Debt oils the wheels of the economy. It enables people to make significant investments today, such as buying a home or going to college, offering some of their future income as collateral.

That is very well in theory. But as the financial crisis showed, rapid growth in household debt, especially mortgages, can be dangerous.


Household debts

Household debts

A new IMF study carefully examines the possible consequences of rising household debt in different types of economies, as well as the measures that economic policymakers can take to alleviate these consequences and keep debt within reasonable limits. In summary, the message is: the short-term benefits of increasing debt have medium-term costs as a counterpart, but policymakers can do much to mitigate this phenomenon, according to Chapter 2 of the October 2017 edition. of the World Financial Stability Report.

Given the great suffering caused by the crisis, one would expect that people would have become fearful of borrowing more. Amazingly, that has not happened. Since 2008, household debt as a share of gross domestic product has increased significantly in a sample of 80 countries. In advanced economies, the average debt ratio rose from 52% in 2008 to 63% last year. Among emerging market economies, the increase was from 15% to 21%. A change of luck 

Our study concludes that, in the short term, an increase in the household debt ratio is likely to stimulate economic growth and employment. But within three to five years, these effects are reversed; growth is slower than it would otherwise have been and the chances of a financial crisis increase. These effects are more intense in advanced economies, which usually have higher levels of indebtedness, and more subdued in emerging markets, where lower levels predominate.


What is the reason for this phenomenon?

debt loans

In the beginning, households go into more debt to buy things like new houses and cars. In the short term, this gives the economy a boost as automakers and home builders hire more workers. But later, households with high levels of debt may have to cut back on expenses to pay off their loans. This slows down growth. In addition, something happens that was demonstrated in the 2008 crisis: an unexpected economic shock, such as falling property prices, can trigger a spiral of credit defaults that shakes the foundations of the financial system.

More specifically, our study concluded that a 5 percentage point increase in the household debt ratio relative to GDP over a three-year period predicts a 1.25 percentage point decline in inflation-adjusted growth three years later. A higher level of indebtedness is associated with a significantly higher level of unemployment up to four years later. Likewise, a 1 percentage point increase in debt increases the probability of a future financial crisis by almost 1 percentage point. This constitutes a considerable increase, when taking into account that the probability of a crisis is 3.5%, even without any increase in indebtedness.

The good news is that policymakers have ways to reduce risks. Countries with lower external debt and a floating exchange rate, and with greater financial development, are in a better position to face the consequences.


Mitigate risks

loan risks

Improving financial sector norms and reducing income inequality is also helpful, but not enough. Countries can also mitigate risks by taking steps to moderate the growth of household indebtedness, such as modifying the down payment needed to buy a home or the portion of the household’s income that can go towards debt repayment. Therefore, the right policies, institutions and standards make a difference, even in countries with high coefficients of household indebtedness in relation to GDP. Furthermore, countries with poor policies are more vulnerable, even if they have a low initial level of household indebtedness.

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