The meteoric rise of household debt

Household debt is four times larger than government debt.

In 2000, it was $2 billion and government debt was $0.16 billion ($160 million). The rise in household debt has been meteoric: in the run- up to the recession, it increased by an average of 14 per cent each year, whilst the economy grew by less than 4 per cent over the same period.

Here’s what’s disturbing. Recessions are more severe when they are preceded by large increases in household debt. At least this is the view of the latest chapter from the International Monetary Fund’s (IMF) World Economic Outlook released last week.

The IMF study looked at 33 Organization for Economic Cooperation and Development (OECD) economies over the period 1950 to 2010, as well as case studies of episodes of excessive household debt in the US, Iceland and Scandinavia. Since 2008, the performance of local retail sales, a proxy for household consumption, correlates closely to the experience of OECD countries, with large household debt.

How households choose to deleverage — reduce their debts — will go a long way in determining the timing and pace of recovery. There are three options open to households: varying degrees of default; restructuring; and soldiering on.

It should come as no surprise that debt is not evenly distributed among households. In the run-up to the recession, households at the lower end of the income ladder took on more debt than those at the top.

What’s more, low-income households tend to spend a larger portion of both total and, more importantly, additional income on goods and services which generate additional rounds of spending and income. More technically, households at the lower end have a higher marginal propensity to consume. Consequently, a dollar redistributed from a high-income household to a low-income household is potentially expansionary for the macro-economy.

Liberals, in the utilitarian tradition, argue that the redistribution improves gross domestic happiness since the loss of happiness at the top end is more than compensated for by the gain at the lower end. There are caveats: taking from the wealthy will not negatively affect their willingness to work; or the low interest rate environment may be just the thing to encourage high-income households to save less and spend more.

Libertarians correctly point out that redistribution is a risky business; that equality of opportunity is more important than equality of incomes. Some go further arguing that governments have no moral right to redistribute income or wealth.

The recession exposed major failures in the ability of the financial services sector to deliver an optimal quantity of socially useful products, which is what markets are supposed to do. On that basis, carefully designed government intervention into the markets for residential and commercial real estate and the financial services sector can improve on purely market-driven outcomes. Intervention can also help repair the damage done by excessive lending and the selling of financial products that served little social purpose. The inappropriate use of derivatives is a case in point.

Household spending will continue to decline because of deleveraging. Deleveraging is a natural reaction to: the realization that houses were overvalued; a tightening in credit standards; and a sharp revision of income expectations and increased economic uncertainty.

In the US, negative house price effects led to increased waves of foreclosures that led to price declines of almost 30 per cent and these in turn led to negative wealth effects that depressed household consumption.

It should come as no surprise that households with negative equity forego investments that improve home values. In fact, the evidence suggests that households with negative equity spend 30 per cent less on home improvement.

No one benefits from fire sale prices. A precursor of fire sales is an unsustainable increase in non-performing loans. Non-performing loans doubled between September 2010 and 2011 and have continued upward albeit at a slower pace, according to a Bermuda Monetary Authority (BMA) banking digest.

These undermine a financial institution’s ability to lend and borrow, which in turn contracts the supply of loanable funds or credit. The nature of financial services externalities justifies intervention aimed at averting waves of household defaults and foreclosures.

Distress sales are the main driving force behind the recent declines in US house prices. More disturbingly, data suggest that US house prices have fallen below the level consistent with some fundamentals.

What should government intervention look like?

Firstly, policy efforts should lower the cost of restructuring debt by facilitating write-downs, and helping to prevent foreclosures. Debt restructuring is key to the deleveraging effort.

Examples include: voluntary out-of-court debt restructuring including write-downs on principal and interest; government sponsored debt restructuring programs involving direct negotiation between lenders and borrowers or with the help of a debtor’s ombudsman; and government buying distressed mortgages and selling them back to financial services firms or other investors when the market improves.

Secondly, temporary fiscal stimulus in the form of increased social assistance targeted at financially constrained households could be expansionary and reduce the risk of households deleveraging through default.

Budget 2012-2013 provides for $39 million of financial assistance. Given the severity of the present situation, the budgeted amount is woefully inadequate. We have already shown that a stimulus targeted at low-income households can be expansionary for the macro-economy.

Third, given the spread between local and overseas base rates, there is room for monetary stimulus. Lower mortgage rates would ease debt servicing and provide much needed relief to debt burdened households.

All of these policies reek of moral hazard. If a borrower believes that the government may restructure her mortgage, then she has an incentive to renege on the original terms.

The government’s programme may create an unnecessarily large demand for restructured mortgages. Lenders, if they believe debt restructuring is a permanent fixture in the government’s policy arsenal, will have an incentive to lower standards and lend disproportionately to ‘sub-prime’ types. Government, or more accurately, taxpayers, bear the risk of restructuring mortgages programs.

The borrowing and lending decisions of households and the financial services sector in the run up to the recession are creating a drag on the recovery effort. What started out as a private affair is now having economy-wide effects. It’s a public issue now, begging for a policy response from the government and financial services sector.

And yes, some of the responses will drive government debt higher. Failure on the part of the main stakeholders to act quickly could prolong the recession well into 2014 or worse, and plunge the housing market into a vicious cycle of defaults, foreclosures and falling prices.

• Craig Simmons is an economics lecturer at Bermuda College.