Markets

One way to predict economic slumps

By Dee Gill     
February 26, 2016

From: Magazine

Illustration by Nicole Dudka.

In a 2008 visit to the London School of Economics, Queen Elizabeth famously asked economists why no one had predicted the onset of the financial crisis then afflicting the global economy. For Princeton University’s Atif Mian and Emil Verner, along with Chicago Booth’s Amir Sufi, the answer may be explained in part by a fundamental misunderstanding in macroeconomics of the relationship between household debt and economic growth.

Research conducted by Mian, Sufi, and Verner debunks a basic assumption about debt that has long featured in macroeconomic models. A rise in debt, the assumption goes, reflects investment that can be expected to improve the economy. Using data from 30 countries between 1960 and 2012, the researchers demonstrate that rather than predicting economic growth, an increase in debt actually predicts a fall in GDP.

Countries with the biggest rises in household debt over the three-to-four-year period before the crisis suffered the biggest postcrisis declines in spending, as well as higher unemployment rates, the authors note. They also find that household debt is the most predictive component of private debt, rather than the nonfinancial-firm debt that’s considered more important in standard economic models.

Conventional assumptions about debt, the research suggests, can help explain shortcomings in economic forecasts published by economic agencies throughout the recession. Some organizations, including the International Monetary Fund and the Organisation for Economic Co-operation and Development, tended to underestimate the negative effects of a large rise in household debt-to-GDP ratio, Mian, Sufi, and Verner argue. Changes in debt-to-GDP ratios, they find, predict forecasting errors with standard models.

The research also describes a global household debt cycle with predictive powers:  a strong rise in the global household debt-to-GDP ratio associates with a large decline in subsequent global economic growth. Mian, Sufi, and Verner point out that there is no such correlation between global nonfinancial-firm debt-to-GDP ratios and global GDP growth.

Atif Mian, Amir Sufi, and Emil Verner, “Household Debt and Business Cycles Worldwide,” Working paper, September 2015.

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