Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Household Debt Holds Back Recoveries but Restructuring Can Help

April 10, 2012

  • Research finds housing busts and recessions preceded by larger household debt buildup are longer and deeper
  • Combination of household debt and house price declines governs recession's severity
  • Bold debt restructuring programs can reduce defaults and foreclosures

The more households accumulate debt during a boom, the deeper the subsequent slump in the economy and the weaker the recovery, according to new IMF research.

Household Debt Holds Back Recoveries but Restructuring Can Help

Woman shopping in Madrid, Spain. Consumer debt racked up during housing boom now holding back recovery (photo: Andrea Comas/Reuters)


“Dealing with Household Debt,” published in the April 2012 World Economic Outlook, finds that housing busts preceded by larger runups in gross household debt—mortgages, personal loans, and credit card debt—are associated with significantly larger contractions in economic activity.

Household consumption and real GDP fall substantially more, unemployment rises more, and the reduction in economic activity persists for at least five years. A similar pattern holds for recessions more generally: those preceded by larger increases in household debt are more severe, according to the study’s statistical analysis.

This is sobering for economies today, such as Iceland, Ireland, Spain, the United Kingdom, the United States, and others, where house prices collapsed during the Great Recession and the substantial amount of debt racked up during the boom became a burden holding back the recovery.

Potent combination

Household debt soared in the years leading up to the Great Recession. When house prices fell at the advent of the global financial crisis, many households saw their wealth shrink relative to their debt. Combined with less income and more unemployment, that meant it was harder for many people to make their mortgage payments, and defaults and foreclosures became endemic in some countries. Household deleveraging—paying off debts or defaulting on them—has begun and is most pronounced in the United States.

The study looks at the relationship between household debt (and deleveraging) and economic activity. It finds that larger declines in economic activity are not simply due to the larger drop in house prices and the consequent reduction of households’ wealth. Indeed, household consumption falls by more than four times the amount explained by the fall in house prices in high-debt economies. It seems to be the combination of house price declines and prebust household indebtedness that accounts for the severity of the contraction.

Nor is the larger contraction in the economy simply driven by financial crises. The research finds that the relationship between household debt and the contraction in consumption holds even for economies that did not experience a banking crisis around the time of the housing bust.

The study includes case studies of how governments have responded during episodes of household deleveraging—in the United States in the 1930s and today; Hungary and Iceland today; Colombia in 1999; and three Scandinavian countries (Finland, Norway, and Sweden) in the 1990s. In each case a housing bust was preceded by or coincided with a substantial increase in household debt.

Monetary easing, fiscal transfers effective tools

The study reviews the government policy responses to household debt in each of these cases and concludes that macroeconomic policies are a crucial tool to prevent contractions in economic activity during periods of household deleveraging.

Monetary easing in economies where mortgages typically have variable interest rates—in the Scandinavian countries, for example—can quickly reduce mortgage payments and avert household defaults.

Fiscal transfers to households through social safety nets can boost households’ incomes and improve their ability to service debt; again, this happened in the Scandinavian country cases. Such automatic transfers can further help prevent self-reinforcing cycles of rising defaults, declining house prices, and lower demand.

Macroeconomic stimulus, however, has its limits. Nominal interest rates can only be cut down to zero, and high government debt may constrain the scope for fiscal transfers.

Debt restructuring to avoid foreclosures

Government policies aimed at reducing a household’s debt relative to its assets—and its debt service payments relative to its income—could be an inexpensive way to mitigate the negative effects of household deleveraging on economic activity. Such policies are particularly relevant for economies today that have limited scope for expansionary macroeconomic policies and in which the financial sector has already received government support.

Bold and well-designed household debt restructuring programs such as those implemented in the United States in the 1930s and in Iceland today can significantly reduce the number of household defaults and foreclosures. That helps prevent downward spirals of declining house prices and lower demand. Once the mortgages are restructured to be more affordable, their market value rises, and the government can sell them, using the revenue to offset the initial cost to the taxpayer.

But these programs must be carefully designed. If access to them is overly restrictive, they will not have the full intended impact. And if they are too broad and imposed on an already fragile financial sector, they can cause a dangerous credit crunch.