Peter Praet: Household heterogeneity and the transmission mechanism
Dinner speech by Mr Peter Praet, Member of the Executive Board of the European Central
Bank, at the ECB Conference on Household Finance and Consumption, Frankfurt am Main,
17 October 2013.
* * *
I would like to thank Sébastien Pérez-Duarte and Jirka Slacalek for their contributions to this speech; all views
expressed remain my own.
Distinguished members of academia, dear colleagues:
Thank you for contributing to the ECB Conference on Household Finance and Consumption.
As you know, the Eurosystem has recently released the Household Finance and
to researchers, a new dataset which gives detailed,
Consumption Survey (HFCS)
household-level information on the cross-sectional distribution of assets, liabilities, income,
indicators of financial pressure, etc. By covering 62,000 households, it is representative of
15 euro area countries, and I understand that plans to conduct the HFCS in the next wave
are well advanced in the two, and soon three, remaining euro area countries. We hope the
new dataset will encourage research on household heterogeneity and household finance, in
particular from a cross-country perspective.
The central theme of this conference - already the third on the topic that the ECB has
organised over the past five years - is that individual households are heterogeneous in many
respects and that it is important to measure and analyse this heterogeneity because it can
have important implications for aggregate figures.
Some of these implications are of interest not only to the research community, but also to
policy-makers at central banks. This is because the interplay between the heterogeneity
across households and differences in institutions and shocks can affect the functioning of the
transmission mechanism of monetary policy. It is also of relevance for financial stability.
Of key interest to central bankers is the question as to how shocks - including unexpected
changes in incomes, interest rates and asset prices - are transmitted in the overall economy.
The survey can bring new insights into how individual households are affected by economic
shocks, with due consideration of their demographic and socio-economic characteristics, as
well as of the current phase of their life cycle, their income, assets or liabilities, etc.
The onset of the Great Recession in many developed countries was marked by an increase
in the personal savings rate, which was more marked and persistent than those in the
previous recessions. The corresponding weak dynamics of aggregate consumer spending
were driven not only by the response of the "representative" consumer to aggregate shocks,
but also by the different responses of individual households to these shocks, and by the
response of households to household-specific shocks. I will now elaborate on how these
different shocks, in particular wage shocks and interest rate shocks, may affect individual
households and the overall economy.
Tomorrow's keynote speech will address the question of what mechanisms households use
to protect themselves against wage shocks and how the adjustment both of their spending
and of the labour supply depends on demographic and economic characteristics. A key
finding in Blundell et al. (2012) is that the response of household spending varies over the life
cycle and depends on the amount and structure of available assets. Households with more
assets, in particular those with more liquid assets, are better able to protect their
consumption expenditure against adverse shocks. However, even wealthy households can
find it difficult to sustain their spending if the shocks persist for a longer period of time.
This finding is in line with a number of similar recent results, including those of Anderson et
al. (2013) who estimate that households respond to shocks very differently depending on
their income and wealth: while the wealthiest households respond to government spending
and tax policy shocks as predicted by standard real business cycle models, poorer
households act in a non-Ricardian way, on account of e.g. the existence of credit constraints.
In today's keynote address, Professor Carroll has proposed a realistically calibrated
economic model with precautionary saving.1 This model matches the uneven distribution of
wealth in the data and it is able to replicate the size and the differences across households in
the marginal propensity to consume out of transitory income, as reported in the existing
literature, to which some participants of this conference have contributed. In particular,
households with low wealth and few or not sufficiently liquid assets are not able to
adequately smooth income shocks and are particularly likely to increase their spending in
response to a fiscal stimulus.
Of crucial importance for the economy's response to shocks is the structure of households'
balance sheets, on both the asset and the liability side - we have seen insightful
presentations on these topics using data from euro area countries this morning. Much of the
recent research2 has stressed the importance of liquid assets, as opposed to measures
such as net wealth, which include illiquid asset types, most importantly housing wealth.
A robust fact across developed countries is that a substantial proportion of households have
an only modest buffer of liquid assets that they can readily use if they experience adverse
economic shocks. For example, the median value of net liquid assets in the euro area is 19%
of households' annual income, as shown in an extensive report on the results of the first
wave of the HFCS (HFCN (2013)). Consequently, many households may have to cut their
spending quite substantially, especially when faced with large and persistent shocks like
those that occurred during the Great Recession, a finding that would be in line with much of
the research undertaken by Richard Blundell.
Of course, the response of households also depends on the availability of financial products
that make it possible to extract equity from illiquid assets (housing wealth). This availability is
limited in many European countries and, accordingly, the response of consumption to wealth
shocks - the wealth effect - seems to be more modest than in the United States (as much of
the literature has found).3
However, in any case, households in many countries may currently find it difficult to smooth
consumption because of the combination, size and persistence of the adverse shocks they
have recently experienced: significant declines in house and stock prices, negative shocks to
labour income and the substantial accumulation of debt. Much of the evidence available,
based on US data,4 suggests that households which had accumulated a large stock of debt
before the crisis respond disproportionately to adverse shocks, also because many are
endeavouring to deleverage and reduce their debt burdens. The HFCS data document that
debt participation and debt holdings vary substantially across countries, and seem to be
related to institutional settings, such as the length of repossession periods, as again
documented in the report on the HFCS (HFCN (2013)). This implies that the dynamics of
aggregate spending and output vary across countries, depending not only on the size of
shocks and their distribution across households, but also on the institutional settings, which
may have affected the accumulation of debt and house price dynamics to a varying extent
before the crisis.
