Philip Bunn, Jagjit Chadha, Thomas Lazarowicz, Stephen Millard and Emma Rockall
Does higher household debt lead to greater labour supply? Ahead of the Global Financial Crisis (GFC), UK household debt rose considerably. Since that crisis, the UK labour market has experienced high employment and high participation, alongside relatively weak wage growth. Might these observations be evidence that higher debt leads to higher labour supply? In a recent Working Paper, we attempt to answer this question. We do find a significant channel by which households with higher debt increase their labour supply in response to negative income shocks by more than households with lower (or no) debt. But, we do not think the effect is strong enough to explain the post-crisis strength in employment and participation at the aggregate level.
Higher debt and higher labour supply
Intuitively, one might expect any causal link between debt and labour supply to go either way. The higher a household’s debt is, the more they need to work to pay it off; and yet the more hours they work, the more income they have, the higher the level of debt they can comfortably manage. The motivation for our paper came from two stylised facts in UK data. First, household debt rose considerably as a proportion of household income ahead of the GFC and remains high (Chart 1). Second, labour force participation and employment have remained higher after the crisis than might have been expected given their previous relationship with national output (GDP) (Chart 2). The question asked by our paper is whether the high household debt resulted in a positive labour supply response since the GFC.
Chart 1: Household debt to income ratio
Chart 2: Employment and participation rates
A theoretical framework
We first develop a simple framework within which we can think about how household debt affects labour supply. Our framework examines three types of households: outright homeowners (savers), mortgagors (borrowers) and renters, who are neither savers nor borrowers. An individual household maximises utility – which arises from consumption of goods, housing services and leisure – subject to a budget constraint, which depends on whether they pay or receive rent on their housing and/or they pay interest on a mortgage. The model generates four testable hypotheses on the links between household debt and labour supply for each type of household:
- In steady state, higher wealth (both housing and financial) is associated with a lower level of labour supply. In contrast, higher household debt is associated with higher labour supply.
- For owner-occupiers, a negative income shock leads to a fall in household labour supply. But for mortgagors, a negative income shock leads to an increase in the labour supply.
- Surprise increases in interest rates (tightening of financial conditions) are associated with increases in household labour supply that are larger the higher the initial level of household debt – we find a scale effect.
- For mortgagors, a surprise fall in house prices leads to an increase in labour supply, but there is no effect on owner-occupiers or renters.
Empirical results
Using data from the ONS ‘Labour Force Survey’ we examined participation and hours of the different housing tenure groups. Chart 3 shows that the participation rate of mortgagors is higher than that of renters, which is, in turn, higher than that of owner-occupiers. Chart 4 shows that the average weekly hours worked of mortgagors is higher than that of renters, which is, in turn, higher than that of owner-occupiers. In other words, a simple analysis of the data suggests that higher debt is associated with higher labour supply on average, as predicted by our theoretical framework.
Chart 3: Participation rate by tenure
Chart 4: Average weekly hours worked by tenure
To examine whether household debt might affect the response of labour supply to negative income shocks, such as those that resulted from the GFC, we first need to identify such a shock at the household level. To do this, we considered the effects on household labour supply arising from the head of household (HoH) involuntarily losing their job. In line with our theoretical framework, we found, using fixed-effects regressions, that such an event led to a reduction in labour force participation among households that were outright homeowners (Chart 5). That is, heads of outright home-owning households were more likely than heads of other households to show a discouraged worker effect. Chart 5 also suggests a small added-worker effect among mortgagors, where non heads of household became more likely to participate in the labour market following the head of household losing their job. Furthermore, we found that when the head of a mortgagor household lost their job it led to an increase in the desired hours of all the members of the households.
Chart 5: Change in probability of participating following HoH job loss
So far, these results support the predictions of the theoretical framework. But, using the ‘Labour Force Survey’ on its own, we could not examine whether the level of debt matters for the response of households to shocks. Indeed, given the considerable heterogeneity within mortgagors, the results to date will likely understate the impact of debt on the responsiveness of household labour supply for the most highly indebted and constrained households. To try to capture these channels, we used a measure of debt imputed from the ‘Wealth and Assets Survey’ to examine whether mortgagors with higher loan to value (LTV) mortgages or higher outstanding mortgage balances are more responsive than those mortgagors who are comparatively unconstrained. Adding these variables to our fixed-effects regressions, we found that low-LTV heads of household decreased their participation by significantly more in response to job loss than high-LTV heads of households (Chart 6). High-LTV mortgagors also subsequently increased their average hours significantly more than outright owners (conditional on being employed).
Chart 6: Change in probability of participating following HoH job loss
To examine the effects of a surprise rise in interest rates, we use a series of exogenous monetary policy shocks, developed by Cesa-Bianchi et al (2016). The idea is that monetary policy shocks should exogenously result in changes in households’ mortgage rates (and thus the repayments they face), separate from, for example, demand conditions that may themselves affect labour supply. Such a shock will potentially feed through into the households’ collateral constraints, altering the cost of borrowing for households that are unable to adjust borrowing in response to changes to interest rates. We included the shock series directly in the regression as a proxy for the retail interest rates that households face. We found that this shock led to an increase in the participation rate of mortgage holders, in line with the theory (Chart 7). In addition, the shock led to increases in the desired hours of mortgage holders and owner-occupiers together with a significantly larger increase in the desired hours of renters (Chart 8).
Chart 7: Change in probability of participating following positive interest rate and negative house price shocks
Finally, we examined the effects of house price movements on labour supply within our fixed-effects regressions. To identify exogenous movements in house prices, we used average house prices for the local authority area in which our households live. We found that a fall in house prices led to an increase in actual and desired hours of mortgagors, in line with our theory. However, contrary to the theory, we found that hours also increased for owner-occupiers and renters (Chart 8). Renters may respond in this way because they are accumulating savings prior to obtaining a mortgage but the increase in hours by savers is something of a puzzle.
Chart 8: Change in hours worked following positive interest rate and negative house price shocks
Policy implications
Putting all our results together suggests that the rise in secured household debt leading up to the financial crisis in the United Kingdom has the potential, at least partly, to explain the subsequent behaviour of employment, hours and wages. In addition, an increase in indebtedness could potentially affect the potency of monetary policy since a rise in interest rates will have a stronger effect on the income available for discretionary spending (ie, after interest payments are taken out) of debtors, the higher is their level of debt, encouraging a stronger increase in labour supply.
Since the GFC, household debt has fallen as a proportion of GDP but has remained high relative to before the crisis. While the analysis in our paper pre-dates Covid-19 (Covid), one can easily apply lessons learned to today’s climate. Specifically, this high level of debt suggests that the fall in incomes brought about by Covid could result in a positive labour supply response for highly indebted households once the direct effects of Covid subside.
Philip Bunn and Stephen Millard work in the Bank’s Structural Economics Division, Jagjit Chadha works for the National Institute of Economic and Social Research, Thomas Lazarowicz works at University College, London and Emma Rockall works at Stanford University.
If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.
Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.
