Summary: Perhaps the most important frontier in microeconomics is the effect of debt on growth, especially private sector debt (government debt has different dynamics). Many economists have attempted to integrate debt levels into mainstream theory (e.g., Hyman Minsky). While so far unsuccessful, research has produced many useful insights. Here is a new study with a powerful conclusion: “An analysis of business cycles in 30 mostly advanced economies finds that burgeoning household debt is a strong indicator of an impending economic downturn.” {1st of 2 posts today.}
This is a follow-up to Fact & myth about the debt supercycle, a story of modern America.
Look at the end of this article to see America’s ratio of household debt to GDP.
“Household Debt and Business Cycles Worldwide”
By Matt Nesvisky in the January 2016 Digest
of the National Bureau of Economic Research. Reposted with permission.
An increase in household debt in relation to a country’s GDP is, at least in the short to medium term, a strong predictor of a weakening economy, according to an analysis of data from 30 nations by Atif R. Mian, Amir Sufi, and Emil Verner. The researchers use slowing growth and rising unemployment as key indicators of weakening. They find that the household debt factor is a better predictor of downturns than the debt of non-financial firms.
In “Household Debt and Business Cycles Worldwide“, the researchers analyze databases from the Bank for International Settlements, the World Bank, the Organization for Economic Cooperation and Development (OECD), and the International Monetary Fund (IMF) over the last half-century. They find that a rise in household debt, largely produced by more readily available credit, is a valuable forecaster of a contracting economy, citing as a prime example the growth of household debt in the early to mid-2000s and the slowing of global growth in the latter part of that decade.
The researchers see lower credit spreads and increases in risky debt as primary factors driving the rise in household debt. The availability of cheap credit spurs borrowing to finance higher consumption. In particular, household spending as a share of income rises during household debt booms, as do total imports and the share of consumption goods in total imports.
The expansion in household debt is followed by a sharp slowdown in GDP, consumption, and investment growth. This slowdown is not anticipated by professional forecasters at the IMF and OECD, giving household debt the ability to predict growth forecast errors.
The expansion in household debt is also followed by a sharp reversal of the current account balance, driven primarily by a fall in imports. If a number of countries are experiencing household debt growth at the same time, net export margins are unlikely to help an individual country export its way out of a downturn. Countries with a household debt to GDP cycle in line with that of the global debt cycle therefore see even larger declines in future output growth following a rise in household debt.
The researchers state that their approach to relating changes in household debt to subsequent GDP would have predicted a fall in global GDP growth during the 2007 to 2012 period. “The Great Recession was not an extreme outlier,” they write, but “followed a pattern we would expect given the tremendous rise in global household debt that preceded it.”
They acknowledge that predicting economic developments is prone to error and miscalculation, but argue that their study nevertheless suggests that considering periods of rapid growth in household debt in relation to GDP is a useful means of foreseeing periods of economic retrenchment.
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America’s ratio of household debt to GDP.
Our household debt to gdp level has falled by a fifth from its peak — and still falls, albeit at a slowing rate of descent (non-profits have relatively little debt). So we’re OK in terms of this analysis.
Unfortunately that’s not the full story. Household debt is still too high for a nation locked into slow growth, especially with so much of the debt held by boomers nearing retirement — when their ability to service the debt will drop, as many lack the retirement assets and income to service the debt. We might see large-scale bankruptcies by boomers during the next two decades.
About the study
Abstract to “Household Debt and Business Cycles Worldwide”
By Atif R. Mian, Amir Sufi, Emil Verner
NBER Working Paper, September 2015
A rise in the household debt to GDP ratio predicts lower output growth and higher unemployment over the medium-run, contrary to standard macroeconomic models. GDP forecasts by the IMF and OECD underestimate the importance of a rise in household debt to GDP, giving the change in household debt to GDP ratio of a country the ability to predict growth forecasting errors.
We use lower credit spreads and increases in risky debt issuance as instruments for the rise in household debt to GDP to argue that our results are supportive of recent models where debt growth is driven by changes in credit supply, borrowing constraints, or risk premia.
We also show that a rise in household debt to GDP is associated contemporaneously with a rising consumption share of output, a worsening of the current account balance, and a rise in the share of consumption goods within imports. This is followed by strong external adjustment when the economy slows as the current account reverses and net exports increase due to a sharp fall in imports.
Finally, an increase in global household debt to GDP also predicts lower global output growth. The pre-2000 predicted relationship between global household debt changes and subsequent global growth matches closely the actual decline in global growth after 2007 given the large increase in household debt during the early to mid-2000s.
About the National Bureau of Economic Research (NBER)
Founded in 1920, the NBER is the nation’s leading nonprofit economic research organization, a private, non-profit, non-partisan organization dedicated to conducting economic research.
The Bureau’s associates concentrate on four types of empirical research: developing new statistical measurements, estimating quantitative models of economic behavior, assessing the economic effects of public policies, and projecting the effects of alternative policy proposals. The NBER is supported by research grants from government agencies and private foundations, by investment income, and by contributions from individuals and corporations.
For More Information
(a) Typically excellent Fed research: “Deleveraging: Is it over and what was it?“, 24 June 2014.
(b) It’s superficial, but interesting: “Pay attention to long-term debt cycle” by Ray Dalio of Bridgewater Associates, Financial Times, 25 January 2016. Dalio does not distinguish between private and public debt, although they have radically different characteristics. There is little evidence that US public debt has reached the levels at which the effects he warns of apply. The rapid rise of debt in recent years has been corporate debt, which is high — but unclear if creating substantial risks to the overall economy.
(c) Please like us on Facebook, follow us on Twitter. See these posts about debt, about the debt supercycle, and especially these…
- Death of the post-WWII geopolitical regime, III – death by debt.
