Excessive Household Debt Drags Future Economic Growth

Monday, Jul 3, 2017
by vrosenth

A new paper by Atif Mian, Amir Sufi and Emil Verner, “Household Debt and Business Cycles Worldwide,” finds that an increase in the household debt predicts lower future GDP growth. Based on a panel of 30 countries over the period 1960-2012, the paper shows that a 6.2 percentage point increase in the household debt to GDP ratio over the final three years of a boom is associated with a 2.1 percent decline in GDP over the next three years.  This effect is strong and far outstrips the effect of non-financial firm debt.  Furthermore, economic forecasters systematically ignore this effect and consistently over estimate growth following a housing boom. The paper debunks the rational expectations-based credit-demand shock models that contend that household credit booms are rational responses to expected future income increases - if this were the case, credit booms would coincide with higher interest rates.  But, in fact, rises in household debt are associated with lower interest rates lending support to the credit supply shock-based models.  Borrowing surges because money is cheap.  The paper also finds that nominal rigidities (such as fixed exchange rates) and monetary policy constrains exacerbate the decline in future growth. Countries with a household debt to GDP cycle that is more correlated with the global debt cycle experience stronger negative effects – this is because of their inability to boost exports when many countries are suffering from a household debt hangover at the same time.  

The BIS 87th Annual Report released on June 26th cites Mian’s finding and reports research confirming Mian’s conclusions.  The press has taken notice, with the findings being reported in England, Australia and Korea (links below).  According to Mian, referring to countries with high household debt, "The key challenge for policymakers is to come up with a way where you can slow down credit growth but at the same time generate other sources of domestic demand.”

Bank cannot afford to delay in dealing with Britain’s household debtThe Times
Booming household debt has a sting in the tailThe Australian Business Review
S. Korea needs to address inevitabilities of household debt: economistYonhap News Agency
Why Ottawa should bail out homebuyers if house prices tank – Maclean’s

Household Debt and Business Cycles World Wide
Abstract
An increase in the household debt to GDP ratio predicts lower GDP growth and higher unemployment
in the medium run for an unbalanced panel of 30 countries from 1960 to 2012. Low mortgage spreads
are associated with an increase in the household debt to GDP ratio and a decline in subsequent
GDP growth, highlighting the importance of credit supply shocks. Economic forecasters
systematically over-predict GDP growth at the end of household debt booms, suggesting an important role of flawed expectations formation. The negative relation between the change in household
debt to GDP and subsequent output growth is stronger for countries with less flexible exchange rate
regimes. We also uncover a global household debt cycle that partly predicts the severity of the
global growth slowdown after 2007. Countries with a household debt cycle more correlated with the
global household debt cycle experience a sharper decline in growth after an increase in domestic
household debt.

Download and read the full paper here >

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