Question

What are the Economic implications of Rising Household Debt? (2-3 paragraphs)

Answer 1

Household borrowing has grown considerably in many countries over the past two decades, both in absolute terms and relative to household incomes. The extent of the increase in household borrowing has raised concerns about its sustainability and the possible implications for the financial system and the macro-economy if it is not sustainable.

Let us examine the factors that have contributed to the rise in the debt. It highlights two main influences: firstly a decrease in the prevalence of credit rationing that resulted from the deregulation of financial systems that occurred through the 1980s; and secondly the decline in interest rates, both in real and nominal terms, over the past two decades. In addition to the direct effect of a lower cost of borrowing, these factors have contributed to a sizeable easing of liquidity constraints on households. These developments have allowed households to structure their borrowing to achieve a more desirable path of consumption over their life cycle than was possible previously. In this sense the increased indebtedness can be seen as rational decisions by households. However, it is difficult to assess whether these factors can explain the full extent of the rise in indebtedness that has occurred.

Regardless of whether the increase in household debt is sustainable, which primarily may be an issue for prudential policy, the greater indebtedness of households has important macroeconomic implications. The household sector will be more sensitive to movements in interest rates, particularly if they are unexpected, and changes in household income such as that caused by unemployment. The sensitivity of the household sector to interest rate changes will depend on whether the interest rate applying to the debt is predominantly fixed or variable over the life of the loan. This feature of a loan affects the location of interest rate risk in the economy. It determines whether households, financial intermediaries or pension funds are most exposed to changes in interest rates. In turn this will influence the near-term impact of changes in interest rates on the economy.

How household debt affects economic growth

A new working paper by economists Atif Mian and Emil Verner of Princeton University and Amir Sufi of the University of Chicago points to household debt as a source of instability and lower economic growth. The dynamics of how household debt affects economic growth are quite interesting. Higher debt results in more consumption by households and a larger share of economic output coming from consumption. At the same time, this results in the country running a larger current account deficit with the rest of the world as imports increase, with consumption goods making up a larger share of those imports. Once the economy enters a recession, however, imports fall dramatically and the country starts to export more than it imports. This mechanism allows the country that ran up debt to bounce back by selling goods to the global economy.

But that mechanism only works if the rest of the global economy is doing well and other countries didn’t also see an increase in the household debt. If the entire global economy has more household debt, then individual countries will have nowhere to export their goods when growth stalls. Mian, Sufi, and Verner find that an increase in global household debt is also predictive of lower economic growth for individual countries, and that countries particularly dependent on trade are affected even more by this global build-up.A lot of these dynamics sound a lot like what happened during the 2000s in the run up to the Great Recession of 2007-2009,

These results are however important not for shaming certain institutions, but rather to show how important it is to consider the role of household debt in economic stability and growth.