Macroeconomic effects of household debt: an empirical analysis
Yun K. Kim
Keywords: household debt; business cycles; financial instability hypothesis; cointegration; VAR; VECM
Published in print:Apr 2016
Category:Research Article
Pages:127–150
Download PDF (886.3 KB)
Multi-equation econometric frameworks are used to investigate the impact of household debt on GDP in the US. In the vector autoregression analysis capturing the transitory feedback effects, we observe a bidirectional positive feedback process between aggregate income and debt. According to the estimation of vector error correction models, there are negative long-run relationships between household debt and output. These empirical results provide a support for the view of the debt-driven business cycles.
Full Text
1 INTRODUCTION
Prior to the financial crisis of 2007, the US experienced a significant increase in household debt relative to income. Figure 1 depicts the ratios of consumer, mortgage, and household debt (sum of mortgage and consumer debt) relative to gross domestic product (GDP). Household debt outstanding as a share of GDP, for example, increased from about 45 percent in 1975 to nearly 100 percent in 2009. Although there is more fluctuation in the consumer debt–GDP ratio, a clear upward trend is observed, especially since 1985. Mortgage debt seems to be a dominating component of household debt, and the household and mortgage debt–GDP ratios seem to show close comovements.
Figure 1
Debt outstanding as a share of GDP (1951Q4–2009Q1)
Citation: 4, 2;10.4337/roke.2016.02.01
Figure 2 depicts the evolution of debt–net worth ratios. This provides additional evidence of the substantial increase in debt. Similar to the debt–GDP ratios, both household and mortgage debt–net worth ratios exhibit a clear upward trend over the whole sample period. Consumer debt–net worth ratio shows an upward trend until the middle of 1970, but, after that, it shows considerable fluctuations. In general, the liability side has grown more rapidly than the asset side over the sample period. Similar to the debt–GDP ratios, household and mortgage debt–net worth ratios seem to show close comovements.
Figure 2
Debt outstanding as a share of household net worth (1951Q4–2009Q1)
Citation: 4, 2;10.4337/roke.2016.02.01
Figure 3 depicts two measures of the debt service burden: household financial obligations as a percentage of disposable personal income (FODSP) and household debt service payments as a percentage of disposable personal income (TDSP). These two series have been used by the Federal Reserve as primary measures of the household debt burden (Greenspan 2004), and are available starting in 1980. 1 Both measures also show upward trends, indicating that households’ financial positions have been continuously worsening. These levels of debt accumulation eventually proved untenable – as has been broadly implied in the Great Recession.
Figure 3
Debt service and financial obligation as a share of disposable income (1980Q1–2009Q1)
Citation: 4, 2;10.4337/roke.2016.02.01
A number of post-Keynesian scholars have addressed the macroeconomic implications of household debt using formal models. For example, Palley (1994) incorporates consumer debt into a linear multiplier-accelerator model and analyses the cyclical aspects of consumer borrowing over the business cycle. In his model, a rise in consumer debt initially increases consumption and hence promotes growth, but eventually the accumulation of debt becomes excessive. This implies that there is a transfer of income from low saving agents (debtors) to high saving agents (rentiers) at an increasing rate due to the debt service payments. The debt service burden then reduces consumption and output level. This provides a mechanism of credit-driven cyclical process of output. Dutt (2006) investigates the role of consumer debt within a neo-Kaleckian growth and distribution framework. In Dutt's model, an increase in household consumption debt raises the growth rate in the short run. In the long run, however, the effect is ambiguous because the accumulation of consumer debt results in a shift in income distribution toward rentiers, who have a higher propensity to save. This latter result has a depressing effect on the long-run growth rate in a demand-driven model. Nishi (2012) incorporates an endogenous interest rate into a neo-Kaleckian growth model, where the change in interest rate responds to workers’ indebtedness, and investigates the dynamic stability of the system. He also demonstrates that the introduction of household borrowing can change the characteristics of a demand-generating process (that is, wage-led and profit-led). 2
Post-Keynesian thoughts on the effect of debt on the macroeconomy are also strongly influenced by Hyman Minsky's financial instability hypothesis. Minsky's theory clarifies the two-sided aspects of debt-financed spending. During the boom phase of the business cycle, debt-financed household spending (and investment as traditionally emphasized) provides a source of additional economic stimulus. 3 However, as the economy experiences a prolonged phase of prosperity, more debt-financed spending occurs and the debt-to-income ratio eventually rises. The balance sheets of businesses and households deteriorate and the system becomes financially fragile. The system becomes highly vulnerable to negative shocks, potentially resulting in a severe economic downturn.
