Consumption Smoothing

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A topic that perhaps deserves more discussion is whether/how households are actually smoothing consumption throughout this recession, particularly where one or more household member has been laid off or had substantial reductions in salary and hours. There are many dozens of papers that one could cite in developing some ideas in this area. Two papers below have particularly interested me as I have been thinking about this. The first looks at the extent to which increased debt payments interfere with consumption smoothing. The second looks at the extent to which consumers can maintain welfare by cutting back on durable expenditure while maintaining non-durable consumption. In an optimistic version of the Irish economy, people who have been made unemployed may be able to smooth through the current period by (i) using savings (ii) using redundancy payments (iii) delaying durable expenditure (iv) using extra time available to seek lower prices (v) taking advantage of generally lower prices economy wide (vi) working with financial institutions to restructure their debt payments (vii) switching more to domestic production e.g. making sandwiches rather than buying lunch in a cafe (viii) using informal bartering as a method of acquiring services (ix) borrowing from relatives (x) social welfare (xi) income insurance (xii) charity. I am sure readers can think of many other ways in which people who have been laid off are trying to smooth consumption. We have never had high unemployment in Ireland coinciding with very high levels of personal debt and, as such, relying on previous Irish research is not likely to be very informative as to the welfare issues at stake here. The previous discussion on price indices is clearly relevant but a wider discussion of the role of formal and informal institutions in consumption smoothing in this new environment would be interesting.

Do High Debts Hinder Consumption Smoothing?

Shocks, Stocks and Socks

5 Responses to “Consumption Smoothing”

  1. Gerard O'Neill Says:

    Just on your last point Liam –

    “We have never had high unemployment in Ireland coinciding with very high levels of personal debt”

    this is true in aggregate but we need to recognise that we have ‘very concentrated’ very high levels of personal debt.

    The Central Bank’s study on Financial Capability (http://centralbank.ie/frame_main.asp?pg=con_icbp.asp&nv=con_nav.asp) shows that only 5-10% of the adult population experience difficulties with either debt or the general cost of living. 60% have no debts.

    Of course, unemployment has risen sharply since the study was completed last year, but prices and mortgage rates have fallen, compensating to a degree.

    My conversations with various banks about consumer indebtedness and unemployment shows that they are more than willing to be flexible with those made redundant in terms of flexing repayment schedules etc. So add that to the other measures you describe and I think you end up with a lot of consumption smoothing.

    Worth also considering that those made redundant recently are more likely to have better financial management skills and deeper financial resources than those who have been dependent on social welfare since before the recession.

  2. Pat Donnelly Says:

    One of the main and proper concerns of economic study, seems to be the cut-off points for dissatisfaction and more importantly, rebellion within a defined group, such as a nation or a class of workers therein who might sway others into rebellion.

    Now that is going to become more relevant….

    Remember Iceland!

  3. Liam Delaney Says:

    Gerard.
    With regard to the flexibility of the banks, it would be good to know the nature of these arrangements in more depth. A consumer heavily in debt cannot simply shop around for providers so it would be interesting to see whether, for example, penalties imposed for changing mortgage arrangements are being levied harshly.

    I’m not fully sure what to glean from the Financial Capability report given the data was collected in late 2007. If 5-10 per cent of people were already experiencing trouble (albeit subjectively expressed) back then, then Im not sure what my guess would be for that figure now. You have some figures if I remember correctly though given the nature of how people try to get through a recession, one would not necessarily expect to see people getting into immediate trouble. The question is what happens when redundancy payments, savings etc,. have been spent down and its conceivable that only next year will many people who have had shocks this year really feel the pinch. Having said all that, Im not sure I could say with a straight face that consumption blips express the welfare cost of unemployment anyway. I think a lot of the welfare cost of unemployment looks to be independent of consumption as we can measure it.

    Your point on financial management is fascinating and I will address this at a later time wearing my behavioural economics hat. The financial literacy construct is interesting but it would be good to look at models of financial behaviour that incorporate emotional elements and features such as bounded self-control.

  4. John McHale Says:

    Liam, you draw attention to an important and understudied issue. One additional complication is that many households are surely facing a substantial reduction in permanent income (brought about, e.g., by reduced wealth, long-term unemployment, a lower path for potential output, etc.). Even forward-looking, non-liquidity-constrained consumers should adjust consumption significantly when facing such shocks. An unfortunate aspect of the current sitution is that there is likely to be “excess smoothing” for less forward-looking households, which doesn’t auger well for aggregate consumption in coming quarters.

  5. Tom Says:

    Need more work on the role expected permanent income.

    During the monetary/credit bubble, Irish people thought they were smoothing consumption. They believed that in the (near future) they would be able to finance lots of consumption. So they smoothed their way into it based on these formuated expectations and thus was the world’s grandest ever fleet of German luxury automobiles and Scandinavian designer kitchens was launched.

    At present, I suspect, that not only have expected permanent incomes plummeted, but possbly undershot in classic dynamic error-correction style and what might appear as an undershoot in consumption (relative to a consumption smoothing model) might be nothing of the sort, when expectation adjusted permanent incomes are considered.

    Now that is the hypothesis that I would like tested, but we are back to that hoary old thorn of expectations modelling.

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