Additional evidence from the HFCS also suggests that low-income households may be
financially particularly vulnerable to economic shocks, as they, for example, typically face
higher debt-assets and debt service-to-income ratios than households with higher incomes.
In summary, research and evidence from available data thus suggest that all of the
aforementioned factors, together with tighter credit constraints, depressed income
expectations and heightened perceptions of uncertainty, are likely to contribute to a sluggish
recovery of household spending from the recession. These additional factors also likely vary
across households and geographic regions; for example, estimates from the HFCS data
suggest that younger, less educated households and households living in Mediterranean
countries face tighter credit constraints. Similarly, lower-income and less wealthy households
may have been affected by larger adverse income shocks, and may also have cut their
spending more sharply in response to these shocks.
Monetary policy, in turn, has responded to the crisis by lowering nominal interest rates to
levels close to the zero lower bound. This monetary policy easing has quite substantially
alleviated the financial burden on holders of mortgages.5 In addition, as documented in Hurst
and Stafford (2004), reductions in mortgage rates stimulate the economy substantially as
households with accumulated home equity can refinance their mortgages at a lower rate in
order to reduce their stream of mortgage payments, or to access accumulated home equity,
which may be particularly relevant in times of distress. This can be partially offset by the fact
that the income and spending of net savers will be negatively affected by a decline in interest
rates. However, the offsetting effect is likely to remain moderate because a substantial
proportion of households (50% - 80% in most countries) are not able to save and because
the savings of those who do may be less sensitive to interest rates, as the latter tend to be
wealthier and to have more diversified assets.
Among many other factors, two key parameters which affect the economy's response to
interest rate changes are the mortgage participation rate, i.e. the proportion of households
holding a mortgage, and the fixation periods of mortgage rates. As we know, both
parameters vary substantially across euro area countries - for example, the proportion of
households holding a mortgage on their main residence varies between around 9% (in Italy
and Slovakia) and more than 30% (in Cyprus, Luxembourg, the Netherlands and Finland).
Similarly, the share of variable rate mortgages ranges from less than 20% in France and
Germany to more than 80% in Luxembourg, the Netherlands, Portugal and Slovakia (see
Ehrmann and Ziegelmeyer (2013)).
The great variety of households revealed by household-level data stands in sharp contrast to
the stark representation of consumers in many DSGE models (especially those of the first
generation), in which consumption smoothing or intertemporal substitution is typically
governed by a single parameter that is often calibrated in an ad hoc manner. The experience
of the Great Recession, in which individual households were subject to different income,
interest rate and wealth shocks that generated responses that differed from those recorded
in previous recessions, suggests that we should take household heterogeneity seriously.
To conclude, the Eurosystem's Household Finance and Consumption Survey provides
researchers with an invaluable source of information that will make it possible, by way of a
cross-country perspective, to enhance our knowledge about the effects of specific monetary
policy measures on the financial and economic decisions taken by households.
Thank you for your attention.
References
Anderson, E., Inoue, A. and Rossi, B. (2013), "Heterogeneous Consumers and Fiscal Policy
Shocks", CEPR Discussion Papers, No 9631, Centre for Economic Policy Research.
Blundell, R., Pistaferri, L. and Preston, I. (2008), "Consumption Inequality and Partial
Insurance", American Economic Review, No 98(5), pp. 1887-1921.
Blundell, R., Pistaferri, L. and Saporta-Eksten, I. (2012), "Consumption Inequality and Family
Labor Supply", NBER Working Papers, No 18445, National Bureau of Economic Research.
Broda, C. and Parker, J. (2012), "The Economic Stimulus Payments of 2008 and the
Aggregate Demand for Consumption", mimeo, Northwestern University.
Carroll, C., Slacalek, J. and Tokuoka, K. (2013), "The Distribution of Wealth and the Marginal
Propensity to Consume," mimeo, Johns Hopkins University.
Brookings
Dynan, K. (2012), "Is a Household Debt Overhang Holding Back Consumption?",
Papers on Economic Activity (Spring 2012), pp. 299-344.
Ehrmann, M. and Ziegelmeyer, M. (2013), "Household Risk Management and Actual
Mortgage Choice in the Euro Area", mimeo.
Household Finance and Consumption Network (2013), "The Eurosystem Household Finance
and Consumption Survey - results from the first wave", Statistics Paper Series, No 2,
European Central Bank.
Hurst, E. and Stafford, F. (2004), "Home Is Where the Equity Is: Mortgage Refinancing and
Household Consumption", Journal of Money, Credit and Banking, Vol. 36(6), Blackwell
Publishing, December, pp. 985-1014.
Jappelli, T. and Pistaferri, L. (2013), "Fiscal Policy and MPC Heterogeneity", CEPR
Discussion Papers, No 9333, Centre for Economic Policy Research.
Kreiner, C.T., Lassen, D.D. and Leth-Petersen, S. (2012), "Heterogeneous Responses and
Aggregate Impact of the 2001 Income Tax Rebates", CEPR Discussion Papers, No DP9161,
Centre for Economic Policy Research.
Mian, A.R., Rao, K. and Sufi, A. (2013), "Household Balance Sheets, Consumption, and the
Economic Slump", mimeo, Princeton University.
Slacalek, J. (2009), "What Drives Personal Consumption? The Role of Housing and Financial
Wealth", The B.E. Journal of Macroeconomics, Vol. 9(1), De Gruyter, October, pp. 1-37.