Household Debt and Business Cycles Worldwide

TLDR: This article found that 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, and uncover a global household debt cycle that partly predicts the severity of the global growth slowdown after 2007.

Abstract: 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.

Figures

Figure 3: Estimates of βHH,i for Each Country

Table 2: Summary Statistics

Table 12: Global Household and Firm Debt and Global Growth

Table 6: Declining Spreads, Credit Expansion, and Output: Sovereign Spread Convergence in the Eurozone and Falling Mortgage Spreads During the 2000s Credit Boom

Figure 4: Debt Expansions and Subsequent IMF Forecasts and Forecast Errors

Figure 8: Debt Expansions and Subsequent Growth across Exchange Rate Regimes

Full text

NBER WORKING PAPER SERIES
HOUSEHOLD DEBT AND BUSINESS CYCLES WORLDWIDE
Atif R. Mian
Amir Sufi
Emil Verner
Working Paper 21581
http://www.nber.org/papers/w21581
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
September 2015
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, Óscar Jordá, Anil Kashyap, Guido Lorenzoni, Virgiliu Midrigan,
Emi Nakamura, Jonathan Parker, Chris Sims, Andrei Shleifer, Paolo Surico, Alan Taylor, and
seminar participants at Princeton University, Northwestern University, Harvard University, NYU,
NYU Abu Dhabi, UCLA, the Swedish Riksbank conference on macro-prudential regulation,
Danmarks Nationalbank, the Central Bank of the Republic of Turkey, Wharton, the Bank of
England, 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. The views expressed
herein are those of the authors and do not necessarily reflect the views of the National Bureau of
Economic Research.
NBER working papers are circulated for discussion and comment purposes. They have not been
peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies
official NBER publications.
© 2015 by Atif R. Mian, Amir Sufi, and Emil Verner. All rights reserved. Short sections of text,
not to exceed two paragraphs, may be quoted without explicit permission provided that full
credit, including © notice, is given to the source.

Household Debt and Business Cycles Worldwide
Atif R. Mian, Amir Sufi, and Emil Verner
NBER Working Paper No. 21581
September 2015, Revised July 2016
JEL No. E17,E2,E21,E32,E44,G01,G21
ABSTRACT
An increase in the household debt to GDP ratio in the medium run predicts lower subsequent
GDP growth, higher unemployment, and negative growth forecasting errors in a panel of 30
countries from 1960 to 2012. Consistent with the “credit supply hypothesis,” we show that low
mortgage spreads predict an increase in the household debt to GDP ratio and a decline in
subsequent GDP growth when used as an instrument. The negative relation between the change in
household debt to GDP and subsequent output growth is stronger for countries that face stricter
monetary policy constraints as measured by a less flexible exchange rate regime, proximity to the
zero lower bound, or more external borrowing. A rise in the household debt to GDP ratio is
contemporaneously associated with a consumption boom followed by a reversal in the trade
deficit as imports collapse. 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.
Atif R. Mian
Princeton University
Bendheim Center For Finance
26 Prospect Avenue
Princeton, NJ 08540
and NBER
atif@princeton.edu
Amir Sufi
University of Chicago
Booth School of Business
5807 South Woodlawn Avenue
Chicago, IL 60637
and NBER
amir.sufi@chicagobooth.edu
Emil Verner
Princeton University
Bendheim Center For Finance
26 Prospect Avenue
Princeton, NJ 08540
verner@princeton.edu