Minsky's financial instability hypothesis has been applied to household debt by Cynamon and Fazzari (2008), who provide a very informative discussion of household debt from a Minskyan perspective. They observe that, from the 1980s to the early 2000s, the US experienced consumption expansion accompanied by significant household debt accumulation. Cynamon and Fazzari (2008) argue that, although this provided a substantial macroeconomic stimulus, this unprecedented rise in household debt could have planted the seeds for financial instability and a non-trivial economic downturn.
As the argument by Cynamon and Fazzari (2008) implies, Minsky's financial instability hypothesis can be read as highlighting distinctive debt effects depending on the time frame under consideration. Debt-financed household spending may provide a source of additional economic stimulus in the shorter time period, but eventually the accumulation of debt could become excessive, generating a negative impact on consumption and output level in the long run (for example through the higher debt service payments and frugal consumer behavior due to the excessive debt level). The system could become highly vulnerable to negative shocks, potentially resulting in a severe economic downturn. From this point of view, there are distinguishing effects of debt in the short and longer time period. 4
I approach my empirical investigation from the theoretical perspective of debt-driven business cycles. I will empirically distinguish the short-run and the long-run impact of household debt on real GDP. Multi-equation econometric frameworks are used to analyse the relationship between household debt and aggregate income. I study the unit roots and cointegrating relationships. Based on the findings, I implement vector autoregression (VAR) and vector error correction (VECM) models. In the VAR analysis, which captures the transitory (short-run) feedbacks among the growth rates of debt, GDP, and net worth, I observe a bidirectional positive feedback process between aggregate income and debt. According to the VECM estimation, which captures long-run relationships in a multi-equation framework, there is a negative long-run relationship between household debt and output. Our results provide evidence for household debt-driven busine
Download PDF (886.3 KB)
Multi-equation econometric frameworks are used to investigate the impact of household debt on GDP in the US. In the vector autoregression analysis capturing the transitory feedback effects, we observe a bidirectional positive feedback process between aggregate income and debt. According to the estimation of vector error correction models, there are negative long-run relationships between household debt and output. These empirical results provide a support for the view of the debt-driven business cycles.
Full Text
1 INTRODUCTION
Prior to the financial crisis of 2007, the US experienced a significant increase in household debt relative to income. Figure 1 depicts the ratios of consumer, mortgage, and household debt (sum of mortgage and consumer debt) relative to gross domestic product (GDP). Household debt outstanding as a share of GDP, for example, increased from about 45 percent in 1975 to nearly 100 percent in 2009. Although there is more fluctuation in the consumer debt–GDP ratio, a clear upward trend is observed, especially since 1985. Mortgage debt seems to be a dominating component of household debt, and the household and mortgage debt–GDP ratios seem to show close comovements.
Figure 1
Debt outstanding as a share of GDP (1951Q4–2009Q1)Citation: 4, 2;10.4337/roke.2016.02.01
Figure 2 depicts the evolution of debt–net worth ratios. This provides additional evidence of the substantial increase in debt. Similar to the debt–GDP ratios, both household and mortgage debt–net worth ratios exhibit a clear upward trend over the whole sample period. Consumer debt–net worth ratio shows an upward trend until the middle of 1970, but, after that, it shows considerable fluctuations. In general, the liability side has grown more rapidly than the asset side over the sample period. Similar to the debt–GDP ratios, household and mortgage debt–net worth ratios seem to show close comovements.
