Why Don’t Households Smooth Consumption? Evidence from a 25 million dollar experiment

Households who regularly report spending in the Nielsen Consumer Panel in 2008 were surveyed about financial and behavioral characteristics as well as their receipt of an Economic Stimulus Payment. Using roughly 25 million dollars in reported payments and the random timing of payments, this paper relates household characteristics to the propensity of households to spend pre-announced, lump-sum income on arrival. The average household spends a highly statistically significant amount on arrival and most of the spending is done by households with low liquidity. Models of beliefs do not explain this result: most households expect the payment, and increases in spending are similar between those expecting and not expecting payments. The propensity to increase spending is not transitory, due to current or recent income shocks or to liquidity management with illiquid assets, suggesting that it is instead due to preferences. Increases in spending are as closely associated with low income in 2006 and with being the type of person that spends and lives for today as they are with low levels of liquidity. Levels of sophistication or planning are also associated with consumption smoothing: spending responds for households that make more use of coupons or deals, or that have made financial plans. Finally, there is scant evidence for an important role for the available measures related to procrastination or self-control. For helpful comments, I thank Christian Broda, Chris Carroll, Nicholas Souleles, Steven Zeldes, two anonymous referees on the survey grant application, and participants at seminars at the Board of Governors of the Federal Reserve System, the Consumer Financial Protection Bureau, the Federal Reserve Bank of Boston, Harvard, MIT and the NBER Household Finance meetings July 2014. I thank the MIT Sloan School of Management, the Kellogg School of Management at Northwestern University, the Initiative for Global Markets at the University of Chicago, and the Zell Center at the Kellogg School of Management for funding. I thank Ed Grove, Matt Knain and Molly Hagen at Nielsen for their work on the survey and their careful explanation of the Nielsen Consumer Panel. The results of this paper are calculated based on data from The Nielsen Company (U.S.) LLC and provided by the Marketing Data Center and the University of Chicago Booth School of Business. Contact information: MIT Sloan School of Management, 77 Massachusetts Avenue, Building E62-642, Cambridge MA 02139–4307; http://japarker.scripts.mit.edu/. 1 The canonical assumption that the benefits of additional consumption decline with the level of consumption – that marginal utility is diminishing – implies that people should seek stable consumption over time. Absent financial frictions, expected changes in income should have no contemporaneous effect on marginal utility or consumption. However, while many issues complicate testing, this proposition of consumption smoothing has been frequently rejected: on average, predictable changes in people’s incomes cause significant changes in their spending, with the causal effects concentrated among people with low liquid wealth or low income. Both the significant average spending response and the heterogeneity in response with liquid wealth suggest that household behavior is significantly influenced by liquidity or financial constraints. But, but beyond this ingredient, there is significant disagreement about what causes lack of consumption smoothing. One possibility is that illiquidity and lack of consumption smoothing are the result of poor income shocks or temporary portfolio illiquidity , as in the textbook buffer stock model or life-cycle/permanent income model (LCPIH) with borrowing constraints (e.g. Zeldes (1989a), Deaton (1991), Carroll (1997), Ludvigson (1999)). When some households experience poor income realizations that lead to low liquid wealth relative to future income, an inability or unwillingness to borrow leads to a close relationship between current income and current consumptions. Similar predictions follow from a model in which households have costly access to high-return, relatively illiquid savings vehicles (Kaplan and Violante (2014)). Households with low liquidity will tolerate some deviations in consumption smoothing to avoid the costs associated with accessing relatively illiquid assets. According to these models, lack of consumption smoothing among low wealth households is due to temporary low liquidity. An alternative interpretation, incorporated into a number of competing rational and behavioral models, is that low liquidity and an inability or unwillingness to smooth consumption are persistent traits of some households that are due to preferences or behavioral characteristics rather than being situational. The most straightforward version of such a theory is that some households are simply highly impatient, hand to mouth households in extreme. Alternatively, other theories motivated by evidence from laboratory experiments and neurological studies characterize lack of consumption smoothing as due to the limits of human reasoning or the complexity of human motivation in economic behaviors. As examples, lack of consumption