22/5/16: House Prices & Household Consumption: From One Bust to the Other

In their often-cited 2013 paper, titled “Household Balance Sheets, Consumption, and the Economic Slump” (The Quarterly Journal of Economics, 128, 1687–1726, 2013), Mian, Rao, and Sufi used geographic variation in changes house prices over the period 2006-2009 and household balance sheets in 2006, to estimate the elasticity of consumption expenditures to changes in the housing share of household net worth. In other words, the authors tried to determine how responsive is consumption to changes in house prices and housing wealth. The study estimated that 1 percent drop in housing share of household net worth was associated with 0.6-0.8 percent decline in total consumer expenditure, including durable and non-durable consumption.

The problem with Mian, Rao and Sufi (2013) estimates is that they were derived from a proprietary data. And their analysis used proxy data for total expenditure.

Still, the paper is extremely influential because it documents a significant channel for shock transmission from property prices to household consumption, and thus aggregate demand. And the estimated elasticities are shockingly large. This correlates strongly with the actual experience in the U.S. during the Great Recession, when the drop in household consumption expenditures was much sharper, significantly broader and much more persistent than in other recessions. As referenced in Kaplan, Mitman and Violante (2016) paper (see full reference below), “… unlike in past recessions, virtually all components of consumption expenditures, not just durables, dropped substantially. The leading explanation for these atypical aggregate consumption dynamics is the simultaneous extraordinary destruction of housing net worth: most aggregate house price indexes show a decline of around 30 percent over this period, and only a partial recovery towards trend since.”

With this realisation, Kaplan, Mitman and Violante (2016) actually retests Mian, Rao and Sufi (2013) results, using this time around publicly available data sources. Specifically, Kaplan, Mitman and Violante (2016) ask the following question: “To what extent is the plunge in housing wealth responsible for the decline in the consumption expenditures of US households during the Great Recession?”

To answer it, they first “verify the robustness of the Mian, Rao and Sufi (2013) findings using different data on both expenditures and housing net worth. For non-durable expenditures, [they] use store-level sales from the Kilts-Nielsen Retail Scanner Dataset (KNRS), a panel dataset of total sales (quantities and prices) at the UPC (barcode) level for around 40,000 geographically dispersed stores in the US. …To construct [a] measure of local housing net worth, [Kaplan, Mitman and Violante (2016)] use house price data from Zillow…”

Kaplan, Mitman and Violante (2016)findings are very reassuring: “When we replicate MRS using our own data sources, we obtain an OLS estimate of 0.24 and an IV estimate of 0.36 for the elasticity of non-durable expenditures to housing net worth shocks. Based on Mastercard data on non-durables alone, MRS report OLS estimates of 0.34-0.38. Using the KNRS expenditure data together with a measure of the change in the housing share of net worth provided by MRS, we obtain an OLS estimate of 0.34 and an IV estimate of 0.37 – essentially the same elasticities that MRS find. …Overall, we find it encouraging that two very different measures of household spending yield such similar elasticity estimates.” The numerical value differences between the two studies are probably due to different sources of house price data, so they are not material to the studies.

Meanwhile, “…the interaction between the fall in local house prices and the size of initial leverage has no statistically significant effect on nondurable expenditures, once the direct effect of the fall in local house prices has been controlled for.”

Beyond this, the study separates “the price and quantity components of the fall in nominal consumption expenditures. …When we control for …changes in prices, we find an elasticity that is 20% smaller than our baseline estimates for nominal expenditures.” In other words, deflation and moderation in inflation did ameliorate overall impact of property prices decline on consumption.

Lastly, the authors use a much more broadly-based data for consumption from the Diary Survey of the Consumer Expenditure Survey “to estimate the elasticity of total nondurable goods and services” to the consumer expenditure survey counterpart of expenditures in the more detailed data set used for original estimates. The authors “obtain an elasticity between 0.7 and 0.9 … when applied to total non-durable goods and services.”

