What is the relationship between high consume debt levels, and consumption? This is an important question for Australia, given the current record levels of personal debt, and sluggish consumer activity. Also, what will happen should house prices slip back, and households shift to a deleveraging mentality? The short answer is it will have a significant depressive economic impact – if insights from a newly published paper are true.
In a Bank of Canada Staff Working Paper, “Debt Overhang and Deleveraging in the US Household Sector: Gauging the Impact on Consumption” they use a dataset for the US states to examine whether household debt and the protracted debt deleveraging helps to explain the dismal performance of US consumption since 2007, in the aftermath of the housing bubble. By separating the concepts of
deleveraging and debt overhang—a flow and stock effect—they conclude that excessive indebtedness exerted a meaningful drag on consumption over and beyond income and wealth effects.
The leveraging and subsequent deleveraging cycle in the US household sector had a signifi cant impact on the performance of economic activity in the years around the Great Recession of 2007-09. A growing body of theoretical and empirical studies has therefore focused on explaining to what extent and through which channels the excessive buildup of debt and the deleveraging phase might have contributed to depressing economic activity and consumption growth.
They use panel regression techniques applied to a novel data set with prototype estimates of personal consumption expenditures at the state-level for the 51 US states (including the District of Columbia) over the period from 1999Q1 to 2012Q4. They include the main determinants as used in traditional consumption functions, but add in debt and its misalignment from equilibrium. They conclude that excessive indebtedness of US households and the balance-sheet adjustment that followed have had a meaningful negative impact on consumption growth over and beyond the traditional effects from wealth and income around the time of the Great Recession and the early years of the recovery. The e ffect is mostly driven by the states with particularly large imbalances in their household
sector. This might be indicative of non-linearities, whereby indebtedness begins to bite only when there is a sizable misalignment from the debt level dictated by economic fundamentals. They show that some states experienced significant deleveraging and a fall in household wealth.
They argue that the nature of the indebtedness determines the ultimate impact of debt on consumption. The drag on US consumption growth from the adjustments in household debt appears to be driven by a group of states where debt imbalances in the household sector were the greatest. This suggests that the adverse e ffects of debt on consumption might be felt in a non-linear fashion and only
when misalignments of household debt leverage away from sustainable levels – as justfi ed by economic fundamentals – become excessive. Against the background of the ongoing recovery in the United States, where the deleveraging process appears to be already over at the national level, one might expect house-hold debt to support consumption growth going forward as long as the increase in debt does not lead to a widening of the debt gap.
Note that Bank of Canada staff working papers provide a forum for staff to publish work-in-progress research independently from the Bank’s Governing Council. This research may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this paper are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank of Canada, the European Central Bank or the Eurosystem.
