Apr 2012 19

How Dangerous is High Household Debt for the Economy?

Posted by Jay Banks
House in Vancouver by Amy Thibodeau
House in Vancouver by Amy
The International Monetary Fund (IMF) analysis shows that over the past thirty years of downturns and recessions in our economy, the pattern has emerged. Housing busts and recessions preceded by broader periods of household debt tend to be more violent and severe. According to IMF, in advanced economies, during the five years preceding 2007, the ratio of household debt to income rose by an average of 39 percentage points to 138 percent. There are of course ways of averting this, or at least reducing the harm caused. This is to be done by implementing the series of policies similar to those of the 1930s United States or present-day Iceland. Such policies might help prevent further house price declines and additional contractions in output.

What is the relationship between household debt and the depth of economic downturns?

If household debts increase considerably before the recession kicks in, the effect of such a downturn would be far more serious. Real GDP and household consumption would plummet, unemployment would increase considerably, and the time of the recovery would be prolonged. According to IMF’s research, household consumption falls by more than four times the amount that can be explained by the fall in house prices in high-debt economies. The relationship between household debt and the contraction in consumption also holds for economies that did not experience a banking crisis around the time of the housing bust.

Why might gross household debt be a problem?

It’s already been mentioned that IMF’s findings suggest that downturns are more severe when they are preceded by larger increases in household debt. Household debt is dangerous mainly because it amplifies the effect of macroeconomic shocks and weakens recoveries significantly. The pattern is as follows:

De-leveraging could stem from a realization that house prices were overvalued, a tightening in credit standards, a sharp revision in income expectations, or an increase in economic uncertainty. Here, a sufficiently large fall in the interest rate could induce creditor households to spend more, thus offsetting the decline in spending by the debtors.

What can governments do to support growth when household debt becomes a problem?

Mantioba House by Wendy Cutler Mantioba House by Wendy Cutler
It is likely that states are able to soothe the effects of household de-leveraging on net economic activity. One of the tools to accomplish this is fiscal transfers to unemployed households through the welfare system. According to the IMF analysis, this can boost their incomes and improve their ability to service debt, as in the case of the Scandinavian economies in the 1990s. Such an approach can reduce mortgage payments and prevent household defaults as well. Another part of state intervention is the support to the financial sector, which should secure higher openness to supply credit to households. However, government can give only so much before it takes on too big a deficit to function safely.

The main idea behind the governmental policies is that:

Targeted household debt restructuring policies can deliver significant benefits. Such policies can, at a relatively low fiscal cost, substantially mitigate the negative impact of household de-leveraging on economic activity… reduce the number of household defaults and foreclosures, and alleviate debt repayment burdens. In so doing, these programs help prevent self-reinforcing cycles of declining house prices and lower aggregate demand.
All such programs have to be set up just right neither to have only fractional effect nor to damage fiscal stability with their vastness.

How’s Canada Holding Up?

Canada has also introduced more regulations in the mortgage market. There is the dispute of whether these changes are right, but there’s definitely ground for some change. The debt-to-income ratio among Canadian households fell in the fourth quarter of last year to 152.9 per cent from 154.2 per cent. According to a report released by the Canada Mortgage and Housing Corporation (CMHC), only 42 per cent of homeowners in Canada are mortgage-free. According to a report by CIBC World Markets Inc., the surge in Canadian borrowing over the last five years has been driven by the most indebted households. Households heavily dependent on borrowing now hold 73 per cent of all household debt in Canada. Despite several warnings in the media, Canadians have no reason to be discouraged yet. Mortgage rates are still at historic low levels.

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