Too Much of a Good Thing? Households’ Macroeconomic Conditions and Credit Dynamics
Households’ credit dynamics are an important topic from both the monetary policy and financial stability perspectives. A number of global economies have experienced the destabilising effects of household overindebtedness, which is often accompanied by rapid growth in prices of assets, especially real estate. The most recent such experience was the Global Financial Crisis (GFC) of 2008–2009. This is no surprise. The literature shows that overindebtedness is often followed by an economic contraction. The larger and longer is the credit boom, the deeper the subsequent drop tends to be.[1]
Households’ expectations regarding future economic developments play a key role in their borrowing decisions. In good times, when the economy is growing at an above-average pace, households may begin to underestimate the risks associated with their economic decisions. If they erroneously start to expect the good times to last for years, or “forever”, and to give insufficient weight to risk signals and adverse information. They may become over-indebted, because they expect future income growth to allow them to repay the increased debt without any problems. In the literature, such expectations are termed extrapolative – households extrapolate their perception of the present situation into the future.[2]
In our two papers, we investigate the relationship between the macroeconomic conditions faced by households, the confidence of households as consumers and investors, and credit growth. We build on the concept of extrapolative expectations and we consider households’ expectations regarding future developments to be one of the key factors affecting their demand for credit. Our results show that households tend to form their expectations regarding future economic developments based on their recent experience.
The aggregate evolution of households’ macroeconomic conditions is captured by the new Households’ Macroeconomic Conditions Index (H-MCI) which we present in our first paper Introducing a New Index of Households’ Macroeconomic Conditions. The H-MCI is the result of a factor model estimation for 22 OECD countries. Chart 1 shows the H-MCI for the Czech Republic along with a decomposition into individual factors. Positive values of the index indicate favourable conditions for households and negative values unfavourable conditions. These are then reflected in households’ optimism or pessimism about the future economic outlook. It can be seen, for example, that households’ optimism before the GFC was primarily a result of the favourable evolution of the real economy and asset prices. By contrast, interest rates functioned as a dampening factor during this period. After the outbreak of the GFC, the H-MCI turned pessimistic. In recent years, we observe renewed growth in the H-MCI. This time the optimism is being driven by the real economy and the low interest rate environment. At the end of 2018 and in the course of 2019, the H-MCI began to show a gradual turnaround due to a declining contribution from the domestic economy, reflecting a households’ slightly worsening outlook regarding the future economic situation.
In the paper, we use the Czech Republic as a case study to show that the H-MCI can serve as a good predictor of credit to households. The H-MCI is able to predict consumer loan growth at short horizons (up to 1 year) and mortgage growth at longer horizons (from 2 years up). This shows that households generally need a longer continuous period of good macroeconomic conditions to take on a mortgage, while a relatively short period of growth is sufficient to lift demand for consumer credit.
Chart 1: The H-MCI for the Czech Republic and the contributions of individual factors
Note: The vertical axis shows the standard deviation. The variables used to estimate the H-MCI are listed in Table 1 in Introducing a New Index of Households’ Macroeconomic Conditions.
In our second paper, Too Much of a Good Thing? Households’ Macroeconomic Conditions and Credit Dynamics, we focus on the link between the new H-MCI and credit dynamics in OECD countries. We show that households’ macroeconomic conditions significantly influence the dynamics of bank loans provided to this sector. Our results suggest that the procyclicality of credit to households is stronger in periods of very good macroeconomic conditions. Once the business cycle turns down and economic conditions deteriorate, households start to become pessimistic, because their existing indebtedness is no longer matched by sufficient income growth. Households thus find themselves burdened with too much debt, which they can repay only with great difficulty, if at all. This may be reflected in increased losses for the banks that extended such credit, and in reduced consumption and investment. These findings underscore the importance of having macroprudential policies that are countercyclical – in the sense of either slowing excessive credit growth or creating reserves to cover future losses in the banking sector.
Bordalo, P., N. Gennaioli and A. Shleifer (2018): “Diagnostic Expectations and Credit Cycles.” Journal of Finance, 73(1): 199–227.
Borio, C. (2012): “The Financial Cycle and Macroeconomics: What Have We Learnt?” BIS Working Paper No 395, Bank for International Settlements.
Dell’Ariccia, G., D. Igan, L. Laeven and H. Tong (2016): “Credit Booms and Macrofinancial Stability.” Economic Policy, 31(86): 299–355.
Foote, C., K. S. Gerardi and P. S. Willen (2012): “Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis.” NBER Working Paper 18082, National Bureau of Economic Research.
Fuster, A., D. Laibson and B. Mendel (2010): “Natural Expectations and Macroeconomic Fluctuations.” Journal of Economic Perspectives, 24(4): 67–84.
Jordà, Ò., M. Schularick and A. M. Taylor (2010): “Financial Crises, Credit Booms, and External Imbalances: 140 Years of Lessons.” NBER Working Paper 16567, National Bureau of Economic Research.
Jordà O., M. Schularick and A. M. Taylor (2013): “When Credit Bites Back: Leverage, Business Cycles and Crises.” Journal of Money, Credit and Banking, 45: 3–28.
Schularick, M., and A. M. Taylor (2012): “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870–2008.” American Economic Review, 102(2): 1029–1061.
[1] Studies on this issue include Schularick and Taylor (2009), Borio (2012), Jordà et al. (2010), Jordà et al. (2013) and Dell’Ariccia et al. (2016).
[2] There are many theoretical studies on this subject, such as Fuster et al. (2010), Foote et al. (2012) and Bordalo et al. (2018).