Impact of household debt and saving rate on economic growth

3.3 Economic Growth

When per capita GDP or any other means of calculating total income rises, economic growth arises and this is usually registered as the yearly rate of change in GDP. Economic growth results from advances in productivity in terms of more production of goods and services with the same factors of production.

The dependent variable economic growth is measured by real GDP per capita. At times, total GDP figures are not reflective of the actual performance in the economy. Hence, GDP per capita is a better measure as it is liable to fewer errors and some errors tend to affect population estimates and thus they have offsetting impacts. Furthermore, the natural log of real GDP will be taken into account to avoid any large outliers.

3.4 Household Saving

Household saving can be defined as a percentage of household disposable income which is not consumed and household savings rate can be calculated on gross or net basis. Depreciation is considered in the net savings rate which is more commonly used compared to the gross savings rate. Household saving is assumed to have a positive relationship with economic growth.

Comparisons of savings rate among countries become hard by these two different measures of gross and net savings rate due to distinct social security and pension programmes, variable tax schemes which have an impact on disposable income. The household savings rate of a country can be affected by age of the economy’s population, the accessibility of credit, general wealth issues, cultural and social factors. Nevertheless, household savings rates are still a good a measure of an economy’s income in relation to consumption over time.

A country can finance its debt domestically if it has a relatively high level of household savings. High debts levels funded mostly by foreign creditors are less persistent than high debts levels financed by internal savings.

Consumption allows GDP to grow and this is a significant factor in economic expansion. With the existence of financial crisis, the whole economy could be dampened with lower consumption due to higher debt and lower savings level. A larger portion of GDP growth should then come from FDI, exports and government expenditure.

Household saving is the most essential domestic source of funds to back capital outlay and this is a substantial boost for economic growth on the long term basis. Household savings rate vary greatly among countries as shown in the chart. This is partially due to the level pensions schemes are financed by government rather through personal saving and also to the extent governments offer insurance against sickness and unemployment.

3.5 Household Debt

When a country has a substantial degree of household debt, it increases its inclination to financial crisis and this acts as a hindrance for economic growth. Household debt is assumed to have a negative relationship with economic growth.

There have been forecasts about house bubbles which were caused and thus creating the countries to be overheated. A large portion of the economic growth was centred on household consumption which was backed by loans from banks.

When banks noticed the lack of credit worthiness from consumers who even lost their confidence in the financial system, there had been strict controls over the lending conditions for loans. As a result, the ongoing vicious circle preceded a major decline in economic growth following the fall in consumption and repayments of debts.

Analysing the graph results with the conclusion that USA is not the only main country having experienced the worst GDP slowdown but many other countries like Iceland and Portugal are following suit with the level of household debt actually rising substantially. It would not be logical for a country burdened by a large level of household debt to expect its economic performance to flourish in the coming years.

When analysing the GDP percent basis, it can be seen that household debt for USA is not among the worst countries with too much of debt burden but it does not have a safe margin either. It is Denmark which has the heaviest household debt burden both with the GDP and disposable income basis. It has been forecasted that the household debt ratio would get even worse in the future for example Iceland and Portugal which are following suit with the heavy household debt burden they are carrying. Italy has fared relatively well compared to the other countries mentioned above, closely followed by Austria, France and Finland with an approximate difference of 25%. Germany, Sweden, USA and Canada have a relatively heavier household debt burden of around 100-125%. Japan, UK and Netherlands do not have a safe margin since they tend to have high household debt which can get even worse in the future if this is not closely monitored and this may take a toll on their economic growth which would be negatively affected.

3.6 Rates of interest

The rate of interest has a great influence on the given level of aggregate disposable income which is divided between consumption and saving. However, it cannot be predicted with conviction that a lower interest rate would imply more disposable income will be dedicated to consumption and less to saving or vice versa. The rate of interest is assumed to have a positive relationship with economic growth.

As a matter of fact, there can be a rise or fall in the total amount saved following a change in interest rate and this depends on the income and substitution effects and their strengths of their net effects. A higher level of future consumption arises at the detriment of present consumption with substitution effects due to higher interest rates and thus resulting in more savings in the present period.

On the other hand, a consumer’s future income compared to his present income can be increased following higher interest rate and this leads to higher consumption by borrowing from future income and hence, less is saved. However, this may not be necessarily the case for lower income earners who would save only a small part of their incomes even when interest rates are high. The substitution effect will then outweigh the income effect and there will be a direct link between income and rate of interest. For some people who prefer to save a greater portion of their incomes, the income effect may offset the substitution effect and thus higher interest rates would result in lower present savings level

3.7 Price level/Inflation

One of the theoretical concepts of economics says that when there is a change in the price level, this may affect consumption and savings positively or negatively. It is usually believed that household’s confidence in money erodes when there is inflation and hence, they have the tendency to save more since inflation actually raises the variance of expected real income. The fact that consumers have greater preference for unplanned increases in savings compared to withdrawals, it usually incites consumers to save more when inflation is high. Inflation is assumed to have a negative relationship with economic growth.

There is also an indirect effect of inflation whereby the real value of nominal asset is diminished and thus the real value of liquid assets decreases the net household wealth. Real consumption is often reduced and savings rate increases.

3.8 Consumption

The total value of goods and services purchased by people aggregated over time is called consumption and it is usually the greatest GDP component. A country’s economic performance is often assessed on its consumption levels. Different income earners would be consuming differently depending on their standard of living and purchasing power. Consumption is usually determined by current income, accumulated savings and expectations on future income. Consumption is assumed to have a positive relationship with economic growth.

As it can be shown in the above chart, consumer debt relative to personal disposable income and consumption relative to personal disposable income are rather fluctuating but there is a higher fluctuation on the part of the consumer debt which means that people were consuming more than they could afford and this resulted in higher debt burden among countries across the world.

3.9 Investment

When an owner usually acquired property for the purpose of generating income like plants and equipments, this is called investment as it is spending on income-generating assets.

If a country wants to achieve long term sustainable economic growth, it should be able to the rates of accumulation of capital – be it human or physical so that it can result in more efficient assets and so that the whole population can have access to those assets.

With the help of financial instruments, markets, and institutions, the extent to which information, enforcement and transactions costs can have their impact on savings rates, investment decisions, technological innovations and steady-state growth rates can be improved. Investment is assumed to have a positive relationship with economic growth.

If economic growth continues going at such a slow and unsteady speed, there is not much room for improvement for investment to be forecasted in the future and this is not a good sign as economic performance is going to decline drastically.