The Economics of Financial Stress

Résumé

We study the psychological costs of financial constraints and their economic consequences. Using a US-based representative survey, we document the prevalence of financial stress among US households and that financial stress strongly correlates with measures of financial constraints. We incorporate financial stress into an otherwise standard dynamic model of consumption and labor supply. There are two main findings. First, sophistication versus naivete is critical in determining stressed households’ behavior and welfare costs of financial stress. Sophisticates, who understand the economic consequences of financial stress, would save out of high-stress states. Naifs, instead, dis-save, fall into a poverty trap, and incur higher welfare losses. A psychology-based theory of poverty traps hence requires two equally important components: financial stress itself and naivete about financial stress. Second, the financial stress channel can reverse the counterfactual negative wealth effect of labor supply because relieving stress releases resources for productive work. Financial stress also has macroeconomic consequences on widening wealth inequality and increasing fiscal multipliers. (work with Chen Lian and Yuriy Gorodnichenko)