How do households in a crisis, marked with price volatility, employment uncertainty, and complex information alter their savings, borrowing, and payment behavior?
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Shocks with prolonged effects on the economy and social life of people seep into a household's daily routine. One major domain that gets severely impacted is the household's finance. Negative effects of these shocks, which may take forms of economic crisis, natural disaster, or pandemics, can alter the financial behavior of households and individuals through changes in expectations. For all the actors build in the new information about the shock into their decision plans. For the individual/households, the psychological appeal extends beyond rational utilitarian gains. Keynes believed that human psychology drives many of the booms and busts in the markets. But psychological mechanisms play an equally significant role post-crisis (not just economic crisis) too. Moreover, the altering of aspirations and expectations evokes emotions and cognitive errors, blinding homeowners to risk.
Let us look at some of the dimensions that play out during crisis like COVID19 or the 2008 economic slowdown, and which have effects on household/individual financial behaviors:
1. Sources of Uncertainty
The source of uncertainty during a crisis can play an important role in generating reactions. The uncertainty might arise from anticipated job loss/unemployment, reduced wages, expected price volatility, or in times of pandemic a threat to well-being and health.
i) Loss/Reduced Income: The impacts of crisis may affect an individual’s income through either long term unemployment resulting from retrenchment, wage loss due to inactivity, or negligible growth in expected income due to labor market pressures. In 1930, fear of long-term unemployment and the expectation that the depression can last forever perceived as rampant back then, led people to cut spending, thus prolonging the downturn.
ii) Price Volatility: Immediate impact of supply-demand asymmetry and govt. infusion of liquidity into the markets in times of crisis can result in inflationary pressures on consumer goods, making them expensive.
iii) Non-Regular Expenses: Shocks such as pandemics or natural disasters impose high and uncertain expenses to cater to medical bills, reconstruction bills, which are less anticipated or accounted for in regular consumption plans.
2. Risk Perception Vs Risk Tolerance
Risk perception is a cognitive evaluation for an accurate appraisal of external and internal states that exist. In a crisis, the external states are marked by downturns. Risk perception is an idiosyncratic process that adds subjective meaning to an objective situation and is in itself a function of knowledge, emotion, and experience. In a crisis, this risk perception might not be the same as the actual risk. On the other hand, risk tolerance is more innate and personality rooted. And refers to the amount of risk that an individual is willing to accept towards his/her objectives.
3. Response Horizon
Response horizon is the time that an individual has to respond to the financial shocks accompanying an economic or health crisis. The behavior of individuals who are young or have greater time to respond to shocks is different from that of older or near retirement cohorts. Higher response time means there is an opportunity to increase labor or increase sources of income to respond to the decrease in the income, savings, or consumption experienced during a crisis. Longer response horizon coupled with patience, and high-income replacement rate can drive compensatory behavior more in the short-term. The effects mentioned above are compounded by good health and well-being, which get affected during pandemics. Hence pandemic shocks can relatively reduce the perceived response horizon.
There are 3 primary financial behaviors that get affected by income shocks accompanying major crises like the 2008 financial crisis, or current COVID19 pandemic. These are:
Savings-Consumption
There is a strong coupling between Consumption and Income. Consumption is found to strongly react to both unexpected income shocks and also predictable income changes. The effects on discretionary spending are more than on calorific & nutritional consumption, for which a minimum consumption plan/structure is adhered to. Anticipated changes in income impact savings priors and can lead to moderation of consumption to increase the buffer saving stock. If households rationally anticipate the shocks that create motives to borrow, then households should save in anticipation by creating a buffer saving stock. High buffer stock savings can help households to protect their consumption set during temporary income declines or transitory periods of unusually high expenditure instead of using high-cost debt. An extreme case of income loss can result from unemployment, resulting in a decrease in both present consumptions as well as alter future consumption.
Depending on the time to retire, different cohorts have different response horizons which affect how they respond. The younger workforce might save relatively less than the older workforce because of the opportunity to work more in a non-crisis situation. Whereas the older workforce might increase their work efforts to pump up savings by reducing consumption significantly since there is no expected income in the future. Also, the drop in consumption is seen to be high for individuals who have lower income replacement rates, like individuals who are close to retirement. There seems to be no effect of accumulated wealth in this case. When older persons are hit by a combined financial and economic crisis, they might try to maintain their expected future consumption by increasing working hours or short-term offsets to reduced savings.
