Fiscal Policy as an Anchor in Household Debt Cycles: Evidence from Spain

Abstract

[Abstract] This paper examines the relationship between Spanish GDP and household debt from a business cycle perspective, with a particular focus on the role of government spending. According to Minsky's Financial Instability Hypothesis (FIH), an over-indebted economy becomes highly vulnerable to exogenous shocks. Using a Vector Error Correction Model (VECM) that includes public expenditure, investment and household net worth as control variables for Spain over the period 1999-2017, the findings indicate that although the expansion of household debt favoured economic growth, there is not enough evidence to argue for a balance between household debt and GDP. Instead, while household debt bears much of the short-term adjustment toward GDP’s long-run equilibrium, government expenditure emerges as the key determinant of the long-run equilibrium. Household debt mainly operates through short-run and errorcorrection channels, underscoring the importance of countercyclical fiscal policy as a key buffer during periods of household deleveraging.