An extensive and growing literature examines how households smooth consumption in response to idiosyncratic income shocks. Many of these studies focus on the role played by government programs such as unemployment insurance (Gruber, 1997; Browning and Crossley, 2001), AFDC (Gruber, 2000), or Food Stamps (Blundell and Pistaferri, 2003). Other studies have considered how households insure via private transfers (Bentolila and Ichino, 2004), or self-insure against income shocks through the earnings of other household members (Cullen and Gruber, 2000), by postponing purchases of durable goods (Browning and Crossley, 2001), or by refinancing mortgage debt (Hurst and Stafford, 2004).
This paper contributes to this literature by considering another mechanism by which families can self-insure against income shocks borrowing through unsecured credit markets. There are important reasons to focus on unsecured credit markets in this context. First, unlike other components of net worth, unsecured debt is potentially available to families that have no assets to liquidate or to collateralize loans. Thus, these credit markets provide low-asset households with a unique mechanism for transferring their own income intertemporally. Second, with recent expansions in these markets, unsecured credit is potentially available to a substantial fraction of U.S. households. More than three-quarters of all U.S. households have a credit card, and outstanding balances on revolving credit exceed $750 billion (Federal Reserve, 2005). Recent research suggests that unsecured debt has become easier to obtain: limits on credit cards have become increasingly more generous; unsecured debt as a percentage of household income has grown; and the risk-composition of credit card loan portfolios has deteriorated (Evans and Schmalensee, 1999; Lupton and Stafford, 1999; Gross and Souleles, 2002; Lyons, 2003). Moreover, growth in credit card debt has been most striking among households below the poverty line. From 1983 to 1995, the share of poor households with at least one credit card more than doubled, from 17 percent to 36 percent, while average balances across poor households grew by a factor of 3.8, as compared to a factor of 2.9 for all households.
This expansion of unsecured credit could have particularly important implications for these low-income households. Bird, Hagstrom, and Wild (1999) shows that low-income households paid down credit card debt during the economic expansion of the mid to late 1980s, but that outstanding credit card balances grew during the recession of 1990-1991. Observing this counter cyclical trend in credit cards balances, the authors speculate that poor households may use credit cards to smooth consumption inter temporally, implying that these credit markets effectively serve as a safety net. The possibility that credit markets help households smooth consumption has very important policy implications if families can self-insure against transitory earnings variation, then this diminishes the need for public transfers. Nevertheless, little is know about the degree to which households use unsecured credit markets in response to income shocks.
The first part of this paper investigates whether unsecured debt plays an instrumental role in a household's ability to smooth consumption by examining how borrowing responds to unanticipated unemployment-induced earnings variation. The results show that low-asset households do not borrow from unsecured credit markets in response to these idiosyncratic shocks. Thus, these credit markets are not serving as an important safety net for these households. This finding is robust to a variety of different tests of sensitivity.
The second part of this paper considers several possible explanations for why these households do not borrow. For example, these households may simply use other supplemental income sources to maintain consumption when earnings are low such as government, inter-household, or intra-household transfers, obviating the need for unsecured markets. The evidence presented here, however, indicates that these households are not relying on alternative sources in lieu of credit markets. Welfare and private transfer receipt is small for this sample. Moreover, I show that these households are not able to smooth consumption over these temporary income shocks.
The fact that consumption falls in response to transitory spells of unemployment implies that these low-asset households may be short on liquidity during unemployment. I therefore also investigate whether these households face binding borrowing constraints in unsecured credit markets. I present evidence that these households tend to have very low credit limits and their applications for credit are frequently denied, suggesting that low-asset households face frictions in unsecured credit markets. I also show that the borrowing behavior of households that are not likely to be constrained from unsecured credit markets those with higher asset holdings is different from that of low-asset households. Unlike low-asset households, those with assets increase unsecured debt on average by 10 cents for each dollar of earnings lost due to unemployment. Among this group with assets, borrowing is particularly responsive to these shocks for younger and less educated households. While I cannot rule out other possible explanations such as precautionary motives or impatience, the evidence presented here points to the fact that, despite recent expansions in unsecured credit markets, low-asset households do not have sufficient access to these markets to help smooth consumption in response to a large idiosyncratic shock.
The following section discusses the empirical literature examining how households insure against income shocks as well as studies examining the sensitivity of consumption to known income variation. I present a description of the empirical methodology in Section 3 and describe the data in Section 4. The results in Section 5 show that low-asset households do not borrow to supplement lost earnings during unemployment. This section also explores why these households do not borrow, comparing their consumption and borrowing behavior to other households. In Section 6 I discuss sensitivity analyses, verifying that the results are robust to different specifications and functional form assumptions. Section 7 concludes.
Download
PDF Ebook Borrowing During Unemployment: Unsecured Debt as a Safety Net
