Based on analysis of advanced economies over the past three decades, housing busts preceded by larger run-ups in household debt tend to be more severe and protracted.
This is one finding presented in the International Monetary Fund, World Economic Outlook April 2012, titled Growth Resuming, Dangers Remain.
Australia is not absence from the list of advanced economies who have witnessed a rapid rise in household debt. Down under, we have almost quadrupled our household debt as a percentage of household disposable income over the past thirty years causing many to question if this level of debt burden is sustainable.
Most of this debt has been piled into our residential property market, which has now experienced price declines for five consecutive quarters while the growth of housing finance falls to levels not seen since records started some 35 years ago.
According to the IMF report, in the five years preceding the Great Recession (GFC) of 2007, advanced economies recorded an average household debt to income increase of 39 percentage points. A quick look at the Reserve Bank of Australia figures suggest Australia’s household debt to income ratio increased by a bit more than 37 percentage points.
Chapter 3 of the IMF report sets out to determine the relationship between household debt and the depth of economic downturns.
It found the declines in economic activity after a housing bust are not simply reflective of the decline in the asset price and the associated destruction of household wealth. It is a combination of the former and pre-bust leverage that ultimately explains the depth of the contraction. Simply put, the more household debt, the bigger the bust and this holds true regardless of a banking crisis or not. Economic downturns following high debt housing busts are also more protracted, with declining consumption lasting for at least five years.
According to the report, in economies with high household debt, household consumption can fall by more than four times the amount that can be reasonably explained by falling house prices alone. This is caused, in part, by more pronounced de-leveraging, as households try to repair their weak balance sheets. In low debt housing busts, as could be expected, there is no discernible decline in household debt to income ratios.
De-leveraging can result from a number of factors including a realisation that house prices were overvalued, a tightening of credit standards, a sharp revision in income expectations and an increase in economic uncertainty. Uncertainty can also lead to an increase in household savings, at the expense of consumption.
High debt busts typically cause greater falls in real GDP and larger increases in unemployment.
As unemployment rises due to falling consumption, the ability of households to service their large debts diminish causing defaults and foreclosures starting what the IMF call a ‘self-reinforcing contractionary spiral’. Estimates presented in the report suggest a single foreclosure can lower neighbouring house prices by 1 per cent, but a wave of foreclosures could wipe as much as 30 per cent off local prices.
Negative equity can also have a role to play, with a U.S. study finding homeowners with negative equity spend 30 per cent less on maintenance and home improvements, than those that don’t. Maintenance and home improvements either retain or increase the relative value of the home.
Similarly, as supply exceeds demand or as foreclosed homes sit vacant on the market, months of neglect and deterioration further reduce values. Vacant homes and unemployment can also result with social issues such as high crime rates making areas less desirable to purchase in.
» World Economic Outlook, Growth Resuming, Dangers Remain – International Monetary Fund, April 2012.