I’ve written several times about the problems household debt is creating for the Dutch economy (here, here and here). But Denmark has more household debt than even the Netherlands – possibly more than any country in the world. How’s the Danish economy doing?

Not well at all. Danish GDP is well below its pre-crisis peak, reached in the second quarter of 2008. And the main culprit is weak household consumption, which is 4.3% lower (adjusted for inflation) than it was at its peak in the fourth quarter of 2007.

Bloomberg News
A sightseeing boat passes residential and commercial properties in Copenhagen, Denmark, in March.

There is a strong relationship between household debt, real-estate prices and consumption (see Figure 6 of this Citigroup report). Consumer spending in countries with high household debt levels — mortgages are the main source of this debt — tends to be very sensitive to changes in housing prices: When they fall, highly indebted households save more and spend less.

It’s not hard to understand why. If you borrowed a lot of money to buy your house (and the land it sits on), and then your house (and the land it sits on) is worth much less than you paid for it, you are going to feel more pressure to pay down your mortgage. You’re probably less likely to go out to dinner, renovate your house or buy the latest Bang & Olufsen stereo equipment. That has repercussions throughout the economy.

Danish house prices have fallen sharply since 2007, about 18%. And after registering a brief recovery in 2010, they are falling again. If that keeps up, household consumption is likely to suffer even more, with grave consequences for the economy as a whole.

What can Danish policymakers do in this situation? Not much. The government pegs its currency to the euro, so there’s little possibility of using looser monetary policy to kick-start the economy. Nor is fiscal stimulus an option: While the Danish budget deficit was well below the EU’s 3%-of-GDP-limit last year, the result was due to a one-off benefit from unexpectedly strong proceeds from the Danish tax on pension assets.

Danske Bank economists said in February that a deficit of 5.2% of GDP this year is likely, requiring austerity measures from the government.

So Denmark may be facing a long period of stagnation while its households deleverage. And this prognosis may be optimistic. A more pessimistic scenario would go something like this: Danish house prices keep falling, prompting more cutbacks by consumers. That in turn lowers GDP and raises unemployment, boosting the government budget deficit and requiring sharper cutbacks to keep the deficit in line with EU rules. With unemployment higher, more Danes start defaulting on their mortgages, forcing Danish banks to horde capital against losses and cut back lending to the real economy. That causes GDP to fall a more, requiring more austerity, etc….

Both Denmark and the Netherlands argue that simply looking at gross debt levels ignores the large savings their households have tucked away in pension funds and other accounts. But here are two questions: Can these assets be accessed in the short-term? Some of them are locked up in pension funds, so sometimes not. And what happens when everyone starts selling assets at the same time to offset an economy-wide decline in real-estate prices? Asset prices will fall, worsening household balance sheet problems.

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