Monday, March 14, 2011

Financial fragility

I mentioned in my previous blog post the importance of having a buffer stock of savings. I would like to continue to discuss what individuals actually have or can rely on in case they are hit by a shock. This is part of a new research project, which is joint work with Peter Tufano of Harvard Business School and Daniel Schneider, a sociologist who is finishing his Ph.D. at Princeton University.

We engaged the market research firm TNS Global and collaborated with them to design a new survey that was fielded in June–September 2009. Specifically, we ask respondents: “How confident are you that you could come up with $2,000 if an unexpected need arose within the next month?” Respondents could reply:

• I am certain I could come up with the full $2,000
• I could probably come up with $2,000
• I could probably not come up with $2,000
• I am certain I could not come up with $2,000

Because we are dealing with an unexpected event in the future, it is important to ask about confidence rather than ask a yes or no question. The $2,000 figure reflects the order of magnitude of the cost of a major car repair, a large co-payment on a medical expense, legal expenses, or a home repair.

The news is not good: The capacity to cope with financial emergencies is very limited. Half of Americans report that they would probably or certainly be unable to cope with such an emergency. More specifically: 24.9% of respondents reported being certainly able to cope; 25.1% probably able to cope; 22.2% probably unable to cope; and 27.9% certainly unable to cope.

The capacity to cope with a financial emergency is not only generally limited but also varies significantly with the economic and demographic characteristics of individuals and their households. While those with higher income and greater educational attainment report greater capacity to cope, a large proportion of individuals with middle-class incomes report they are certainly not or probably not able to cope. Moreover, even among those with some higher education, more than half reply that they would be certainly or probably not able to cope. In other words, while inability to cope is severe among the less educated and low-income groups, it is not limited to the poor or to a small group of the population. Similarly, while financial fragility is more pronounced among the young, many older respondents, who are presumably close to retirement and at a point in life when their wealth accumulation should be at its peak, report anticipating difficulty in coping with a financial a shock. And women and families with children are less likely to be able to cope with shocks.

The financial crisis is a clear contributor to financial fragility, although not the only one. Those who suffered wealth losses, particularly large losses in excess of 30%, report greater inability to cope. This may explain why even some wealthy people anticipate potential inability to cope with a shock—likely due to lowered wealth in conjunction with high fixed costs and inflexible commitments The unemployed are also much more financially fragile, with just about one-third reporting they would certainly or probably be able to cope and 41.2% reporting they would certainly be unable to cope.

This is a worrisome finding as it shows that individuals and the economy are fragile to shocks. Many policies have so far focused on promoting asset building for the long run. It may be useful to start considering the short run as well.

I am presenting this work at the Brookings Institution this week, and I will keep discussing more findings and the potential implications of this work. Please send me your comments, too.

The Huffington Post featured this paper on their web and asked to share your story. Here is the link:


Anonymous said...

This is exactly what happened to us a few years ago. Our ac/heater unit of 28 years decided to die during a real cold spell. The cost to replace it--$2200. We were able to go to our credit union and get the money almost immediately. The problem was getting a plumber to get the unit installed in timely manner! So, you certainly picked a good question to ask.

John Comer, CFP® said...

You alluded to one of the factors that I think is very important in freeing up reserves and that is high fixed expenses. When I sold mortgages for a bank in 1990, monthly principal and interest could not be more than 25% of the applicant's monthly gross income. When I refinanced a mortgage in 2007, we were offered up to 50% of our monthly gross income.

We need to spend more time educating consumers on the impact of their fixed expenses on their ability to absorb surprises. At 25% mortgage, the consumer probably has 55% of their income dedicated to fixed expenses. At 50% mortgage they probably have 75% of their income dedicated. Not much room there to absorb a surprise $2,000 expense.

John Comer

Anonymous said...

Would this include the ability to place $2K on a credit card? What are the incomes associated with the study?

Elizabeth said...

As a business person with an online retail site and a consumer I have found the lack of liquidity to be a barrier in accomplishing what prior to this were reasonable goals. I am middle class, and finding it harder and harder keep my head above water. I believe those responsible for the current state of the American economy are not the ones who are suffering, indeed the tide has turned for wall street and the market is coming back. But people who have money are simply keeping it, and there spending powers can not be the only consuming to bring back the middle class to a point, where they can afford to have emergency funds, fund children's education, and have enough put aside for retirement. They don't do this because they are stupid, it is because they were "shocked" by what happened to there housing market, the pension funds and the 401 (k) and 403 (B). They aught to down size, but how do you even sell a house? You are left with abandoning it and renting which really doesn't change the predicament they are in. They are simply falling out of the middle class and can't afford more then the day to day expenses

Jay Sanders said...

Dr. Lusardi,

In 2009 and thru mid 2010 most Americans were running on their spare tires, now most are riding on the rims. There's no cushion.

That's not to say there's no hope. People are slowly changing their consumption habits to adjust to the conditions. Frugality may even become fashionable and if it does the savings problem goes away. What that might do on a macro level is a whole other question.

Last week I taught fin lit to 6 honors economics classes in NYC as I do each year. One of the questions I ask is what drives your consumption decisions. I know this is anecdotal but the mood is a lot more serious.


Chris Bauknecht said...

I believe you are absolutely correct, Dr. Lusardi. It has to be a balance between short- and long-term. The last decade has shown that black swans show up far more often than any of us thought possible.

So what can be done? We have to help educate people. And the earlier we start, the better off all of society will be.

I sincerely believe that kids can be taught money management basics at a young age. And if they are given an opportunity to earn a little money (perhaps through community programs) while they learn how to manage it, that can make all the difference.

Education, formal practice and balance can help build a very strong foundation.

Best wishes,
Chris Bauknecht