Household Debt and Business Cycles Worldwide

An increase in the household debt to GDP ratio predicts lower subsequent GDP growth and higher unemployment in an unbalanced panel of 30 countries from 1960 to 2012. Low mortgage spreads are associated with an increase in the household debt to GDP ratio and a decline in subsequent GDP growth, highlighting the importance of credit supply shocks. Economic forecasters systematically over-predict GDP growth at the end of household debt booms, suggesting an important role of flawed expectations formation. The negative relation between the change in household debt to GDP and subsequent output growth is stronger for countries with less flexible exchange rate regimes and those closer to the zero lower bound on nominal interest rates. We also uncover a global household debt cycle that partly predicts the severity of the global growth slowdown after 2007. Countries with a household debt cycle more correlated with the global household debt cycle experience a sharper decline in growth after an increase in domestic household debt. ∗This research was supported by funding from the Initiative on Global Markets at Chicago Booth, the Fama-Miller Center at Chicago Booth, and Princeton University. We thank Giovanni Dell’Ariccia, Andy Haldane, Òscar Jordà, Anil Kashyap, Guido Lorenzoni, Virgiliu Midrigan, Emi Nakamura, Jonathan Parker, Chris Sims, Andrei Shleifer, Paolo Surico, Alan Taylor, Giancarlo Corsetti, Jeremy Stein, Larry Katz, Robert Vishny, four anonymous referees, and seminar participants at Princeton University, Chicago Booth, Northwestern University, Harvard University, NYU, NYU Abu Dhabi, UCLA, UT-Austin, the Swedish Riksbank conference on macro-prudential regulation, Danmarks Nationalbank, the Central Bank of the Republic of Turkey, Wharton, the Bank of England, the European Central Bank, the Nova School of Business and Economics, the NBER Monetary Economics meeting, and the NBER Lessons from the Crisis for Macroeconomics meeting for helpful comments. Elessar Chen and Seongjin Park provided excellent research assistance. Mian: (609) 258 6718, atif@princeton.edu; Sufi: (773) 702 6148, amir.sufi@chicagobooth.edu; Verner: verner@princeton.edu. Link to the online appendix. The Great Recession has sparked new questions about the relation between household debt and the macroeconomy. The increase in household debt during the years leading up to the Great Recession predicts the severity of the downturn across U.S. counties (Mian and Sufi (2014)) and across advanced economies (IMF (2012), Glick and Lansing (2010)). A recent body of theoretical research explores the links between behavioral biases, household debt, house prices, macroeconomic frictions, and fluctuations in output. Much of this research emphasizes the importance of shifts in credit supply and behavioral biases by lenders such as underestimation of default risk.1 In this study, we begin by showing a systematic empirical relation between household debt and business cycles across 30 mostly advanced countries in an unbalanced panel from 1960 to 2012. Results from a vector auto regression (VAR) show that a shock to the household debt to GDP ratio in a country leads to a three to four year rise household debt, which then subsequently reverts. During the household debt boom, the consumption to GDP ratio increases, imports of consumption goods rise, and GDP experiences a boost. However, the boost is temporary, and GDP subsequently falls. As a result, the rise in the household debt to GDP ratio over a three to four year period in a given country predicts a decline in subsequent economic growth.2 This predictability is large in magnitude. A one standard deviation increase in the household debt to GDP ratio over the last 3 years (6.2 percentage points) is associated with a 2.1 percentage point decline in GDP over the next three years. This predictive relation is robust across time and space. Exclusion of the post-2006 Great Recession period leads an effect that is 30% smaller, but it remains statistically significant at the one percent level. A rise in non-financial firm debt is associated with a smaller and more immediate negative effect on GDP, but firm debt dynamics do not generate the boom-bust growth cycle associated with household debt. Over the medium-run horizon we examine, a rise in non-financial firm debt has only weak predictive power on subsequent GDP growth once household debt is taken into account. After documenting this empirical relation, we focus in the rest of the study on the underlying economic model that is most consistent with the facts. We group theories explaining the rise in household debt into two broad categories: models based on credit demand shocks and models We discuss the theoretical research in detail in Section 3. We follow standard time-series econometrics terminology and use the term “predict” to refer to the predicted value of an outcome using the entire sample used to estimate the regression. This is in contrast to the term “forecast” that refers to the estimated value of the outcome variable for an observation that is not in the sample used to estimate the regression coefficients. See Stock and Watson (2011), chapter 14. 