Overall, the shock transmission channel that works from declining house prices and housing wealth to household consumption is not only non-trivial in scale, but is robust to different sources of data being used to estimate this channel. House prices do have significant impact on household demand and, thus, on aggregate demand. And house price busts do lead to economic growth drops.



Full paper: Kaplan, Greg and Mitman, Kurt and Violante, Giovanni L., "Non-Durable Consumption and Housing Net Worth in the Great Recession: Evidence from Easily Accessible Data" (May 2016, NBER Working Paper No. w22232: http://ssrn.com/abstract=2777320)

21/2/2014: Homeownership, Negative Equity, Entrepreneurship: Data from France

Over recent years I wrote extensively about the issues of negative equity and the costs of this phenomena to the society and economy at large. Much of the research in this areas focuses on the US data, with some departures for German and Italian data sets. Here is a recent paper using French data and dealing with the issue of housing collateral (house prices-linked borrowing constraints) and entrepreneurship.

"HOUSING COLLATERAL AND ENTREPRENEURSHIP" by Martin C. Schmalz, David A. Sraer, David Thesmar (Working Paper 19680 http://www.nber.org/papers/w19680) provides evidence on whether entrepreneurs "face credit constraints, which restrict firm creation, post-entry growth, and survival, even over the long run. The existing literature documents a strong correlation between entrepreneurial wealth and the propensity to start or keep a business (Evans and Jovanovic, 1989; Evans and Leighton, 1989; Holtz-Eakin et al., 1993)."

The problem is that there is still "a considerable debate …about whether such a correlation constitutes evidence of financial constraints. For instance, individuals who experience a wealth shock, through personal accumulation or inheritance, may also experience an expansion of business opportunities for reasons unrelated to their wealth (Hurst and Lusardi, 2004)."

The authors used "variations in local house prices, combined with micro-level data on home ownership by entrepreneurs. …We compare entrepreneurial outcomes of entrepreneurs owning a house and entrepreneurs renting a house, and compare this difference across geographic regions with different house price dynamics. The comparison between owners and non-owners allows us to filter out local economic shocks that may drive the creation, growth, and survival of local businesses." Do note the important aspect of this data set - by controlling for home ownership v renters, the paper also allows us to look at the potential benefits of the former or the latter in terms of entrepreneurship.

"We investigate both the extensive and intensive margin of entrepreneurship, that is, entry decisions as well as post-entry growth. Our investigation starts with firm growth and survival, conditional on entry. We construct a large cross section of French entrepreneurs starting a businesses in 1998. Combining survey data and administrative data, we are able to observe a variety of personal characteristics, in particular, the home location of the entrepreneurs, as well as their home-ownership status. We match this information to firm-level accounting data of the newly created firms for up to eight years following creation."

Now for the results: 

• "We find that in regions with greater house price growth in the 1990s, firms started by homeowners in 1998 are significantly larger and more likely to survive than firms started by renters." Oops, for the folks saying that homeownership should not be encouraged or incentivised. "In other words, the difference in the size of businesses created by owners and renters is larger in regions in which house prices have appreciated more in the past five years. 
• This effect is robust to controlling for a large set of entrepreneurial characteristics. It is also persistent: in 2005, firms started by entrepreneurs with lower collateral values in 1998 remain significantly smaller in terms of assets, sales, employment, or value added. 
• Finally, this effect is economically large: going from the 25th to the 75th percentile of house price growth in the five years preceding creation allows homeowners to create firms that are 6.5% larger in terms of total assets."
• "We then verify how collateral shocks affect the probability of starting a business, that is, the extensive margin of entrepreneurship. …We find that homeowners located in regions where house prices appreciate more are significantly more likely to create businesses, relative to renters located in the same regions. In other words, the difference between owners and renters in the propensity to start a business is larger in regions in which house prices appreciated more in the past. 
• Again, the effects are economically sizable. Going from the 25th to the 75th percentile of past house price growth increases the probability of firm creation by homeowners, relative to renters, by 9% in our preferred specification."
• More to the above: "We confirm the importance of this result in the aggregate: total firm creation at the regional level is more correlated with house prices in regions where the fraction of homeowners is larger."

