Housing busts and recessions are more severe and last for at least five years when they follow a big run-up in household debt, according to a study released on Tuesday by the International Monetary Fund.
The findings suggest that economies of the United States, the UK and other European countries that saw consumer debt balloon along with house prices ahead of the onset of the financial crisis in 2007 may only just be starting to see the light at the end of the tunnel.
Weak consumer spending has been holding back a strong recovery in the United States. The UK has a similar problem and has been skirting a second recession, while several euro zone countries are confronting another downturn.
The IMF studied advanced economies over the past three decades and found that household spending and national output fall more steeply, unemployment rises further, household deleveraging -- whether as a result of debt default or debt pay down -- is more pronounced when a crash is preceded by a large run-up in consumer debt.
The United States, Spain, Iceland, Ireland and the UK all saw a concurrent boom in asset prices that made large debt loads easy to handle. But once asset prices plunged, many households saw their wealth and incomes shrink and found their debt loads less manageable.
Monetary policies can ease the pain quickly via a reduction in interest rates to reduce the cost of household debt repayment, the IMF said. And government policies can boost household incomes through unemployment benefits and other social support programs, which improve the ability to repay debts, as the Scandinavian economies showed in the 1990s.
These programs help reduce reinforcing cycles of declining house prices and lower aggregate demand, the IMF said.
These programs must be carefully designed, however, and they have their limits. Central banks cannot cut rates below zero, and fiscal policies that are too restricted have limited effects and ones that are too broad undermine the health of the financial sector, the IMF said.
The study is included in the World Economic Outlook, due for release next week when the IMF holds its spring meetings.
(Reporting By Stella Dawson; Editing by Leslie Adler)