Rapid buildup of household debt during boom leads to deeper downturn when bubble bursts, World Economic Outlook argues
Governments should step in to help struggling households write off part of their mortgages in the wake of a financial crisis to avoid the risk of a prolonged economic slump, according to new research by the International Monetary Fund.
In a chapter of the spring edition of its World Economic Outlook, the rest of which will be published next week, the IMF’s economists find that a rapid buildup of household debt during a boom leads to a deeper downturn when the bubble bursts.
“Housing busts preceded by larger run-ups in gross household debt are associated with deeper slumps, weaker recoveries, and more pronounced household deleveraging,” they find.
From Iceland to the US, Spain to the UK, a rapid increase in debt was a common characteristic across many economies in the years before 2007, as homeowners took advantage of low interest rates to borrow against the rocketing value of their properties.
When house prices crashed, many borrowers inevitably found themselves in trouble and were forced to cut back sharply, contributing to the deep recessions that followed the financial crisis.
But when they examined scores of historical property crashes, the IMF found that where consumers were battling with a heavy debt burden spending fell on average four times as fast as could be explained by the decline in house prices alone.
“The decline in economic activity is too large to be simply a reflection of a greater fall in house prices. And it is not driven by the occurrence of banking crises alone,” they say. “Rather, it is the combination of the house price decline and the pre-bust leverage that seems to explain the severity of the contraction.”
Because of this strong relationship between the debt burden before a crisis and consumer behaviour in the years afterwards, the IMF says governments should consider intervening to help households write off or restructure their mortgages.
It details the case of the Home Owners’ Loan Corporation, which was introduced by the Roosevelt government during the Great Depression. The HOLC bought 1m distressed mortgages from troubled banks and used the government’s firepower to bring down the costs for homeowners – for example by extending the term of the loan. Just a fifth of the mortgages eventually ended in default – 800,000 were paid back.
The IMF suggests recent efforts by the White House to reduce foreclosures have been disappointing by comparison.
The report also praises Iceland’s recent efforts to deal with the impossible household debts run up during the housing boom, which included a temporary moratorium on repossessions and a government-backed scheme to allow struggling borrowers to reschedule their payments.
“Bold and well-designed household debt restructuring programmes, such as those implemented in the United States in the 1930s and in Iceland today, can significantly reduce the number of household defaults and disclosures. In so doing, these programmes help prevent self-reinforcing cycles of declining house prices and lower aggregate demand.”
The IMF’s findings offer fresh support to a warning issued recently by consultancy McKinsey, which suggested that the UK faces a tough struggle to restore growth, because the total debt burden has barely budged since before the crisis.
McKinsey said total debt, including borrowing by companies and the government, as well as households, now exceeds 500% of GDP, barely below the level in Japan, and suggested it would take until 2020 for these legacy debts to be dealt with.
However, other analysts, including Ben Broadbent of the Bank of England’s monetary policy committee, have argued that the legacy of debt left over from the boom years should not hold back economic recovery, because it was largely backed by increases in the value of assets such as property. House prices have so far fallen less sharply in the UK than in many other countries.
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