As an aside, consider also the following discussion from the paper: The link between funding of start ups and wealth constraints is non-trivial. "Robb and Robinson (2013) document that debt is a large source of financing for start-ups (approximately 44%) and that its availability is related to the scarcity —and therefore the value— of real estate collateral. Hurst and Lusardi (2004) and Adelino et al. (2013) are closest to our paper, because they also investigate the role of housing wealth on firm creation."

However, the latest paper "makes two significant advances relative to these papers:

1. the information on individual homeownership allows us to control for local economic shocks that might create a spurious correlation between entrepreneurial rate and local house prices, and 
2. the nature of our data allows us to track not only firm creation (the extensive margin), but also post-entry growth and survival over a long horizon (the intensive margin)."

"Several earlier papers focus on the role of inheritance shocks to firm quality and survival. Holtz-Eakin et al. (1993) find that firms started after a large inheritance are more likely to survive, a finding they interpret as evidence of credit constraints. By contrast, using Danish data, Andersen and Nielsen (2011) find that businesses started following a large inheritance have lower performance. This finding suggests the relationship between wealth and entrepreneurship may be driven by private benefits of control, or in other words, that business ownership has a luxury-good component (Hurst and Lusardi, 2004). The relation between wealth shocks and post-entry growth/survival thus remains an open discussion."

The latest paper "contributes to this debate by looking at wealth shocks generated by local variations in house prices for homeowners. Arguably, these shocks are much less likely to be correlated with the unobserved heterogeneity in entrepreneurial outcome than inheritance shocks."

"Fracassi et al. (2012) also provide a clean identification on the role credit constraints play small business survival, by exploiting a discontinuity in the attribution of loans to start-ups at a small local bank. In a similar vein, Black and Strahan (2002) find that banking deregulations in U.S. states led to a large increase in firm creations. Whereas these papers focus on the effect credit supply on firm creation and survival, our paper focuses on credit demand via the supply of collateral."

There is an intuitive link between the above forces: "When house prices increase, firms and households have more collateral to pledge, which raises borrowing capacity. On the credit-supply size, banks, balance sheets become stronger, which allows them to lend more. Recent papers have documented the link between house prices and household borrowing and consumption (Mian et al., 2011; Gan, 2010), the link between real estate prices and corporate investment (Gan, 2007a; Chaney et al., 2012), and the link between real estate bubbles and bank lending (Gan, 2007b)."

And the conclusion is: "Our paper shows that entrepreneurial activity also strongly reacts to changes in the value of collateral available to potential entrepreneurs."

So back to that 'negative equity only matters for those who want to move from their current house' meme that Irish economists and policymakers keep pushing around… My suggestion: go back to study economics, folks.

14/5/2013: Negative Equity and Entrepreneurship: Local Evidence from the US

I have written before about the role positive/negative home equity has on entrepreneurship and real economic activity. Remember, the Irish Government and media believe that negative equity matters only when/if the household wants or needs to move home and that it has no effect outside this scenario.

A recent (March 2013) paper (linked below) from NBER argues very clearly that positive/negative equity has a real positive/negative effect on employment and business creation and that this effect is local to property prices region. In other words, unlike FDI or other foreign investments, home equity impacts domestic investment, locally anchored, and with it - domestic jobs creation.

Adelino, Manuel, Schoar, Antoinette and Severino, Felipe paper "documents the role of the collateral lending channel to facilitate small business starts and self-employment in the period before the financial crisis of 2008. We document that between 2002 and 2007 areas with a bigger run up in house prices experienced a strong increase in employment in small businesses compared to employment in large firms in the same industries. This increase in small business employment was particularly pronounced in (1) industries that need little startup capital and can thus more easily be financed out of increases in housing as collateral; (2) manufacturing industries where goods are shipped over long distances, which rules out that local demand is driving the expansion. We show that this effect is separate from an aggregate demand channel that relies on home equity based borrowing leading to increased demand and employment creation."

