Financial Stress Hits These Households Hardest: Study

What You Need to Know

Researchers with the National Bureau of Economic Research have published a detailed new analysis of the economics of financial stress.
The researchers find the effects of financial stress are orders of magnitude more harmful for less financially sophisticated individuals.
The promotion of financial literacy could be powerful antidotes to the negative consequences of financial stress, according to the authors.

While finances are the top source of stress for Americans (per recent research from the American Psychological Association) as well as an important topic of concern for financial advisors and their clients, less attention has been paid to the “economics” of financial stress at a societal level.

Specifically, more analysis is needed to explore the interplay of financial stress itself with naivete about financial stress, and how researchers can utilize a deeper understanding of financial stress to complement traditional approaches to the study of key economic principles such as consumption smoothing and portfolio allocation optimization.

So argue researchers in a new analysis published this week by the National Bureau of Economic Research. According to the authors, finding ways to reduce the pain from stressful tradeoffs is the “bread and butter of economics,” and yet, financial stress is itself generally not a key object for macroeconomics and household finance research.

According to Bocconi University’s Dmitriy Sergeyev and University of California, Berkeley’s Chen Lian and Yuriy Gorodnichenko, this status quo is striking, and it should concern all manner of stakeholders in the financial system, given that the expanding field of behavioral economics has underscored a wide spectrum of negative effects stemming from financial stress.

For example, the established literature shows that financial stress leads to a scarcity of cognitive resources that pushes people into a state of tunneling, wherein they neglect activities outside the “financial stress tunnel.” As a result, the authors explain, financially stressed individuals have difficulty focusing, perform poorly in economic tasks and otherwise make poor decisions.

According to the authors, these factors lead to significant economic consequences for labor supply and earnings, as well as consumption and saving decisions. The research, in this sense, provides yet more evidence to underscore the critical importance of better financial education and expanded access to advisory resources.

About the Analysis

To broaden the perspective and link behavioral and traditional takes on financial stress, the researchers sought to develop a “tractable” theoretical model incorporating the psychological costs of financial constraints and stressors.

Using this framework, they find that financial stress not only has a direct effect on households’ utility, but it also influences their economic behavior.

This behavioral impact is especially costly for those individuals and households that are not financially sophisticated enough to make complex optimization decisions while in a state of stress, the researchers suggest.

Ultimately, the analysis warns, financial stress can be shown to “crowd out” valuable cognitive resources and time, even among those who are “distant from financial constraints,” and financial stress’ collective cost on individuals, households and the economy cannot be overstated or ignored.

Sophistication and Stress

The authors dive deeply into what they call the “sophistication-naivete dimension” of financial stress, finding this dynamic represents a key determinant of how financial stress shapes household behaviors and outcomes.

The Bigger Picture

“Although financial stress is a feature of life for many people in developed and developing countries, it remains understudied in economics,” the researchers conclude. “A key innovation of our survey is to introduce questions that allow us to quantify the consequences of financial stress and map them into theory.”

The authors go on to say the “main bulk” of their contribution is the development of their tractable model of intertemporal decisions and wealth distribution incorporating financial stress.

“We show that a psychology-based theory of poverty traps requires not only financial stress itself but also naivete,” the authors conclude. “Our findings suggest several avenues for future research and potential policy recommendations.”

For example, the authors focus on how financial stress crowds out valuable time and cognition from productive work, but they also lay out alternative channels for the impact of financial stress.

“Further exploring these channels empirically and theoretically appears to be a fertile area for future work,” they argue. “The key role of naivete suggests that policies such as default choices that encourage saving and the promotion of financial literacy could be powerful antidotes to the negative consequences of financial stress.”