19 July 2023
Our research uncovers a concerning propagation mechanism whereby rising debt-to-income ratios and higher interest rates systematically cripple real economic activity for years ahead. The mechanism highlights the long-term nature of debt contracts, which entail regular future debt service payments. During credit booms, these future obligations accumulate, eventually outweighing new borrowing. As a result, the initial boost to output from the credit boom is reversed, leading to a decline in economic activity.
To illustrate this pattern, consider a stylized example reflecting typical credit booms. The persistently high levels of new borrowing last for several years. However, repayments are delayed due to the long-term nature of most debt, such as mortgages. Consequently, debt accumulates, resulting in a hump-shaped pattern of debt service (interest payments and amortizations).
This pattern indicates that credit booms provide a short-term stimulus to economic activity but ultimately lead to a significant downturn in the future. One of the driving forces behind this reversal is the disproportionate consumption of available funds by borrowers, creating a positive net transfer from lenders to borrowers that boosts demand during the boom. Conversely, this dynamic depresses demand during the bust phase.