Some more granularity to the top-level results [italics are mine]:

"Overall, the evidence we present in this paper identifies the causal effect house prices in the creation of new small firms. These results show that access to collateral allowed individuals to start small businesses or to become self-employed. We conjecture that without access to this collateral in the form of real estate assets, many individuals would not have made the transition from unemployment to starting a new business or self-employment.

We show that the effect of house prices is concentrated in small firms only and had no causal effect  on employment at large firms. [In other words, there is no measurable effect on location competitiveness from house prices. Irish Government claims that residential property prices declines improved Irish competitiveness are not supported by the evidence from the US.]

Importantly, our results also hold when we exclude industries that are most likely to be affected by local demand shocks and when we restrict our attention to manufacturing industries. The effect of house prices is also stronger in industries where the amount of capital needed to start a new firm is lower, consistent with the hypothesis that housing serves as collateral but is not sufficient to fund large capital needs." [This goes to the issue of which types of firms creation benefit most from collateral access. The evidence suggests that smaller firms do so. But the fact that capital constraints bind also suggests that by typology, services firms, which are human capital intensive and require low levels of physical capital, benefit also more than average. Now, Ireland is human capital intensive economy, so draw your own conclusions.]

Adelino, Manuel, Schoar, Antoinette and Severino, Felipe, House Prices, Collateral and Self-Employment (March 2013). NBER Working Paper No. w18868. Available at SSRN: http://ssrn.com/abstract=2230758

31/3/2013: Entrepreneurship and the Great Recession

Staying on the theme of 'catching up with my reading' today - a very interesting paper by Fairlie, Robert W., "Entrepreneurship, Economic Conditions, and the Great Recession" (February 28, 2013). CESifo Working Paper Series No. 4140.

From the abstract:

"The “Great Recession” resulted in many business closings and foreclosures, but what effect did it have on business formation?

On the one hand, recessions decrease potential business income and wealth, but on the other hand they restrict opportunities in the wage/salary sector leaving the net effect on entrepreneurship ambiguous.

The most up-to-date microdata available -- the 1996 to 2009 Current Population Survey (CPS) -- are used to conduct a detailed analysis of the determinants of entrepreneurship at the individual level to shed light on this question.

• Regression estimates indicate that local labor market conditions are a major determinant of entrepreneurship. 
• Higher local unemployment rates are found to increase the probability that individuals start businesses. [Note: authors do not control for quality of entrepreneurship, e.g. survivorship rates for entrepreneurial ventures founded by 'forced' entrepreneurs out of unemployment spells]
• Home ownership and local home values for home owners are also found to have positive effects on business creation, but these effects are noticeably smaller. 
• Additional regression estimates indicate that individuals who are initially not employed respond more to high local unemployment rates by starting businesses than wage/salary workers. The results point to a consistent picture – the positive influences of slack labor markets outweigh the negative influences resulting in higher levels of business creation. Using the regression estimates for the local unemployment rate effects, I find that the predicted trend in entrepreneurship rates tracks the actual upward trend in entrepreneurship extremely well in the Great Recession."

Wait, what was that about 'home ownership' and 'local home values'? Sure this is not suggesting that negative equity might have an effect on entrepreneurship? Irish Government & our 'Green Jerseys' say that it only matters when one decides to move...

See three posts from 2010 that I wrote on the topic of Negative Equity effects in Ireland: Post 1, Post 2 and Post 3) and another link from 2010 on the topic of Negative Equity and entrepreneurship (here).

18/11/2012: Housing equity and retirement dis-savings

A new paper "Home Equity in Retirement" by Makoto Nakajima and Irina A. Telyukova (September 20, 2012) looks at the effects of homeownership on savings/dissaving by retirees, using the US data for 1996-2006.

Using an estimated structural model of saving and housing decisions, the study finds that "homeowners dissave slowly because they prefer to stay in their house as long as possible, but cannot easily borrow against it. Second, the 1996-2006 housing boom significantly increased homeowners' assets. These channels are quantitatively significant; without considering homeownership, retirees' savings are 24-43% lower."

