarly, rather than a "recession" when households can no longer obtain foreign loans to fund their consumption, domestic firms find new prosperity in selling export goods to the foreigners now importing goods as they obtain repayment of the loans they had made.
More importantly, household saving can be used to fund business investment. Resources, including labor, can be shifted from the production of consumer goods to the production of capital goods--machines, buildings, and equipment. If households increase their borrowing to fund additional consumption, then that leaves less household lending to fund business investment. The individual firm might sell more consumer goods to the individual household, but those firms selling capital goods sell less.
In reverse, it is possible that over-leveraged households will reduce consumption spending to repay debt. And those households receiving debt repayments won't expand their consumption. Instead, the resources freed up from the production of consumer goods can be used to fund capital investment by firms.
Individual households may be "over-leveraged." It is possible that a household may regret its past levels of consumption and be unhappy with the currently reduced levels of consumption made necessary by the need to repay loans. It is possible for all households in a single nation to be in this situation. It is even possible for all households in the world to be in this situation, having produced and enjoyed too many consumer goods and failed to produce enough capital goods.
What is incoherent is the simple minded aggregation of the single household and the single firm. The notion that increased lending allows for increased spending in the aggregate, which is necessary for the resources to be fully employed producing goods and services. In other words, the notion that the economic problem is coming up with something to do with labor and other resources, rather than scarcity. That the fundamental economic problem is coming up with a way to generate sufficient spending.
And most importantly, what is incoherent is the notion that excessive debt must result in decreased expenditure in aggregate. And even more incoherent is the notion that the appropriate response to that situation is to lower production and employment until the excess debt is paid down.
From the point of view of the individual household and the individual firm, these relationships between debt, spending, demand, production and employment are perfectly sensible. When all individuals are aggregated, they make no sense.
P.S. Can't banks make loans with new money created out of thin air? When loans are repaid, can't those receiving the funds just hold on to it? If prices, including wages, are less than perfectly flexible, can't changes in nominal expenditure result in changes in real output and employment? Yes! To all of it. And that is the source of the problem, an imbalance between the quantity of money and the demand to hold it. Complaints about "over-leveraged" households are just a diversion.
P.P.S. But can't households choose to work less, produce less, and enjoy more leisure? Yes! And if changing levels of debt and consumption impact how much leisure households prefer to enjoy and that results in changes in production, then any associated relationship between the levels of household debt and the productive capacity of the economy is not a problem.