The Great Recession has sparked new questions about the relation between household debt and
the macroeconomy. Recent theoretical and empirical research recognizes that a sudden and large
increase in household debt could lower subsequent output growth in the presence of monetary and
fiscal policy constraints. Moreover, households may not internalize the macroeconomic effects of
their own borrowing, making the economy susceptible to “excessive” credit growth.
1
However, empirical evidence on increases in household debt and subsequent economic perfor-
mance is largely limited to the United States and the most recent global recession. A more system-
atic evaluation of the empirical relation between household debt and business cycles worldwide is
needed in order to understand if recent events are representative of a broader pattern. This is im-
portant given the dramatic rise in household debt to GDP ratios over the last 50 years documented
by Jord`a et al. (2014a).
This paper compiles data for 30 countries from 1960 to 2012 and provides several new results
that highlight the importance of household credit shocks in driving business cycles worldwide.
There are two broad hypotheses that relate household debt to business cycles. The “credit de-
mand hypothesis” posits a positive relationship between current household borrowing and future
income. Household borrowing in this view is driven by productivity or technology shocks that
increase expected future income, spurring higher consumption and borrowing in anticipation. On
the other hand, the “credit supply hypothesis” holds that higher household borrowing is driven by
an expansion in the availability of credit. If there are plausible frictions such as nominal rigidities
or monetary policy constraints, then households may borrow excessively which leads to an eventual
slowdown in GDP growth.
Distinguishing the credit demand and credit supply hypotheses is important for our under-
standing of economic fluctuations and for guiding policy. For example, the relation between house-
hold debt and the business cycle is spuriously generated by expected income shocks in the credit
demand hypothesis, leaving no special role for regulation. However, under the credit supply hy-
pothesis, households may over-extend themselves when borrowing during a credit supply boom,
necessitating the need for macro-prudential regulation.
We present a number of results that reject the credit demand hypothesis and support the credit
1
See, e.g., Mian and Sufi (2014) and IMF (2012) for empirical evidence and Eggertsson and Krugman (2012), Guerrieri
and Lorenzoni (2015), Farhi and Werning (2015), Korinek and Simsek (2016), Schmitt-Groh´e and Uribe (2016), and
Martin and Philippon (2014) for theoretical analysis.
1

supply hypothesis. We show that an increase in the household debt to GDP ratio over a three
year period
2
in a given country predicts subsequently lower output growth.
3
The magnitude of the
predictive relation is large – 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 relation is robust across time and space. The strong negative
relation between changes in household debt and subsequent income growth is unique to household
debt. There is no such relation for non-financial firm debt.
The slowdown in GDP in response to an increase in household debt to GDP is not anticipated
by professional forecasters at the IMF and OECD. Consequently, an increase in the household
debt to GDP ratio from four years ago to last year predicts negative GDP growth forecast errors
from this year to three years forward. This finding suggests that the negative correlation between
household debt booms and subsequently lower output growth is unlikely to be driven by news or
income shocks seen by agents in the economy but unobservable to us as econometricians.
We also put together a new cross-country panel series on mortgage credit spreads to show
that low credit spreads predict an increase in household debt to GDP. If an increase in household
debt were driven by credit demand shocks, then we would expect the opposite relation. Using
the mortgage spread as an “imperfect instrument” in the spirit of Nevo and Rosen (2012), we
set-identify the negative effect of a credit supply-induced increase in household debt on subsequent
GDP growth.
The credit supply hypothesis also predicts that the negative relation between the change in
household debt and subsequent GDP growth is stronger when certain constraints on adjustment
are present, such as restrictions on monetary policy. We find that this is indeed the case in the
data. 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, or when a country borrows from abroad. Similarly, an increase in
the household debt to GDP ratio predicts an increase in the future unemployment rate, showing
2
As we explain below, the three year period is not chosen ad hoc. It is based on what the data tell us about the
length of credit cycles.
3
We follow standard time-series econometrics semantics 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.
2

