The Impact of Financial Crisis on Household Consumption

What can we learn from Gerlach-Kristen and Merola (2019) about how credit constraints emerged and spread in Ireland after the financial crisis? Why is this relevant to policymakers? Explain how generalizable you think these arguments are likely to be to other EU countries.

Gerlach-Kristen and Merola (2019) posit that during times of financial crisis, permanent income is revised downwards resulting to a decline in household consumption. The small-scale DSGE model holds that in such times, households can finance their consumption expenditure through borrowing against housing as the collateral good. However, it reaches a point where banks refuse to finance further loans resulting to a decline in household consumption. The more households leverage, the less likely it is for them to smoothen their consumption, which leads to emergence of credit constraints. On the other hand, paying back mortgages requires time considering that one pays both amortisation and interest. This implies that leveraging continue decreasing, which facilitates spread of credit constraints. Unless households are able to bind credit constraints, consumption smoothing is less likely to be realised.

As shown in Figure 1, Gerlach-Kristen and Merola (2019) use data on house prices, consumption, debt and leverage ratio to determine how credit constraints emerge and spread. From the figure, a drop in house prices results in binding constraints. Consumption, debt, and leverage ratio affect house prices while house prices also affect these variables. For example, when house prices fall, households consume less and use their savings to deleverage (See Figure 2). Usually, households use as much credit as they can get to attain the highest level of consumption. However, when house prices start to fall, the credit constrains starts binding tightly forcing households to start paying their debts and consume less (See Figure 2). Households continue consuming less and bound to credit constraints until house prices return to a steady state and leverage ratio normalises.

Based on the findings of Gerlach-Kristen and Merola (2019), banks should lower the loan-to-value ratio in order to lower the effect of credit constraints following falling collateral property prices. In addition, central banks should develop a discretionary fiscal policy to boost the economy when house prices start to fall. The government should revise the monetary policy to pave way for government-backed direct loan and loan guarantee programmes to offer credit subsidies and relaxed credit-rationing constraints in order to counter the effect of falling house prices. These additional channels would provide a fiscal stimulus helping households avoid being severely bound by credit constraints following decline in house prices.

The arguments of Gerlach-Kristen and Merola (2019) are somewhat generalizable to other EU countries. According to IGEES (2016), Ireland has a high number of people with disabilities, one parent families, and children which increases household joblessness. This implies that households in Ireland are at a higher risk of poverty as compared to other EU countries. Therefore, house prices are less likely to rise beyond a certain point, which increases bank’s reluctance to lend money. This effect may not be felt in other EU countries that are not at the risk of poverty. In addition, poor households have less consumption (Eurostat 2017) thus are more likely to smoothen consumption in times of financial crises. This implies that other EU countries with higher GDP are more likely to suffer during financial crises as compared to the poor Ireland households. The Irish Times (2017) states that property prices in Ireland have continued to increase over the past few years. For example, in 2016, Ireland was second to Malta to record the highest price increase in property. The higher property price in Ireland could mean that banks are more willing to give credit as compared to other EU countries with low property price. Therefore, the arguments of Gerlach-Kristen and Merola (2019) cannot be generalised to all EU countries due to differences in consumer behaviour, GDP, property prices, and credit provision.

Figure 1: Negative house price shock (Gerlach-Kristen and Merola 2019)

Figure 2: Positive house price shock (Gerlach-Kristen and Merola 2019)

References

Gerlach-Kristen, P. and Merola, R., 2019. Consumption and credit constraints: a model and evidence from Ireland. Empirical Economics, 57(2), pp.475-503.

IGEES 2016. Characteristics and implications of the level of household joblessness in Ireland. [Online] Available at

The Irish Times 2017. How does Ireland’s property price growth compare with Europe? [Online] Available at

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