Figure 2
Debt outstanding as a share of household net worth (1951Q4–2009Q1)Citation: 4, 2;10.4337/roke.2016.02.01
Figure 3 depicts two measures of the debt service burden: household financial obligations as a percentage of disposable personal income (FODSP) and household debt service payments as a percentage of disposable personal income (TDSP). These two series have been used by the Federal Reserve as primary measures of the household debt burden (Greenspan 2004), and are available starting in 1980. 1 Both measures also show upward trends, indicating that households’ financial positions have been continuously worsening. These levels of debt accumulation eventually proved untenable – as has been broadly implied in the Great Recession.
Figure 3
Debt service and financial obligation as a share of disposable income (1980Q1–2009Q1)Citation: 4, 2;10.4337/roke.2016.02.01
A number of post-Keynesian scholars have addressed the macroeconomic implications of household debt using formal models. For example, Palley (1994) incorporates consumer debt into a linear multiplier-accelerator model and analyses the cyclical aspects of consumer borrowing over the business cycle. In his model, a rise in consumer debt initially increases consumption and hence promotes growth, but eventually the accumulation of debt becomes excessive. This implies that there is a transfer of income from low saving agents (debtors) to high saving agents (rentiers) at an increasing rate due to the debt service payments. The debt service burden then reduces consumption and output level. This provides a mechanism of credit-driven cyclical process of output. Dutt (2006) investigates the role of consumer debt within a neo-Kaleckian growth and distribution framework. In Dutt's model, an increase in household consumption debt raises the growth rate in the short run. In the long run, however, the effect is ambiguous because the accumulation of consumer debt results in a shift in income distribution toward rentiers, who have a higher propensity to save. This latter result has a depressing effect on the long-run growth rate in a demand-driven model. Nishi (2012) incorporates an endogenous interest rate into a neo-Kaleckian growth model, where the change in interest rate responds to workers’ indebtedness, and investigates the dynamic stability of the system. He also demonstrates that the introduction of household borrowing can change the characteristics of a demand-generating process (that is, wage-led and profit-led). 2
Post-Keynesian thoughts on the effect of debt on the macroeconomy are also strongly influenced by Hyman Minsky's financial instability hypothesis. Minsky's theory clarifies the two-sided aspects of debt-financed spending. During the boom phase of the business cycle, debt-financed household spending (and investment as traditionally emphasized) provides a source of additional economic stimulus. 3 However, as the economy experiences a prolonged phase of prosperity, more debt-financed spending occurs and the debt-to-income ratio eventually rises. The balance sheets of businesses and households deteriorate and the system becomes financially fragile. The system becomes highly vulnerable to negative shocks, potentially resulting in a severe economic downturn.
Minsky's financial instability hypothesis has been applied to household debt by Cynamon and Fazzari (2008), who provide a very informative discussion of household debt from a Minskyan perspective. They observe that, from the 1980s to the early 2000s, the US experienced consumption expansion accompanied by significant household debt accumulation. Cynamon and Fazzari (2008) argue that, although this provided a substantial macroeconomic stimulus, this unprecedented rise in household debt could have planted the seeds for financial instability and a non-trivial economic downturn.
As the argument by Cynamon and Fazzari (2008) implies, Minsky's financial instability hypothesis can be read as highlighting distinctive debt effects depending on the time frame under consideration. Debt-financed household spending may provide a source of additional economic stimulus in the shorter time period, but eventually the accumulation of debt could become excessive, generating a negative impact on consumption and output level in the long run (for example through the higher debt service payments and frugal consumer behavior due to the excessive debt level). The system could become highly vulnerable to negative shocks, potentially resulting in a severe economic downturn. From this point of view, there are distinguishing effects of debt in the short and longer time period. 4
I approach my empirical investigation from the theoretical perspective of debt-driven business cycles. I will empirically distinguish the short-run and the long-run impact of household debt on real GDP. Multi-equation econometric frameworks are used to analyse the relationship between household debt and aggregate income. I study the unit roots and cointegrating relationships. Based on the findings, I implement vector autoregression (VAR) and vector error correction (VECM) models. In the VAR analysis, which captures the transitory (short-run) feedbacks among the growth rates of debt, GDP, and net worth, I observe a bidirectional positive feedback process between aggregate income and debt. According to the VECM estimation, which captures long-run relationships in a multi-equation framework, there is a negative long-run relationship between household debt and output. Our results provide evidence for household debt-driven busine
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