RDP 2019-06: The Effect of Mortgage Debt on Consumer Spending: Evidence from Household-level Data 1. Introduction

The household debt-to-income ratio has risen to record levels in Australia in recent years, while household spending has been relatively weak (Figure 1). This follows a period of stagnation in household debt relative to income, which included the global financial crisis (GFC). A similar pattern of high household debt and weak spending has been observed across a range of other countries (Bunn and Rostom 2015; Pistaferri 2016; Lombardi, Mohanty and Shim 2017). This has led to concerns amongst policymakers that elevated levels of household debt are holding back the economic recovery and pose risks to future growth (Hunt 2015; Brazier 2017; Lowe 2017).

Supporting these concerns, international research indicates that expansions in household debt (relative to GDP) can increase the risk of financial crises and subsequently lower household spending (Schularick and Taylor 2012; Jordà, Schularick and Taylor 2013; Mian, Sufi and Verner 2017; Mian and Sufi 2018). This research has typically linked the decline in household spending to the balance sheet adjustments that tend to follow either widespread debt defaults or a tightening in bank lending standards that lowers the ability of households to borrow (e.g. Mian and Sufi 2010, 2018). Either way, the decline in spending is related to disruptions of the financial system and lower credit availability for households.

This makes Australia an interesting case study. Australia has seen a strong increase in household debt and weak spending over recent years despite a persistently stable banking system and reasonable economic growth even during the GFC. This suggests that a high level of household debt may weigh on spending even when the economy is in a more ‘normal’ phase of the business cycle.

So do high levels of household debt cause weaker spending? And does such a relationship exist in both an economic downturn and in more ‘normal’ times? We use a rich source of longitudinal household-level data to test whether higher mortgage debt causes lower household spending (which we refer to as the ‘debt overhang effect’). Our unique data allow us to explore the underlying mechanisms of any debt overhang effect by looking at whether financially constrained households or households with strong precautionary saving motives are particularly sensitive to debt in their spending decisions. Relatedly, we also test for the presence of financing constraints and precautionary saving behaviour by examining whether debt matters for households at all times or only when households experience adverse income or wealth shocks (which we label the ‘debt amplifier effect’).

Identifying the causal effect of mortgage debt on household spending is difficult. First, an increase in spending intentions can lead to higher mortgage debt if households withdraw home equity to support consumption (reverse causality). Second, some unobserved factors, such as an increase in income expectations, may lead to higher debt and spending (omitted variables bias). In both cases, it will be more difficult to identify a negative relationship between mortgage debt and household spending. However, there are other non-causal explanations that may lead to a negative relationship between debt and spending. For instance, higher mortgage debt and lower spending on non-housing goods and services could be due to an unobserved shift in preferences towards owner-occupier housing. Alternatively, weak spending and high levels of debt may reflect the return of spending to its normal level after previously high levels of debt-financed spending (Anderson, Duus and Jensen 2016).

From a policy perspective, it is important to understand and distinguish between these mechanisms. If high levels of debt cause households to reduce their spending, providing debt relief or easing financing constraints through lower interest rates or tax incentives may lift spending. In contrast, if weak household spending is instead due to strong debt-financed spending in the past or a shift in preferences towards owner-occupier housing, such policies may merely postpone a downturn. Moreover, for a policymaker, the distinction between the debt overhang and amplifier effects is important. If debt has no direct effect on spending but affects spending only when there are shocks to income or wealth, the main concern is about the resilience of the economy to such shocks. In contrast, a direct debt overhang effect may explain why household spending in Australia has been relatively weak in recent years despite a strong labour market and rising house prices.

We address the three identification challenges outlined above using longitudinal household-level information from the Household, Income and Labour Dynamics in Australia (HILDA) Survey. This survey is rare by international standards. It not only contains detailed annual information on consumption, income, housing assets and debt of a representative group of households over time, but also provides information on their expectations for future employment and debt, their liquidity holdings and their risk preferences. Moreover, since households are directly asked how much they spend each year, we do not need to impute expenditure like other papers in the literature.