Borrowing/Debt
Willingness to borrow during a crisis can get affected depending upon the anticipated changes the crisis can bring as well as the impact of the crisis on patience. If the latter gets rudely impacted, then the risk tolerance of an individual reduces in line with her/his increase in risk perception. With low-risk tolerance, debt might not be a preferred option for an individual. Hence debt can be seen as an obligation that is state-dependent. A state marked by heavy disruptions both in the short and long term can reduce borrowing whereas as disruptions with high patience factor can have relatively less impact on borrowing.
In a crisis, where individuals are more susceptible to any increment in their asset, the rate of borrowing gets pitched against the actual rate/expected rate of return for investment. The existence of High return investments or anticipation of high returns can increase borrowing. Hence, lower expected/actual credit card interest rates and higher expected/actual property rate-of-return might result in an increase in credit card borrowing to finance high-value purchases like property.
Payments
The households can choose banked or unbanked mode of transaction to pay for services they desire or getting into long-term contractual agreements. Assuming an individual to be a rational actor, the prime factor driving such decisions is minimizing costs incurred. Mode of payments not only change immediate real costs but also maximize/minimize psychological costs in the way transactions take place.
What might we look at
1. Present Bias
Present bias generating from an individual’s tendency to perceive immediate gains more than future gains can be exacerbated in a situation of crisis. The tendency might lead to individuals to hold on to modest long-term investment but persistently failing to maintain liquidity because of the need to finance immediate consumption or the present preferences.
Interventions that help reduce current costs, which otherwise outweigh future-benefits, can help offset the perceived increased short term pessimism.
2. Psychic Pain
The temporal/psychological distance between the act of paying and the loss of money creates a moment “pain from paying”. Loss of tangible cash is perceived to be more painful since one can see the physical outflow. Credit cards or digital payments increase this psychological distance reducing the perceived pain.
In the current scenario, where many transactions are happening on digital platforms scheduled payments can create the necessary temporal distance to reduce the psychological pain associated with immediate cash outflow.
3. Mental Accounting
Mental accounting is an essential component in how individuals/households make decisions. Underestimation of how much an individual/household is able to borrow lowers the marginal propensity or the probability of households eating into their future plans or retirement savings. Because they feel it as “out-of-bound” and want to protect them from any pre-mature spending that might cause disruption in their expected desired future state. Accounting involving exponential growth calculation also misconstrues reality and makes individuals/households to perceive the risk differently than the real risk. One of the effects of this asymmetry is on the tendency of people to consume more rather than save and keep their consumption constant, with any immediate marginal savings.
Reducing cognitive efforts that go into mental accounting can lower the chances of individuals/households wrongly calculating risk. Comparison charts for different decisions, step by step guide, or a working model can assist individuals/households to make more informed and less biased decisions.
4. Reference Dependent Consumption
Individuals/households carry with them two types of expectations. One is the expectation about instantaneous or immediate consumption and the other on the prospective or future consumption. Hence a crisis that drives changes in behavior by affecting these expectations. Hence a individuals/household’s future and immediate expectations interact while making decisions.
Facilitating the creation of relevant and appropriate immediate short term expectations and also long term expectations, and building a necessary coping buffer to manage these expectations can help stabilize reference-dependent consumption in times of uncertainty.
5. Peer Driven
Household behaviors of “peers” have an influence in the decision-making process in line with the “keeping up with the Joneses” behavior. In a crisis where there is high uncertainty, any source of credibility might help individuals/households to decide. Peer decisions are used as a social learning tool helping individuals update her/his belief about a crisis and also stick or shun crisis-driven normative behaviors.
Developing positive private signals in the form of dedicated private information might restrict peer-driven negative herd behavior to take over in an environment marked by negative outlook. In the other case, to promote positive herd behavior, visible signals to inform individuals/households what others are doing can help build shared intentionality.
6. Information Avoidance
Information avoidance in financial matters might be a result of a lack of proper coping against anticipated psychological pain one anticipates from sudden exposure to financial information. The other reason for avoidance may be the limited cognitive bandwidth available during the time of crisis.
Creating relevant financial practices like written financial goals, written spending plans, reading financial statements reduces the suddenness one feels when exposed to financial matters during a crisis.
7. Balance matching heuristics
Individuals/households are prone to use heuristics involving proportion while making decisions. Debts are re-paid in proportion to the respective balances available, instead of minimizing the cost of borrowing.=
Making interest rates salient or providing budgetary assistance tools to households can help individuals/households reconcile costs while they calculate their optimal payment strategy.
Financial Behaviors of households are a complex interplay involving many micro and macro dimensions. But that does not mean that there is a lack of understanding and definitiveness in how households have reacted and are more likely to react when faced with a crisis. The goal and objective of policymakers, private businesses need to be addressed first before navigating through the appropriate responses to help individuals/households make optimal financial decisions.
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