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Monday, January 11, 2010

Fed Economic Letter: "Global Household Leverage, House Prices, and Consumption"

by Calculated Risk on 1/11/2010 02:21:00 PM

From Reuven Glick and Kevin J. Lansing at the San Francisco Fed: Global Household Leverage, House Prices, and Consumption (ht Amir)

"[O]ver-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money." —Irving Fisher (1933)

In the United States and many other industrial countries, the recent financial crisis contributed to the longest and most severe economic contraction since the Great Depression. The rapid expansion in the use of borrowed money, or leverage, by households in recent years, is one factor that may help account for the virulence of the downturn.

In the years leading up to the crisis, a combination of factors, including low interest rates, lax lending standards, a proliferation of exotic mortgage products, and the growth of a global market for securitized loans fueled a rapid increase in household borrowing. An influx of new and often speculative homebuyers with access to easy credit helped bid up U.S. house prices to unprecedented levels relative to rents or disposable income. U.S. household leverage, as measured by the ratio of debt to personal disposable income, reached an all-time high, exceeding 130% in 2007 (see Glick and Lansing 2009). National house prices peaked in 2006 and have since dropped by about 30%. The bursting of the housing bubble set off a chain of events that pushed the U.S. economy into a severe recession that started in December 2007.

This Economic Letter shows that the recent U.S. experience is by no means unique. Household leverage in many industrial countries increased dramatically in the years prior to 2007. Countries with the largest increases in household leverage tended to experience the fastest rise in house prices over the same period. Moreover, these same countries tended to experience the most severe declines in consumption once house prices started falling. The common patterns observed across countries suggest that, as in the United States, the unwinding of excess household leverage via increased saving or increased default rates could be a significant drag on consumption and bank lending going forward, possibly muting the vigor of the economic recovery.
And a couple of graphs from the paper. The first graph plots the change in house prices vs. the change in household leverage.

Note: this is on a national basis. Professors Atif Mian and Amir Sufi (both University of Chicago Booth School of Business and NBER) published a paper last year showing the same result across U.S. counties), see: The Household Leverage-Driven Recession of 2007 to 2009 or my post last September for excerpts and graphs: MEW and the Wealth Effect

Distressed Sales Click on graph for larger image in new window.
Figure 3 ... shows that countries exhibiting the largest increases in household leverage from 1997 to 2007 also tended to experience the fastest rise in house prices over same period. The pattern suggests that the link between easy mortgage credit and rising house prices held on a global scale.
The second graph shows the change in consumption following the financial crisis vs. the change in household leverage prior to the crisis:

Distressed Sales
Figure 4 shows that countries experiencing the largest increases in household leverage before the crisis tended to experience the most severe recessions, where severity is measured by the percentage decline in real consumption from the second quarter of 2008 to the first quarter of 2009. Consumption fell most sharply in Ireland (-6.7%) and Denmark (-6.3%), both of which saw huge increases in household leverage prior to the crisis. Consumption was flat or fell only slightly in Germany, Austria, Belgium, and France, which were among the countries that saw the smallest increases in household leverage before the crisis. Overall, the data suggest that recession severity in a given country reflects the degree to which prior growth was driven by an unsustainable borrowing trend.
Not a surprise, but this suggests growth will be sluggish in the U.S., and regulators should be alert to rapid increases in household leverage.