Some more details:

Figure 1 shows over the period 1996-2006, median net wealth remains high very late into the life cycle. The observation that many people die with significant savings, which is puzzling in the context of a simple life-cycle model, has been termed the \retirement saving puzzle. However, the picture changes dramatically if we consider the saving behavior of retirees who

own homes, compared to those who do not. Consider figure 2, which documents the cohort profiles of median net worth over the same period, normalized by the first observation, for homeowners versus renters.

The difference is stark. Homeowners have flat or increasing profiles of net wealth over this period, while renters display a far faster rate of asset decumulation. This suggests that housing may play a major role in determining how retirees save or dissave."

Overall, the paper finds that:

• "…high homeownership rate late into the life-cycle that we observe in the data is crucial to consider for understanding retiree saving behavior."
• "Housing-related channels are significant contributors to the retirement saving puzzle. Retirees stay homeowners late in life, but become increasingly locked into their home equity as they age; 
• "...we find that borrowing constraints on retirees tighten considerably. This means, on the one hand, that those who remain homeowners do not decumulate their home equity, thus creating the kind of flat housing profile that we see in the data, while those who face a large expense may come up against their borrowing constraint and be forced to sell the house. 
• "We also use the model to understand why people retirees choose to remain homeowners late in life. We find that the leading motivators are utility benefits of owning a house (which capture also financial benefits, such as tax advantages) and bequest motives. 
• "In contrast, precautionary motives in the face of medical expense risk do not a effect homeownership significantly, but play a role in the puzzle through financial asset accumulation, although overall this role is quantitatively modest and affects younger retirees more than older ones. 
• "Quantitatively, we find that the housing channels {utility benefits of ownership, collateral constraints, and the housing boom} jointly account for between 24 and 43% of the median net worth profile, depending on age.
• "The bequest motive accounts for up to 31% of the median net worth profile, and its importance increases with age. 
• "Medical expense risk accounts for maximum 8% of median net worth, and its importance generally falls with age, due to interaction with Medicaid.
• "..we conduct an experiment where we allow households to make a decision on whether or not to maintain their home. We want to evaluate this as an additional, possibly hidden, channel of asset decumulation, consistent with data evidence that homes of elderly owners depreciate more quickly than those of younger owners. We treat this as a hidden channel because we assume that self-reported housing values of owners who remain in their houses do not take into account the depreciation rate unless they have the house appraised for sale, for example. We find this to be a significant channel of asset decumulation. 30% of our model homeowners choose not to maintain their homes in the 75-85 year old cohort; for the younger cohort, that proportion is over 50%, while it is lower for the oldest cohort. We show that this channel affects median housing asset profiles as well."

All of this has huge implications for countries like Spain and Ireland that have undergone a massive property prices bust. Declines in property prices have wealth effects, negative equity has wealth effects. Both, however, have also direct behavioural effects that are also adverse, as outlined above. In my view, we have not even started to count the real costs of the property busts in our fiscal and economic forecasts.

26/10/2012: Few interesting links

Some links on recent studies of interest

Two hugely important studies from the Kauffman Foundation on the role of immigration in entrepreneurship and human capital as a driver of future economic growth.

Iceland's assessment of financial stability for 2012 Q1 covering in detail household debt dynamics (from page 23) and detailing the success of the Iceland's systemic debt restructuring arrangements.

7/9/2012: Psychological effects of debt

For our brilliant minds in politics and their 'intelectual' parrots who constantly remind us (albeit with, thankfully, decreasing frequency) that negative equity only matters when people need to move, here's one piece of latest research on links between debt (unsustainable) and mental health.

Link.