1 based on credit supply shocks. Within both categories, we consider both rational expectations and behavioral models of credit expansion, and we also focus on the role that macroeconomic frictions play in exacerbating the economic downturn that follows the rise in debt. Based on a number of results, we conclude that models with credit-supply shocks are more consistent with the results. Further, both behavioral biases of lenders during the boom and macroeconomic frictions during the bust appear to play an important role. Models based on credit demand shocks alone are difficult to reconcile with our findings. In rational expectations-based credit-demand shock models, the underlying shock is an increase in future productivity or permanent income against which households today desire to borrow. Such models yield a positive correlation between contemporaneous changes in debt and subsequent economic growth: households borrow because they expect things are getting better. As already mentioned, we find a negative correlation between the rise in household debt and subsequent GDP growth. Further, even behavioral-based models of credit demand shocks have the prediction that interest rate spreads should rise during the household debt boom. If credit supply is fixed and households become over-optimistic, the shift out in credit demand should yield higher interest rates. We construct a new cross-country panel series on mortgage credit spreads to test this prediction. We find the exact opposite: increases in household debt are associated with low interest rate environments. Further, in the United States, a measure of credit market sentiment from Greenwood and Hanson (2013) (the high yield corporate debt issuance share) is positively correlated with household debt booms. We use low interest spreads and measures of elevated credit market sentiment as instruments for a credit-supply induced rise in household debt, and we show that such rises in household debt predict lower subsequent growth. Credit demand factors such as over-optimistic expectations by households are likely important, but on net they are unlikely to be the dominant shock during periods in which household debt sharply rises. The fact that low interest spreads fuel increases in household debt that end badly supports credit supply shock-based models of the rise in household debt. But what is the fundamental source of the increase in credit supply? Models of credit market sentiment suggest that lenders begin to ignore downside risks during debt booms, which makes them willing to make credit more available on cheaper terms (e.g., Gennaioli et al. (2012), Greenwood et al. (2016), Landvoigt (2016)). While we do not have direct evidence on lender beliefs, we show that economic forecasters at the IMF 2 and OECD systematically over-forecast GDP growth at the end of household debt booms. As a result, the rise in household debt over the last three years, which is known by forecasters at the time forecasts are made, predicts growth forecasting errors. These findings are consistent with a growing body of research that the negative consequences of aggressive lending by the financial sector are not understood by market participants (e.g., Baron and Xiong (2016) and Fahlenbrach et al. (2016)). Theoretical models in which a contraction in credit availability induces a recession rely on frictions such as nominal wage and price rigidities and monetary policy constraints (e.g., Eggertsson and Krugman (2012), Guerrieri and Lorenzoni (2015), Farhi and Werning (2015), Korinek and Simsek (2016), Schmitt-Grohé and Uribe (2016), and Martin and Philippon (2014)). We find support for the argument that these frictions are important. The negative relation between the change in household debt and subsequent GDP growth is stronger under more rigid exchange rate regimes or when a country is close to the zero lower bound on nominal interest rates. Similarly, an increase in the household debt to GDP ratio predicts an increase in the future unemployment rate, showing evidence of underutilization of resources. Also, the relation between household debt changes and subsequent GDP is non-linear in a manner consistent with downward rigidity in wages and interest rates: a rise in household debt leads to lower subsequent growth, but a decline in household debt does not lead to higher subsequent growth. Finally, we explore the global dimension of the household debt cycle by first showing that a rise in household debt to GDP leads to a subsequent reduction in the trade deficit as imports decline. The resulting increase in net exports partially offsets the large negative effect of the household debt boom on consumption and investment, and it points to the importance of external spillovers to other countries. We f