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

IMF News, April 10, 2012

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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.
Household consumption falls by more than four times the amount explained by the fall in house prices in high-debt economies.
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.
Economies singled out as facing these dynamics include Iceland, Ireland, Spain, the United Kingdom, the United States, and others.

Rapid pre-bust credit accumulation combined with house price declines reduces household net worth relative to debt, making mortgage payments harder to service amid falling income and rising unemployment.
The “potent combination” of prebust household indebtedness and falling house prices explains contraction severity more than house-price declines alone.
Defaults and foreclosures become endemic in some countries, prompting household deleveraging through paying down debt or defaulting.

The study includes episodes where housing busts coincided with substantial increases in household debt: 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.
Household deleveraging has begun and is most pronounced in the United States.

Macroeconomic policies are a crucial tool to prevent contractions during household deleveraging.
- Monetary easing: In economies where mortgages typically have variable interest rates (for example, the Scandinavian countries), monetary easing can quickly reduce mortgage payments and avert household defaults.
- Fiscal transfers: Social safety nets and automatic transfers to households can boost incomes and improve ability to service debt, helping prevent self-reinforcing cycles of rising defaults, declining house prices, and lower demand.
Limits of macroeconomic stimulus:
- Nominal interest rates can only be cut down to zero.
- High government debt may constrain the scope for fiscal transfers.

Government policies that reduce a household’s debt relative to assets and debt service relative to income can be an inexpensive way to mitigate negative effects of deleveraging on economic activity.
Bold and well-designed household debt restructuring programs (examples: the United States in the 1930s and Iceland today) can significantly reduce the number of household defaults and foreclosures, helping prevent downward spirals of declining house prices and lower demand.
Restructuring raises the market value of mortgages once they become more affordable; the government can sell them and use the revenue to offset the initial fiscal cost.
Design trade-offs and risks:
- If access to programs is overly restrictive, they will not have the intended impact.
- If programs are too broad and imposed on an already fragile financial sector, they can cause a dangerous credit crunch.

IMF Survey online, April 10, 2012
Draws on the chapter “Dealing with Household Debt,” published in the April 2012 World Economic Outlook

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