By Houses and Holes, the founding publisher and former editor-in-chief of The Diplomat, a regular contributor at The Sydney Morning Herald, The Age and The Drum, and a former commentator at Business Spectator. He is also the co-author of The Great Crash of 2008 with Ross Garnaut. He edits MacroBusiness. Originally published at Macrobusiness.
From the Bank of International Settlements (BIS):
Excessive indebtedness has been one of the root causes of financial crises and the ensuing deep recessions. In recent years, the focus has been on household debt, as excessive leverage by the household sector was at the heart of the Great Financial Crisis.
It is well recognised that household borrowing is an important aspect of financial inclusion and can play useful economic roles, including smoothing consumption over time. At the same time, rapid household credit growth has featured prominently in financial cycle booms and busts. For one, household debt – or debt more generally – outpacing GDP growth over prolonged periods is a robust early warning indicator of financial stress.
Furthermore, there is growing evidence that household indebtedness affects not only the depth of recessions but growth more generally. In an influential paper, Mian et al (forthcoming) find that an increase in the household debt-to-GDP ratio acts as a drag on consumption with a lag of several years.
BIS research reinforces this conclusion. For instance, based on a panel of 54 advanced and emerging market economies over the period 1990–2015, Lombardi et al (2017) find that rising household indebtedness boosts consumption and GDP growth in the short run, but not in the longer run. Specifically, a 1 percentage point increase in the household debt-to-GDP ratio is associated with growth that is 0.1 percentage point lower in the long run.
Drehmann et al (forthcoming) shed light on a possible mechanism behind these empirical regularities. When households take on long-term debt, they increase current spending power but commit to a pre-specified path of future debt service (interest payments and amortisations).
A simple framework captures this accounting relationship. It highlights two key features. First, if borrowing rises persistently over several years and debt is longterm, as is typically the case, the debt service burden reaches its maximum only after the peak in new borrowing. The lag can be of several years and increase with the maturity of debt and the degree of persistence in borrowing. Second, cash flows from lenders to borrowers reach their maximum before new borrowing peaks. They turn negative before the end of a credit boom, since the positive cash flow from new borrowing is increasingly offset by the negative cash flow from rising debt service. Empirically, these simple accounting relationships suggest a transmission channel whereby excessive credit expansions lead to future output losses. In particular, using a panel of 17 mainly advanced economies from 1980 to 2016, Drehmann et al (forthcoming) show that an increase in new debt relative to GDP beyond historical norms provides on average a boost to GDP growth in the short run but depresses output growth in the medium term (Graph III.A, left-hand panel and black line in the right-hand panel). As the accounting framework suggests, the increase in new debt feeds into higher debt service burdens. As higher debt service burdens have a strong negative effect on output going forward, this channel explains almost fully the medium-term growth decline (blue bars, right-hand panel). However, the negative effects of high credit growth in the medium term are not unconditional. If households initially have low debt service burdens, additional borrowing continues to be beneficial in the short run without significant adverse effects later on. This suggests, for instance, that there can be room for benign financial deepening in countries where households are not yet constrained.
The adverse effects of excessive credit growth can also be magnified by the economy’s supply side response. For example, banks’ stronger willingness to extend mortgages may feed an unsustainable housing boom and overinvestment in the construction sector, which may crowd out investment opportunities in higher-productivity sectors. Borio et al (2016), for example, report evidence that credit booms tend to go hand in hand with a misallocation of resources – most notably towards the construction sector – and a slowdown in productivity growth, with long-lasting adverse effects on the real economy.
She’ll be right.