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In a study conducted by the International Monetary Fund explains that large personal debt is strongly correlated with the strength of the present economic downturn.
The Washington-based think tank and international lender also suggests that many of the same policies which the US government implemented during the Great Depression of the 1930s could have a positive impact on today’s slumped economy, as long as the programs are “well-designed.”
The IMF report, entitled ‘Dealing with Household Debt’ was published as part of their April ‘World Economic Outlook.’ The report states that the higher the household debt in the country, the worse the resulting economic downturn and the more sluggish the recovering economy.
“Larger declines in economic activity are not simply due to the larger drop in house prices and the consequent reduction of households’ wealth. Indeed, household consumption falls by more than four times the amount explained by the fall in house prices in high-debt economies,” according to the IMF report.
“It seems to be the combination of house price declines and pre-bust household indebtedness that accounts for the severity of the contraction,” the report added.
As a solution to this problem the report suggests that ‘bold’ government policies be developed to help households overcome their debt using tools such as restructuring, which were already tried with success during the 30s and are being utilized even today in Iceland. Debt restructuring for households can help reduce the number of defaults which eliminate the element of demand from the economy, making it impossible for the economy to grow.
“But these programs must be carefully designed. If access to them is overly restrictive, they will not have the full intended impact,” the study warns. “And if they are too broad and imposed on an already fragile financial sector, they can cause a dangerous credit crunch.”
