Long-term debt propagation and real reversals

Abstract

We examine a propagation mechanism that arises from households’ long-term borrowing and show empirically that it has sizable real effects. The mechanism recognises that when there is long-term debt, an impulse to new borrowing generates a predictable hump-shaped path of future debt service. We confirm this pattern using anovel multi-country dataset of debt flows. Whereas new borrowing boosts output contemporaneously, debt service depresses output. Credit booms thus lead to predictablereversals in real economic activity several years later. This long-term debt propagation channel is the main reason for why indicators of credit cycles have predictive power for future economic activity.