- Debt – the core problem of this financial crisis, which also explains how we got in this mess.
- Some Americans worry about we’ll have a lost decade. Bad news – we just had it.
- Rising consumer debt driving the recovery: boon or bane?
Good article but I was already aware of this.
My unanswered question: Is there a relationship between corporate debt and recessions? Also what is the current ratio between GDP and corporate debt?
I’ve read some remarkable things about companies borrowing billions that they cannot repay to make dividend payments, stock buy-back programs, etc. but not a lot since 2010 that actually improves the company’s revenue or reduces production costs.
These bad behaviors will all come back to haunt the company long after the CEO who did this has cashed out but I do not know whether they could cause a recession.
Pluto,
“Good article but I was already aware of this.”
You had already read the research? If not, I doubt you were aware that rising household debt/gdp could predict recessions.
“I’ve read some remarkable things about companies borrowing billions that they cannot repay to make dividend payments, stock buy-back programs”
Name one, please.
“not a lot since 2010 that actually improves the company’s revenue or reduces production costs.”
“Not a lot” is an absurd exaggeration. Many corporations are borrowing for the standard reasons.
“do not know whether they could cause a recession.”
Why would it?
FM, I read the research last week. You are not my only news source.
Me: “I’ve read some remarkable things about companies borrowing billions to make dividend payments and stock buy-back programs”
FM: Name one please.
Okay, IBM, Microsoft, 3M, Travelers, Cisco, Boeing, Caterpillar, just for starters.
https://www.washingtonpost.com/business/corporations-cant-stop-gobbling-up-their-own-stock/2014/05/09/83c8ddb0-d6e6-11e3-aae8-c2d44bd79778_story.html
Here’s the money quote:
“Of the $3.4 trillion in additional debt taken on by nonfinancial corporations since 2009, nearly 87 percent has been sent off to shareholders in the form of dividends and stock buybacks, according to Paradarch Advisors.”
FM: ““Not a lot” is an absurd exaggeration. Many corporations are borrowing for the standard reasons.”
According to the article only 13% of money borrowed by non-financial corporations has NOT been spent on “financial engineering.” Given the fact that we are talking trillions of dollars, your statement is still correct, but I suspect my statement is more accurate.
My original question, “does high corporate debt levels predict a recession,” still stands. Your response is a valid one but is obviously not an answer based on research. My question is based solely on the observation that high household debt predicts recessions. This makes sense because households have been accumulating debt to fund their purchases and high debt reduces near-future purchases.
Is the same true of companies? I am especially interested in companies that spend large amounts of money on things that do not increase revenue or lower costs. I don’t know and I was wondering if anybody had done any research on it.
Pluto,
“IBM, Microsoft, 3M, Travelers, Cisco, Boeing, Caterpillar”
Not nice cutting the key phrase from my question to change its meaning. It’s daft to think that those companies are “borrowing billions that they cannot repay to make dividend payments, stock buy-back programs”. All of those have investment grade ratings, with Boeing and Cat being the only with any long-term concerns about debt quality.
“My original question, “does high corporate debt levels predict a recession,” still stands. Your response is a valid one but is obviously not an answer based on research.”
False.
“My question is based solely on the observation that high household debt predicts recessions.”
Absurd to generalize that to corporate debt.
Pluto,
The source for that is a report by Paradarch Advisors. This factoid is endlessly repeated, but I don’t see a date, link, or excerpt for their their report. I don’t see their website (only looked for a minute). I’ve never heard of them. The number sounds unlikely, imo. It would be more plausible if one includes borrowing for M&A — or if came from a better-known source.
I suggest you not believe everything you read.
Popular among the heterodox camp is the theory that first govt runs a surplus as happened under Clinton. This takes money out of the economy by definition. The middle class tries to maintain status quo consumption by borrowing from banks thus replacing the disappearing money by newly created bank credit money. In short there are two sources of new money: government deficit monetization and bank credit. If one reduces the other rises because people try to maintain their quality of life. People using their homes as ATMs is not a moral failing it is human nature plus govt surplus generating fiscal policy.
I’m sorry, Peter, but this just does not make any sense. Please read and understand some good basic macro and micro-economic books before writing more about this. Here’s a good, entertaining introduction that you might like:
http://www.amazon.com/gp/product/0810988399?ref_=cm_cr-mr-title
Pluto,
I appreciate the effort, but it is hopeless. I have given Peter that advice countless times.
I have him on moderation, screening out his longer or esp daft comments.
“It is the mark of an educated mind to be able to entertain a thought without accepting it.”
— Aristotle
.
.
Editor’s note: This is a fake quote. Aristotle didn’t say it.
Peter,
That has to be the weakest defense of nonsense I’ve seen in a long time. It is also a fake quotation: https://en.wikiquote.org/wiki/Aristotle
Which illustrates exactly what I have told you so many times. You absorb misinformation uncritically.
Me: “My original question, “does high corporate debt levels predict a recession,” still stands. Your response is a valid one but is obviously not an answer based on research.”
FM: False.
Okay, please show me the research.
Pluto,
Sorry. Answering comments is a waste of time. Doing research for comments is insane. I’ve been doing this for 38years. My posts appear on professional-level websites. If you don’t believe me, fine.
Also, I’d like an apology for altering my question in a materially misleading way.
Okay, I apologize for altering your question. The reason I did so was because you were right and I had made an indefensible statement.
Pluto,
That’s impressive, and in my experience (45 thousand comments here, and countless elsewhere) quite rare. It shows a greatness of spirit.
And, unfortunately, the kind of mistake I’ve made too often as well.