RDP 2019-06: The Effect of Mortgage Debt on Consumer Spending: Evidence from Household-level Data 2. Literature Survey and Our Contribution

The study of the effects of debt has a long history in both public and corporate finance. Since the GFC, there has also been growing interest in studying the effects of household debt. In a standard life-cycle model, households borrow and save to smooth their consumption over time and the outstanding stock of debt has no causal effect on spending decisions. Household spending depends on current net wealth, as well as current and expected future income. While debt is a component of net wealth, a change in debt can only have a wealth effect on spending if that change in debt is unanticipated and exogenous (Paiella and Pistaferri 2017).

But the assumptions of the standard life-cycle model may not hold. Most obviously, households may be restricted in their ability to borrow, have limited liquid wealth or face uncertainty about their lifetime income. The importance of borrowing and liquidity constraints as well as uncertainty for consumption has been brought to the fore during the GFC (Pistaferri 2016). To the extent that debt exacerbates borrowing or liquidity constraints or increases uncertainty about future repayment obligations, the composition of household balance sheets and, in particular, the level of debt can matter for spending. In Appendix A, we set out a simple model to illustrate the channels through which higher debt levels might affect spending, and hence explain the debt overhang mechanism.

Previous empirical cross-country evidence shows that expansions in household debt (relative to GDP) driven by (excessive) credit supply can increase the risk of financial crises and subsequently lead to lower spending and economic growth (Schularick and Taylor 2012; Jordà et al 2013; Mian et al 2017; Mian and Sufi 2018). While this research establishes a link between debt and spending at the aggregate level, research at a more disaggregated level can provide important insights into why debt matters for spending. Exploiting regional variation in the United States, Mian and Sufi (2010) find evidence for a debt overhang effect – the regions that experienced stronger pre-crisis increases in household leverage also experienced stronger post-crisis declines in household spending. Mian, Rao and Sufi (2013), on the other hand, provide evidence for the debt amplifier effect by showing that falling housing prices exacerbated the reduction in spending in regions with relatively high levels of leverage. Household-level data is key to further unpacking these effects and identifying the underlying mechanisms.

Our results complement and extend these findings along several dimensions. First, by exploiting rich longitudinal data at the household level, we are able to better identify the causal effect of mortgage debt than studies that use aggregate or regional data. By aggregating across indebted households, region-level data implicitly put more weight on the richer households that spend more and hold more debt. If the debt overhang is less prevalent amongst rich households, this will attenuate any debt overhang effect – a mechanism that applies at the household rather than at the region level.

Second, by studying the Australian case, we generalise the results to show that debt matters even during periods of financial and economic stability. Almost all of the existing debt overhang research at the household level focuses on the GFC period in countries that experienced strong falls in house prices and large increases in unemployment, including the United States (Dynan 2012), the United Kingdom (Bunn and Rostom 2015), Denmark (Andersen et al 2016), and New Zealand (de Roiste et al 2019).^[2] Evidence for the debt amplifier effect at the household level is also typically limited to periods of financial crises or recessions (Yao et al 2015; Atalay, Whelan and Yates 2017; Garriga and Hedlund 2017; Baker 2018). Cho, Morley and Singh (2019) provide further evidence that amplifier effects matter most during episodes of crises by showing that indebted households in the United States exhibited a considerably greater sensitivity to transitory income shocks during the GFC. While we find a similar pattern of stronger effects of debt during the GFC, we show that our results are not driven by this episode alone and that debt weighs on spending even in more ‘normal’ times.

Third, our rich household-level data allow us to inspect the causal mechanisms that link debt to spending. Only a handful of studies have done this. In contrast to these studies, we find the debt overhang effect to be pervasive across indebted households and find only indirect evidence for borrowing or liquidity constraints (Bunn and Rostom 2015; Baker 2018; de Roiste et al 2019; Cho et al 2019) and precautionary saving motives (Bunn and Rostom 2015; Fagereng and Halvorsen 2016) to be possible drivers. However, we can rule out non-causal explanations proposed by the literature. Specifically, our results contradict the finding of Anderson et al (2016) for Denmark that weak current spending can be explained by high levels of past (debt-financed) spending. Instead, we find that higher debt lowers spending even after controlling for past spending and borrowing. In contrast to other studies, we also assess the extent to which a shift in preferences towards housing services can explain the decline in spending, and find little evidence that it does.

Finally, we emphasise that the debt overhang effect persists irrespective of whether we control for gross or net wealth. The latter implies that households that experience an increase in both the asset and liability sides of their balance sheet reduce their spending. This then suggests that any housing wealth effects on spending are reduced if the increase in housing prices is driven by an increase in the supply of mortgage debt. Using household-level data is crucial to isolate this channel, as the net wealth effect of rising housing prices dominates at higher levels of geographic aggregation. We also extend the findings in Mian and Sufi (2015) by showing that higher levels of mortgage debt can have real effects on the economy even if the credit expansion is just a passive response to higher housing prices.

Footnote

Our work complements research on the role of debt for spending by Norwegian households. Similar to Australia, Norway saw little real economic impacts during the GFC and house prices fell only by 1.4 per cent in 2008 (Yao, Fagereng and Natvik 2015; Fagereng and Halvorsen 2016). [2]