Why post-crisis consumption is under house arrest

While household consumption has fallen in many countries since the onset of the GFC, new research shows those with highly leveraged property debt are tightening their purse strings the most.

Vox EU

In most countries, households’ consumption expenditure accounts for more than half of GDP. How much households spend reflects their living standards, and typically households try to smooth consumption over time. As a result, consumption usually does not display large variability and, therefore, has found comparatively little academic and policy attention.

Since the onset of the financial crisis, consumption has dropped markedly in many countries. Figure 1 shows the development of per capita real consumption in the main European crisis countries.

Figure 1: Real per-capita consumption expenditure (2000Q1 = 100)


Graph for Why post-crisis consumption is under house arrest

Authors’ calculations. Consumption expenditure are deflated with the CPI (Source: Eurostat) and corrected for population growth (Source: United Nations).

Several explanations for the decline in household spending in the crisis countries have been offered. One explanation is that permanent income has declined, causing a decline in consumption as posited by the permanent income hypothesis.

A second explanation suggests that consumption has fallen because of credit or liquidity constraints. If actual income falls and households have neither accumulated savings, nor access to credit, their consumption has to adjust downwards, even if permanent income stays constant. The dynamics of consumption, therefore, may change during financial crises when households find access to credit more difficult because of heightened bank risk aversion, tightened credit standards or reduced collateral values.

A third explanation for depressed consumption is precautionary or buffer-stock savings. In the context of the financial crisis, savings may be used more to deleverage. Once households have rebuilt their balance sheets, future consumption can again be financed by new credit. Moreover, even when credit constraints are not currently binding, risk-averse households may try to avoid a situation of binding credit constraints in the future by building up savings beforehand.

In order to formulate policies to revive consumption, two questions become crucial: whether during financial crises something fundamental changes in households’ consumption patterns; and to what extent credit constraints account for the drop in consumption.

The macroeconomic perspective

In their Economic and Social Research Institute working paper, Gerlach-Kristen, O’Connell and O’Toole examine macroeconomic data in 23 countries over 32 years to assess the impact of financial crises on aggregate consumption. Consumption is modelled in an error-correction set-up in which there exists a long-run relationship between consumption, income, housing and other wealth. To account for the fact that consumption functions may differ between countries, the analysis uses a mean-group estimator.

Results suggest that during financial crises only the short-run dynamics of consumption growth change. Consumption growth is lower particularly during banking crises rather than during crises preceded by credit or housing booms.

There is also some evidence that lower income growth depresses consumption growth during crises. One interpretation of this finding is that households are unable to smooth consumption during financial crises, which suggests a role of credit constraints. However, the analysis does not find a role of variables capturing credit volumes or costs. A potential explanation for this failure is that aggregate macroeconomic data may mask the driving forces behind the consumption decisions taken by individual households.

The microeconomic perspective

To take household heterogeneity better into account, Gerlach-Kristen and Merola analyse consumption decisions and credit constraints on a micro level. They first present a small dynamic stochastic general equilibrium (DSGE) model, with occasionally-binding credit constraints, and then assess whether the predictions made by the model are compatible with Irish household data, collected during the financial crisis.

Figure 2 shows consumption expenditure and income by age, and clearly illustrates the heterogeneity of household experiences during the crisis, which has affected younger households more than older ones. One distinct feature of younger Irish households is that they bought property at the height of the boom. Today many of them are in negative equity, and may be trying to rebuild their balance sheets.

Figure 2: Weekly real consumption and disposable income by age group


Graph for Why post-crisis consumption is under house arrest

Data from the latest four waves of the Irish Household Budget Survey. Values in 2010 euros, age of the household reference person. Average income and consumption by group, taking into account the grossing factors capturing the representativeness of the individual households interviewed in the HBS. Percentage numbers indicate the size of a group in question relative to the full population.

This theoretical model illustrates that credit constraints can arise from falling property prices, which reduce the value of collateral and thus raise the leverage ratio of indebted households. Constrained households cease to smooth consumption and use their savings to deleverage in order to improve their future access to credit.

The predictions of the model are corroborated by the empirical analysis. Mortgage households in, or close to, negative equity consume less than the average household, and the permanent income hypothesis is rejected for this population group. The deviation from the permanent income hypothesis is stronger the higher a household’s leverage ratio. This is compatible with deleveraging efforts of highly leveraged households and the existence of credit constraints. Moreover, both the DSGE model and the empirical analysis show that households stop smoothing consumption even if they only expect a decline of house prices in the future and are not facing a credit constraint yet. This suggests a role of precautionary savings.

Interestingly, the permanent income hypothesis is not rejected for the average Irish household, suggesting that most Irish households have continued to smooth consumption in the crisis. It is, therefore, not surprising that analyses at the aggregate level using macroeconomic data find it difficult to identify the exact channel through which credit constraints impact consumption.

Conclusions

In summary, our research papers provide new evidence for policies that may help avoid large declines in household consumption during financial crises. We show that it is crucial to take household heterogeneity into account in order to identify the extent and effects of credit constraints and therefore micro studies are needed alongside macro analyses.

We find that consumption growth is lower during financial crises – particularly during banking crises – and that a drop in income reduces consumption in the short run. This suggests that consumption smoothing is disrupted, and that credit constraints might play a role.

Using Irish data, we show that in a financial crisis that is accompanied by a property bust, consumption smoothing is most disrupted for mortgage households that are highly leveraged in the housing market. One policy measure to reduce the impact of credit constraints is thus to limit the exposure households can take i.e. to enforce a regulatory maximum loan-to-value ratio.

Originally published on www.VoxEU.org. Reproduced with permission.

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