Household-level data is imperative to deal with the challenges posed by externalities that mask any household-level effect of debt when using aggregate or regional-level data.^[1] Moreover, the richness of our data allows us to control for a wide range of observable factors in estimating the effect of mortgage debt on spending. By tracking households over time, we are also able to fully control for unobserved household characteristics that likely do not vary over time but may affect the relationship between debt and spending, such as the household's level of patience. In addition, the longitudinal nature of the data allows us to explore the link between debt and spending during the GFC and in more normal times. This is in contrast to the existing research which often focuses on the linkage between debt and spending during rare episodes such as the GFC.

To further alleviate concerns about endogeneity, we adopt an instrumental variables approach using detailed survey information on each household's home purchase history. This allows us to exploit cross-sectional differences between households in the timing and location of their home purchases. We then use this information as an instrument for the level of outstanding mortgage debt today. In this empirical strategy, households that live in the same area are exposed to identical local demand shocks, but differ in the amount of debt they hold based on when they bought their home.

Based on these identification strategies, we find strong evidence for the debt overhang effect. Estimates from our preferred specification suggest that a 10 per cent increase in debt reduces household expenditure by 0.3 per cent. Notably, we find evidence for this overhang effect when we control for either a household's gross or net housing wealth. The latter implies that households lower their spending even when the gross value of both their debt and assets increases by the same amount (that is, when net wealth remains constant). In other words, a deepening of household balance sheets is associated with less household spending, even if it is not associated with rising net indebtedness. This directly violates conventional consumption theories such as the permanent income hypothesis (PIH), which assumes that the composition of household balance sheets does not affect consumption (Garriga and Hedlund 2017).

We do not find that any specific mechanism, such as financing constraints or precautionary saving, is driving the effect; instead, it appears to be pervasive across all mortgage borrowers, even households that are unlikely to face financing constraints or have strong precautionary saving motives. The effect is also pervasive over time and across regions and persists when allowing highly indebted households to respond more strongly to individual or local unemployment or house price shocks than less indebted households. This suggests that our results are not exclusively driven by financing constraints or precautionary saving motives or reflect the presence of a ‘debt amplifier effect’. However, we do find that households are more sensitive to debt during the GFC and local house price shocks, which could suggest that financing constraints or precautionary saving motives play some role. Furthermore, we rule out some of the non-causal explanations. In particular, the debt overhang effect is evident when controlling for past spending, and also when total spending includes the consumption of (owner-occupier) housing services. This suggests that the debt overhang effect is not driven by spending normalisation or a shift in household preferences towards consuming more housing.

Finally, we use our household-level estimates to consider the potential implications of higher debt levels for aggregate consumption. Simple calculations suggest that the observed increase in aggregate mortgage debt since the GFC weighed on aggregate spending, and this debt overhang effect may explain some of the weakness in aggregate household spending since then. Specifically, we estimate that annual aggregate consumption growth would have been around 0.2 to 0.4 percentage points higher had mortgage debt remained at its 2006 level. However, these estimates abstract from other stimulatory effects of debt. The increase in mortgage debt has likely lifted house prices and by this also supported consumption over this period. Our estimates are thus best interpreted as the loss in consumption had all other trends, such as the growth in house prices, occurred even though debt remained constant. As a result, the net effect of the increase in debt since the mid 2000s is unclear.

The remainder of this paper is organised as follows. In Section 2, we discuss our contribution to the related literature. Section 3 provides an overview of the dataset used in our analysis. Section 4 presents the methodology and results for the debt overhang effect, while Section 5 aims to identify the mechanism behind this effect. Section 6 presents the results for the debt amplifier effect. In Section 7, we assess the potential effect of higher debt levels on aggregate consumption. Section 8 concludes.

Footnote

Estimates using aggregate data are likely to underestimate the negative effects of debt on spending. When one household takes out a mortgage to buy an existing home, the seller of the home receives the proceeds as cash and capital gains, which can increase their consumption. [1]