Too much of a good thing? Households' macroeconomic conditions and credit dynamics

Abstract

Favorable macroeconomic conditions, accompanied by optimistic consumer confidence, can stimulate and shape households' expectations in such a way that they gradually extrapolate the view of good times lasting "forever". As a consequence, households can then be inclined to accept a much higher level of indebtedness - higher than they would be willing to take on if they were to correctly perceive a discontinuation of the positive trend in the future. This paper documents the empirical link between the macroeconomic conditions faced by households, the confidence of households as investors and consumers, and households' demand for credit on a sample of 21 European countries. The well-known procyclicality of household credit is found to grow stronger when favorable macroeconomic conditions are met with optimistic consumer confidence. While household credit goes hand in hand with the improving economy during an economic upturn, it is found to be sticky on the way down. Estimates show that households tend to extrapolate recent and current macroeconomic trends to the future and over-estimate the persistence of favorable or adverse conditions.