The more households accumulate debt during a boom, the deeper the subsequent slump in the economy and the weaker the recovery, according to new IMF research.

“Dealing with Household Debt,” published in the April 2012 World Economic Outlook, found that housing busts preceded by larger run-ups in gross household debt—mortgages, personal loans, and credit card debt—are associated with significantly larger contractions in economic activity.

Household consumption and real GDP fall substantially more, unemployment rises more, and the reduction in economic activity persists for at least five years. A similar pattern holds for recessions more generally: those preceded by larger increases in household debt are more severe, according to the study's statistical analysis.

This is sobering for economies today, such as Iceland, Ireland, Spain, the United Kingdom, the United States, and others, where house prices collapsed during the Great Recession and the substantial amount of debt racked up during the boom became a burden holding back the recovery.

Household debt soared in the years leading up to the Great Recession. When house prices fell at the advent of the global financial crisis, many households saw their wealth shrink relative to their debt. Combined with less income and more unemployment, that meant it was harder for many people to make their mortgage payments, and defaults and foreclosures became endemic in some countries. Household deleveraging—paying off debts or defaulting on them—has begun and is most pronounced in the United States.

The study looks at the relationship between household debt (and deleveraging) and economic activity. It finds that larger declines in economic activity are not simply due to the larger drop in house prices and the consequent reduction of households' wealth. Indeed, household consumption falls by more than four times the amount explained by the fall in house prices in high-debt economies. It seems to be the combination of house price declines and pre-bust household indebtedness that accounts for the severity of the contraction.

Nor is the larger contraction in the economy simply driven by financial crises. The research finds that the relationship between household debt and the contraction in consumption holds even for economies that did not experience a banking crisis around the time of the housing bust.

The study includes case studies of how governments have responded during episodes of household deleveraging—in the United States in the 1930s and today; Hungary and Iceland today; Colombia in 1999; and three Scandinavian countries (Finland, Norway, and Sweden) in the 1990s. In each case a housing bust was preceded by or coincided with a substantial increase in household debt.

The solution, as with so many instances in everyday life, is unpalatable: more discipline required. Specifically, each credit card we hold already has its pre-determined limit; this must become a global limit, for the total of all your credit card debt.

That would rein in personal debt. But is it an “ultimate” answer? Not really. For “ultimate answers” we need to look at policies and financial infrastructural facilities which will create full employment, and we need to ensure that a fair day's work is rewarded with a fair day's pay. That's surely enough – but no, there's more: we need a dramatic increase in the productive efficiency of government, which takes 50% of the national cake and delivers perhaps 25% usable value.

The Economics of Prosperity

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