evidence of underutilization of resources. Further, consistent with the credit supply hypothesis,
the expansion in debt is used to fuel consumption as opposed to investment. The trade balance
deteriorates, and the consumption share of imports rises sharply.
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 find that countries with a household debt to GDP cycle that is more strongly correlated with
the global debt cycle see a stronger decline in future output growth after a rise in the household
debt to GDP ratio. This is driven by the inability of countries to boost net exports when many
countries are suffering from a household debt hangover at the same time. Trade linkages lead to a
global debt cycle: there is a stronger negative relation between the rise in global household debt to
GDP and subsequent global growth.
The relation between a rise in global household debt and subsequent slowdown in global GDP
growth is not driven by the post-2000 period alone. In fact, using estimates from only pre-2000
data, we show that our regression model forecasts (out-of-sample) quite accurately the slowdown
in global growth during the late 2000s given the dramatic rise in global household debt during the
mid-2000s.
Our paper follows the recent influential work by Jord`a et al. (2014a), Schularick and Taylor
(2012), Jord`a et al. (2013), and Jord`a et al. (2014b) on the role of private debt in the macroe-
conomy. The authors put together long-run historical data for advanced economies to show that
credit growth, especially mortgage credit growth, predicts financial crises (also see Dell’Ariccia
et al. (2012)). Moreover, conditional on having a recession, stronger credit growth predicts deeper
recessions.
4
4
There is also cross-sectional evidence from the recent recession in the United States and Europe (see, e.g., Mian
and Sufi (2014), Glick and Lansing (2010), and IMF (2012)) showing that areas with the largest rise in household
debt during the boom saw the biggest decline in economic activity during the bust. Baron and Xiong (2016) show
that a large increase in bank credit to GDP predicts lower equity returns, and Cecchetti and Kharroubi (2015)
find that the growth in the financial sector is correlated with lower productivity growth. Cecchetti et al. (2011)
estimate country-level panel regressions relating economic growth from t to t + 5 to the level of government, firm,
and household debt in year t. They do not find strong evidence that the level of private debt predicts growth.
Reinhart and Rogoff (2009) provides an excellent overview of the patterns of financial crises throughout history.
3

Frequently asked questions

Q1. What are the contributions in this paper?

Consistent with the “ credit supply hypothesis, ” the authors show that low mortgage spreads predict an increase in the household debt to GDP ratio and a decline in subsequent GDP growth when used as an instrument. A rise in the household debt to GDP ratio is contemporaneously associated with a consumption boom followed by a reversal in the trade deficit as imports collapse. This paper compiles data for 30 countries from 1960 to 2012 and provides several new results that highlight the importance of household credit shocks in driving business cycles worldwide. The authors present a number of results that reject the credit demand hypothesis and support the credit See, e. g., Mian and Sufi ( 2014 ) and IMF ( 2012 ) for empirical evidence and 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 ) for theoretical analysis. 

Q2. What are the future works in this paper?

The authors believe their results offer useful guidance for further work aimed at understanding the connections between household credit and the macroeconomy. The authors can not currently discriminate between such possibilities. The authors look forward to research examining these questions. The household debt channel the authors uncover in this paper may be a relatively new phenomena that reflects heightened financialization. 

Q3. What is the main point of the paper?

Their findings regarding the consumption boom, heterogeneity with respect to monetary regimes, and the influence of credit supply shocks on household debt changes are important for understanding the mechanisms that generate the negative relation between household debt changes and subsequent GDP growth. 

Q4. What is the effect of the credit demand hypothesis on GDP growth?

The authors show that an increase in the household debt to GDP ratio over a three year period2 in a given country predicts subsequently lower output growth. 

Q5. What is the effect of a large increase in bank credit to GDP?

Baron and Xiong (2016) show that a large increase in bank credit to GDP predicts lower equity returns, and Cecchetti and Kharroubi (2015) find that the growth in the financial sector is correlated with lower productivity growth. 

Q6. What is the main point of departure from the above literature?

Their methodological point of departure from the above literature is that the authors focus on estimating the unconditional relation between changes in household debt and subsequent GDP growth, while earlier work focuses on the effect of increases in credit on recession severity conditional on having a recession. 

Q7. How does the study show that the household debt cycle is correlated with the trade deficit?

The authors 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. 

Q8. What is the way to explain the relationship between household debt and the economic cycle?

If there are plausible frictions such as nominal rigidities or monetary policy constraints, then households may borrow excessively which leads to an eventual slowdown in GDP growth. 

Q9. What is the effect of the household debt boom on consumption and investment?

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. 

Q10. What is the relationship between the rise in household debt and subsequent growth?

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, or when a country borrows from abroad. 

Q11. What is the relationship between the rise in household debt and the decline in global GDP?

consistent with the credit supply hypothesis, the expansion in debt is used to fuel consumption as opposed to investment.