So, nothing to worry, then. The results are:

• "...Results provide strong evidence  that respondents’ reactions to problem debt have a non-negligible social dimension in which the prevailing local level of indebtedness impacts on individual psychological stress." In other words, other's debt is not just their own problem.
• In a multivariate model "individuals who report they face ‘difficulty’ meeting their housing payments (mortgage or rent) are at least two months late on their housing payments, or who report that meeting their consumer credit repayments presents a ‘heavy burden’ to their household, exhibit worse General Health Questionare scores and greater propensity to suffer from depression". now, note - this is not just about those who are defaulting, but also those who are facing difficulty meeting their repayments.
• Secondly, "...selection into problem debt on the basis of poor psychological health accounts for much of  the observed cross-sectional variation in psychological health between those with and without problem debts. ...individuals who are observed to move into arrears on their housing payments or into reporting a heavy burden of debts between two waves of data exhibited, on average, worse psychological health than those not moving into debt problems in the first wave of data." In my opinion, this is likely the effect of buildup of stress prior to arrears actually arising formally and as households work through their savings, cuts to their budgets and borrowings from relatives on their way into arrears. If so, the longer the delay in dealing with problem debts (and in Ireland it is now counted in years, not months), the worse the psychological outcomes.
• Per negative equity: "...it is shown that mortgage holders who enter into arrears on their mortgage debts in localities where house prices are growing (and so their home equity ‘buffer’ is increasing) suffer less deterioration in psychological health compared to individuals who enter into arrears in localities where house prices are falling (and so their home equity ‘buffer’ is decreasing). Home equity buffers have been shown to be important forms of consumption insurance for households facing adverse income shocks (Hurst et al. 2005; Benito, 2009)." Need I say more.
• "Individuals who exhibit the onset of  problems repaying their unsecured debts in localities with a higher bankruptcy rate ...experience less deterioration in psychological health compared to individuals exhibiting the onset of problem repaying their unsecured debts in localities with lower bankruptcy rates." This is most likely accounted for by much faster and more lenient personal insolvency resolution regime in the UK in general, leaving lower stigma on those defaulting on unsecured debt.
• "By contrast, individuals who exhibit the onset of problems repaying their secured debts in localities with higher mortgage repossession rates are shown to experience more deterioration in  psychological health compared to individuals ...in localities with lower mortgage repossession rates." Again, the UK more developed and more lenient regime for resolving secured debts insolvencies is also at play here, in my view, as repossessions are signals of the deepest form of insolvency, and non-repossession solutions are well advanced. This implies that localities with higher rates of repossessions are more likely to have experienced much greater declines in income, rises in unemployment and/or prices declines in the property markets.

All in, I read the above evidence as the urgent signal that Ireland needs:

1. Immediate reform of its bankruptcy laws to facilitate speedier resolution of debt problems;
2. The reform should focus on pre-bankruptcy resolution mechanisms (as the current Government proposal does suggest) but these mechanisms must be robust and not left to the disproportionate capture by the lenders (as the current Irish Government proposed legislation does).
3. The reform must carry emergency measures to deal with the unprecedented crisis we are facing today - in other words, the reform should not attempt to set a singular new regime for the perpetuity, but have two different regimes - Firstly: a reform to address the emergency situation with much more lenient bankruptcy arrangements for those who have acquired the unsustainable debts in the period 2002-2008, Secondly : a reform to address the future bankruptcy regime, post-emergency. The current legislation is better served for the second purpose, but it does not meet the requirements of the first objective.

13/11/2011: Non Performing Loans and links to macroeconomy

‘Often, the banking problems do not arise from the liability side, but from a protracted deterioration in asset quality, be it from a collapse in real estate prices or increased bankruptcies in the nonfinancial sector’’ (Kaminsky and Reinhart, 1999).

How true this sounds today. Take Euro area banks:

1) Collapse in US and European real estate valuations in recent years has triggered fall off in the value of linked assets held on the banks balance sheets

2) Collapse in the European bonds valuations has triggered a precipitous decline in core assets, including capital-linked assets

3) General recession have further undermined core assets on the loans side in corporate, SME and household lending.

