Avoiding a Household Debt Crisis with a Targeted Policy Response
By: Gudrun Johnsen
The economic effect of the Covid-19 pandemic varies highly across industrial sectors, education levels and income groups, adding further to inequality across the globe. This calls for highly targeted policy responses for the sake of fiscal prudence and to avoid further economic and financial hardship for those in need. Given the general consensus that society at large should bear the cost of the pandemic, the case for targeted public support for those households that have been hit the hardest by the pandemic is imminent.
Guiding principles for household liquidity support
Many countries have already supplied firms with government guaranteed credit lines and enhanced benefits to those that are unemployed to safeguard financial conditions of the private sector during the period of quarantine and lockdowns. In many countries, this has been sufficient to keep defaults at bay so far. Yet, many countries are now faced with increased fiscal commitments to honor unemployment insurance for an increasingly larger portion of the population that is now unemployed for a longer period than previously expected. In some countries, maintaining the same strong fiscal support for firms and households in the longer term may not be an option.
Targeted liquidity support to households is therefore being considered, e.g. in Iceland, to mitigate the risk of debt defaults as well as financially and socially harmful consequences of widespread, long lasting unemployment. Policy measures aimed at safeguarding the financial health of households should, inter alia, be guided by the following principles:
- Fiscally prudent — by targeting fiscal outlays at those in need and by planning for fiscal recovery,
- Inclusive — by being non-discriminatory towards the heterogeneous financial obligations of households, e.g. mortgages, rent, student loans, consumer loans, and non-discriminatory towards wage earners and small business owners,
- Building back better — by addressing systemic fault lines.
Enhanced unemployment benefits coming to an end — now what?
Regular unemployment insurance often only goes so far. Unemployment benefits across the OECD range from just over 30% of previous in-work income in Australia to 90% in the initial months of unemployment in Belgium. Average benefits vary from 66% in the initial two months to 30% after five years of unemployment.
As a result, becoming unemployed pushes many people towards the lowest quartile of the income distribution, leaving them unable to meet their financial commitments made in times of prosperity. In the presence of illiquid savings, many households have become beholden to hand-to-mouth consumption. The most vulnerable ones need added support to regular unemployment benefits to stay current on rent, mortgages, and other financial obligations.
Raising unemployment benefits for an extended period across the board is often not an option from a fiscal standpoint. It may also be inefficient and could disincentivize job market participation. At the same time unemployment benefits need to be high enough to keep debtors and renters current on their payments during this crisis.
With this in mind, instead of an overall increase in unemployment benefits, government support should take into account the heterogenous needs for liquidity support among the unemployed population. In order to avoid a domino effect and costly debt restructuring that mass defaults may trigger, liquidity support to households or individuals should enable households to stay current on their financial obligations, irrespective of the sources of those obligations, such as student loans, mortgage payments, rent, car loans, and minimum payments of consumer debt. The support should reach individuals that have been left short of income as a result of the pandemic; irrespective of whether they were previously employed or self-employed.
Government support for households in need distributed through the financial sector
Against this background, a coalition of trade unions in Iceland have proposed a scheme for targeted government support for households in need.
At the center of the targeting is a mechanism to determine the funding requirements of those in need through banks and other financial service providers. By employing the credit assessment methods and distribution channels of the financial sector, governments can swiftly deliver targeted support to households in need based on the difference between cost-of-living estimates, financial obligations and current income streams (unemployment benefits or reduced income). The suggested program would allow financial services to accept applications for a credit line from their customers who can show income loss since the Covid-19 outbreak. Households would be able to draw on the credit line monthly until the applicant has secured employment for a maximum of 18 months, without repayments during this period. To determine the maximum withdrawal amounts, the bank performs a reversed credit assessment: instead of assessing the ability to pay off a loan, the assessment is based on (1) the monthly payments of existing financial obligations, (2) a benchmark amount for the cost of living in the area where the borrower lives, and (3) his or her current income. The monthly withdrawal from the credit line would be the difference between income and financial obligations, where (1)+(2)-(3) = the amount of the monthly credit allowance. The maximum monthly withdrawal is proposed to be capped at $2400.
Turning the credit line into a 10-year loan agreement paid off through a progressive income tax rebate
After employment is secured or the maximum period of 18 months has passed, the credit line is turned into a loan agreement with 10 annual annuity payments due at the time when the tax authorities reimburse overpaid taxes. Repayments start in the calendar year following the year when the loan agreement has been issued and match the date of the tax rebate.
Borrowers receive an income tax rebate that exactly matches the annual payment of the loan, through a discount on income tax depending on income levels. The lowest discount would be applied to the highest wage earners, and vice versa, so to ensure that the rebate fully covers the annual payment of the loan.
Support funded through the central bank with a 100% state guarantee
The credit lines provided to households would be funded by the central bank via a special purpose vehicle (SPV). The SPV would disburse monthly liquidity to commercial banks to fund the credit lines as they are being drawn on at discount window rates. The credit lines and loan agreements would be backed by a 100% government guarantee. As the credit lines have been fully drawn on, they would be turned into loan agreements, at an interest rate equivalent to the risk-free rate of 10-year government bonds. Under the proposed scheme, individual banks do not carry the credit risk of this credit facility, yet would receive a service fee for each loan. The credit risk of financial institutions is mitigated, as the supplemental credit lines enable borrowers to stay current on their pre-existing loans and financial obligations towards banks, landlords, car dealers etc., that are paid off through direct transfers set up by the banks.
An example of liquidity support to an eligible individual falling back on financial obligations due to income loss during the Covid-19 pandemic
Tax collection post-Covid-19
As support from the government will only be provided through income tax rebates, it requires borrowers to file tax returns reporting at least the minimum wage. On this ground the program will partly fund itself through improved tax collection.
The state guarantee would be invoked if insufficient income is reported to provide enough tax rebate to repay the liquidity support. Payments in arrears would need to be processed either through the tax authorities, like other tax payments, or through financial services responsible for dispersing the liquidity support.
As vaccines mitigate the health crisis the economic crisis needs longer to be resolved
Thankfully, vaccines are already freeing individuals from the dangers of Covid-19. It will, however, take longer to bring economic recovery to different economies, firms and households whose income streams were cut short by measures to prevent the spread of the virus. Governments will still need to provide public support to the private sector, especially in countries heavily dependent on the travel industry. In others, structural changes, that the pandemic has brought about are still to be reckoned with. Temporary and targeted liquidity support to households, as described above may prove to be worth considering in the coming weeks as policy maker seek to bridge the economic gap, this pandemic has brought about.