What happens when, in boom times, households run up substantial debt through mortgages, personal loans and credit cards? When the economy starts to slump, the recession is deeper and the eventual recovery is much weaker, according to the International Monetary Fund.
In its new World Economic Outlook report, the IMF found that declines in economic activity aren’t only caused by falling home prices and the resulting crunch on household wealth. Prerecession indebtedness often makes contractions “more severe and protracted.”
In the five years before 2007, the ratio of household debt to income in advanced economies rose an average 39 percentage points a year to 138%. Debt in Denmark, Iceland, Ireland, the Netherlands and Norway peaked at more than 200% of income.
Those debts were then exacerbated by a potent mix of plunging property values, sliding incomes and rising unemployment. And now the deleveraging process -- in which consumers try to pay off or default on those debts -- is holding back the economy, according to the IMF.
But based on past historical examples, the IMF concludes that monetary easing by governments can temper economic slowdowns by helping to reduce mortgage payments and preventing defaults.
“Macroeconomic stimulus, however, has its limits,” the IMF warns. Debt restructuring policies that reduce debt relative to assets and design more income-appropriate payments could also be “an inexpensive way” to deal with the “downward spirals of declining house prices and lower demand.”
Earlier this month, Treasury Secretary Timothy F. Geithner said that although many Americans are still toughing it out, "household debt is down 17 percentage points relative to economy since before the crisis."
In another chapter of the IMF’s report, the organization extols the virtues of saving up during feast years in anticipation of famine by using “counter-cyclical budgetary policies.” The practice, according to the IMF, helps protect commodity-producing countries from boom-bust price swings.
But with a weak global economic outlook, “commodity prices are unlikely to increase at the pace of the past decade,” according to the report. The IMF actually forecasts falling prices for commodities such as oil this year but adds that “sizable downside risks” could push suppress demand and cause a steeper-than-expected plunge.