Long-term debt propagation and real reversals

(May 2023, revised March 2025)

Summary

Focus

Economic propagation mechanisms that capture how disturbances systematically feed through the economy over time are central to macroeconomic models. Such mechanisms allow us to understand the behaviour of key macroeconomic variables and help us make more reliable forecasts. Unfortunately, many macro models lack strong propagation based on understandable economic behaviour and instead rely on mechanisms for which there is no economic rationale.

Contribution

We describe a natural propagation mechanism through which new borrowing can systematically affect future output and lead to reversals in activity. The starting point is simple: the majority of debt contracts are long-term and imply regular future debt service payments (consisting of interest and amortisations). These payments pile up during a credit boom and, as time progresses, eventually outweigh the flow of borrowing. When this happens, the positive output effect from the credit boom reverses and output falls. We confirm this pattern using data from many countries over the last four decades.

Findings

Using a novel multi-country data set of debt flows, we show that the prevalence of long-term debt leads to predictable real reversals. An increase in new household borrowing is associated with significantly positive output growth in the short term. But it also increases the stock of debt and associated debt service payments over time, which eventually depresses output. This propagation mechanism largely accounts for the well-documented fact that growth tends to systematically slow down for several years after a credit boom. By embedding the long-term debt propagation in a New Keynesian model, we show that debt propagation delivers impulse responses that closely reproduce our empirical estimates of the output effects of new borrowing and debt service.

Abstract

We examine a propagation mechanism that arises from households' long-term borrowing and show that it accounts for real reversals after credit booms. An impulse to new borrowing boosts output in the short run, but long-term debt generates a predictable hump-shaped path of debt service that depresses output far into the future. We confirm these patterns empirically using a novel multi-country dataset of debt flows. We embed long-term debt propagation in a New Keynesian model and show how credit shocks generate predictable reversals that are difficult for policymakers to counteract.

JEL classification: E17, E44, G01, D14

Keywords: new borrowing, debt service, financial cycle, financial flows and real effects