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Special Feature
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A sharp contraction: Adjusting to a regime of tight credit
Credit crises usually give rise to some of the worst recessions that central banks can imagine. The recent US financial crisis is one such example. Consumers were living on debt. When the crisis hit, it resulted in a credit crunch made more severe by consumers’ tendency to save instead of spending.
Issue Date - 22/12/2011
Consumers were piling up debt in the years leading up to the recent US financial crisis. Total debt of all households in 2007 surged to 130% of their disposable income, compared with only 92% in 2000, according to data from the Federal Reserve Board. When the crisis hit, banks tightened lending and consumers could no longer get credit as easily as they did before. The adjustment was sharp and painful.

In a recent paper titled, Credit Crises, Precautionary Savings and the Liquidity Trap, I along with Prof. Guido Lorenzoni of MIT find that, the pressure on households to repay debts quickly and save more right after a credit shock can lead to a large fall in consumption. The resulting contraction in output can be severe in the short run, because households initially find themselves far below their desired level of precautionary savings.

When credit suddenly tightens, highly indebted households can no longer roll over their loans. Those with very little savings worry it will be difficult to get a loan should they need one in the future. Add the risk of job loss, which increases with the threat of a recession, and saving and cutting down on consumption begin to feel more urgent.

As households save more and spend less, the central bank may step in to boost consumption. But the recession that follows can be so deep that the central bank may not be able to bring interest rates down to the level where it can sufficiently stimulate spending, because the nominal interest rate cannot fall below zero. The fact that a credit crisis can lead the economy into a “liquidity trap” seems consistent with historical experience. Liquidity traps typically follow large credit crunches, just as we have seen in Japan in the 1990s and in the United States during the Great Depression.

Overshooting interest rates and output

To find out how households respond to a credit crunch, we analyse what happens when the borrowing limit of households is unexpectedly reduced to a level that would bring down the ratio of US household debt to GDP by about 10 percentage points from its peak right before the crisis.

When a credit shock hits, households with debts exceeding this new borrowing limit would have to drastically reduce their debts, and those close to the limit would have to save more as a precaution. Losing a job prior to the crisis may not have been so bad, because people could go to a bank for a loan or use a credit card, and then pay back the loan when they found a job again. But with poor job prospects and without the help of credit markets to smooth consumption, households know they need savings to get them through the rough times.

Real interest rates drop dramatically in the short run because households affected by the tighter borrowing limit are eager to put their money into safe assets, such as savings accounts or Treasury bonds. They are willing to accept low interest rates. Indeed, it is found that the drop in interest rates “overshoots” right after a credit crisis. Households were not ready when the shock hit and so they had to deleverage faster initially.

As households accumulate more safe assets, they start to move closer to their desired level of precautionary savings. The borrowing constraint becomes less worrisome and interest rates start to move up as households gradually save less than they did right after the shock. Interest rates eventually settle at a lower rate.

That real interest rates would fall to such a low level gives a sense of just how much households would be willing to reduce consumption in order to pay back their debts and increase savings. In theory, households would like to work more in response to a credit crunch in order to boost their earnings and thus their ability to get out of debt. If goods and labour markets worked perfectly, this increase in labour supply would dampen the effects of a credit crunch on aggregate activity. However, in a recession, the number of jobs created is driven more by the firms’ ability to sell goods and services than by workers’ willingness to work. Therefore, the labour supply effect would likely be weak. Following a similar pattern as interest rates, output drops on impact as a result of households cutting back significantly on consumption. In other words, output contracts strongly in the short term before gradually settling at a level lower than its pre-crisis level.

Government policy and the liquidity trap

In normal times, the central bank intervenes in the economy by using its nominal policy rate to influence the real interest rates that matter for households’ consumption and saving decisions. When the economy is weak, the central bank typically cuts nominal interest rates to stimulate consumption. We find, however, that the response of households to a credit crisis can be so strong that the nominal interest rate required to pull the economy out of a recession falls below zero. Because the central bank cannot reduce rates below zero, interest rates effectively remain higher than they should be, exacerbating the recession. The inability to stimulate the economy by lowering the interest rate is known as the liquidity trap.

To ease the effects of a severe downturn, the government may consider increasing the supply of bonds. This is beneficial for two reasons. First, the supply of liquid assets for people to put their savings into goes up, thus reducing the downward pressure on real interest rates. Second, the revenue raised from issuing more bonds can be used to increase government transfers or reduce taxes in the short run to help people cope with the recession. Increasing the supply of government bonds helps dampen the overshooting effect on real interest rates and output. We also find that increasing transfers by temporarily raising unemployment benefits is more effective in alleviating the effects of the recession than reducing lump sum taxes. This type of policy allows the government to target the most highly indebted and credit constrained households, who are more likely to cut their consumption in a credit crisis.


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