Friday Flyer: Does Monetary Policy increase debt?
First let's ask what explains household debt? Well if the household formulates a rational plan that conditions on its lifetime budget constraint, over its lifetime debt should be zero. With many overlapping households we might expect to observe debt in a young economy when the proportion of young outweighs the old. Conversely in an ageing economy we might expect to see a high level of saving. We might also think of debt as resulting from impatience or a higher rate of discount applied to future earnings. Debt will also be taken if households think that their future income is going to be higher than they originally thought. Finally we might take on debt if interest rates are lowered or if borrowing constraints are relaxed.
Fundamentally if the lifetime budget is respected, debt results from a situation in which current income is below its average long run level and this will lead a household to borrow in order to stabilise consumption. We might expect less debt in a world of significant borrowing constraints. And a sharp increase in debt if those borrowing constraints are relaxed. We might also see an increase in debt if household convince themselves that they are about to become richer e.g. after the discovery of oil in their back garden.
As with many advanced and ageing economies, household debt indebtedness increased markedly in the period of financial liberalisation in the 1980s. In the UK household debt rose from around 35% of GDP in the early 1980s to just under a 100% in 2010 and it now stands at just under 90%. Advanced economies on average peaked at 80% and now stand at around 75% of GDP. Given that these were ageing economies, it would suggest that a more likely explanation has been the relaxation of credit constraints, which might throw open the strange possibility that we had sub-optimal levels of household debt in the past! And at some point between 1980 and 2010 we passed through the optimal level.
But we also cannot understand debt without realising that it is not the case that households are indebted, once we account for wealth. Financial liabilities are less than 20% of net wealth. Indeed even though loans are about the same as income, net wealth remains a large multiple of consumption. So the overall picture may not be that disturbing.
And so because the operation of monetary policy offsets shocks to income, preferences and asset prices so as to bring forward or defer consumption by changing interest rates. The interest rate can be thought of as the intertemporal price of consumption. So let us suppose that we perceived that debt levels were too high, perhaps as we revised down our notion of permanent income or as the price of loans increased, households would tend to react by increasing the level of savings, perhaps sharply.
If the levels of savings were increased at too abrupt a rate that may lead to a large fall in demand that would in turn induce a persistent or long lived downturn. At this point lower interest rates can smooth the adjustment by slowing down the rate at which savings accumulate. This means we have a longer but smoother adjustment to lower debt levels. In this case, rather than increasing debt, monetary policy can prevent too rapid a reduction in its level because that might threaten macroeconomic and financial stability.
Prof Jagjit Chadha's Gresham lecture can be seen on https://www.gresham.ac.uk/lectures-and-events/debt-and-the-household-balance-sheet