The current recession has been marked by a large fall in US household debt. An influential theory links the two in the following way: due to a credit market shock, borrowers had to reduce consumption to pay down their debts, and the fall in the interest rate was insufficient to encourage others to bring forward spending and compensate. This paper explains why it is crucial for the theory that borrowers indeed paid down their debts, rather than defaulted, in the context of a version of the endowment-economy Eggertsson and Krugman (2012) model that yields new insights on the link between deleveraging and low interest rates.
The paper proceeds to show that the amount of debt that was written off household balance sheets has been large – an upper bound estimate places it close to a trillion dollars, matching the headline fall in household debt. When compared to an amount that takes into account interest accrual, aggregate defaults make up about a third of net debt reduction over the recession. A separate estimate from the cross-section of US counties suggests that, for an average county, this fraction may have been even higher.