A recent IMF paper: “Nonperforming Loans and Macrofinancial Vulnerabilities in Advanced Economies” by Mwanza Nkusu (2011) (IMF WP/11/161, July 2011) looks into the asset-focused linkages between financial and macroeconomic shocks, aiming “to uncover macro-financial vulnerabilities from the linkages between nonperforming loans (NPL) and macroeconomic performance in advanced economies”.

Based on a sample of 26 advanced countries from 1998 to 2009, the paper deals with two empirical questions on NPL and macrofinancial vulnerabilities: 

1) the determinants of NPL and 

2) the interactions between NPL and economic performance. 

With respect of the first question, the literature suggests that the determinants of NPL can be macroeconomic, financial, or purely institutional. In addressing the second question, the paper investigated “the extent to which falling asset prices and credit constraints facing borrowers may backfire and lead to an extra round of financial system stress and subdued economic activity”. 

The findings show that “NPL play a central role in the linkages between credit markets frictions and macroeconomic vulnerabilities. The results confirm that a sharp increase in NPL weakens macroeconomic performance, activating a vicious spiral that exacerbates macrofinancial vulnerabilities. …The broad policy implication is that, while NPL remain a permanent feature of banks’ balance sheets, policies and reforms should be geared to avoiding sharp increases that set into motion the adverse feedback loop between macroeconomic and financial shocks.”

Per authors: “empirical regularities …shape the modeling of NPL, …include the cyclical nature of bank credit, NPL, and loan loss provisions. In particular, in upturns, contemporaneous NPL ratios tend to be low and loan loss provisioning subdued. Also, competitive pressure and optimism about the macroeconomic outlook lead to a loosening of lending standards and strong credit growth, sowing the seeds of borrowers’ and lenders’ financial distress down the road. The loosening of lending standards in upturns depends on the existing regulatory and supervisory framework. In downturns, higher-than-expected NPL ratios, coupled with the decline in the value of collaterals, engenders greater caution among lenders and lead to a tightening of credit extension, with adverse impacts on domestic demand.”

In other words, first order effects of ‘positive’ pressures on lending expansion are reinforced by ‘positive’ second order effects of reduced risk management provisions, regulatory slackening and counter-cyclical capital buffers. Once things blow, however, the same effects again reinforce each other. The bubble acceleration is supported by both moments as well as the bubble explosion – yielding higher peaks and deeper troughs.

Thus, the determinants of NPL “are both institutional/structural and macroeconomic”.

The institutional / structural determinants are found in financial regulation and supervision and the lending incentive structure. “Intuitively, disparities in financial regulation and supervision affect banks’ behavior and risk management practices and are important in explaining cross-country differences in NPL.” 

The macroeconomic environment drivers work by altering “borrowers’ balance sheets and their debt servicing capacity. The set of macroeconomic variables [includes]… broad indicators of macroeconomic performance, such as GDP growth and unemployment...”

The core findings of the study are: 

• “A sharp increase in NPL triggers long-lived tailwinds that cripple macroeconomic performance from several fronts. …of all the variables included in the model, NPL is the only one that has both a statistically significant response to- and predictive power on- every single [macroeconomic performance] variable over a 4-year forecast period. …Regardless of the factors behind the deterioration in loan quality, the evidence suggests that a sharp increase in aggregate NPL feeds on itself leading to an almost linear incremental response that continues into the fourth year after the initial shock.”
• “The confluence of adverse responses in key indicators of macroeconomic performance—GDP growth and unemployment—leads to a downward spiral in which banking system distress and the deterioration in economic activity reinforce each other.”
• “The broad policy implication [is that] …policies and reforms should be geared to avoiding sharp increases that set into motion the adverse feedback loop between macroeconomic and financial shocks. … preventing excessive risk-taking during upturns through adequate macroprudential regulations is the first best.”

In other words, folks, you can’t ignore the macroeconomic effects of Non Performing Loans, as Ireland’s Government is implicitly doing by refusing to focus on repairing household debt overhang here. And, via a link between negative equity and NPL (the study cites evidence that house prices have direct negative effect on NPL – with house prices collapse leading to increased NPLs), we can’t ignore negative equity effects either.