Is Your Household Liquid Enough?
Skip to content
Finance & Accounting Policy Dec 1, 2014

Is Your Household Liquid Enough?

Ample cash reserves aid households when faced with the unexpected.

Based on the research of

Scott R. Baker

Who is better equipped to deal with getting unexpectedly laid off: a person with a few month’s worth of household cash in the bank or a person with millions in home equity on the books?

On paper, the second individual is “richer” because the figure representing his net worth has more zeroes in it. But the first person is more liquid: she can access her funds much more easily in order to deal with a temporary loss of income. And she may not have to change her spending habits all that much while she recovers from the job loss, either.

This financial logic is familiar to anyone who has ever saved up money “for a rainy day” or maintains an emergency fund in his bank account. But measuring how this microeconomic behavior plays out in the real world, and explaining its mechanisms, can be difficult. In recent research, Scott R. Baker, an assistant professor of finance at the Kellogg School, uses novel data from a leading personal finance website to show how liquidity and credit constraints determine whether a family will suddenly “tighten its belt” or maintain its spending habits in the wake of an income loss.

Small Scale, Big Picture

Global and federal policy concerns dominated headlines during the Great Recession of 2007 and 2008. But Baker was interested in how crisis manifested on the individual household level.

“Economic theories and models often assume that all people behave the same way,” Baker says. “But there are large differences in both the characteristics and the financial well-being of households....When they are subjected to the same shock, they may not respond in the same way. During the recession, we tended to see that some people showed more changes in their consumer-spending patterns than others, and it seemed to be related to the levels of debt they had. I wanted to see if this relationship still holds at a household level, and if credit constraints really were the cause of these changes.”

Differences in spending behavior at the household level are often difficult to quantify, Baker says, because detailed data is hard to come by. “There’s a huge amount of government and private-sector information that has portions of people’s finances, but nothing has it all in one source and linked all together,” he says.

Determining whether income shocks cause changes in spending behavior is even harder. “Let’s say I’m paying for my kid’s college tuition and my wife had taken a part time job to help fund this ongoing expense,” says Baker. “If I know that he’s going to [graduate] in six months, my wife might stop working now in anticipation of the decline in required spending. In the data it’ll look like a drop of income followed by a drop in spending six months later, but the income drop didn’t ‘cause’ the spending drop—that household planned it.”

“If you look at two households with the same level of dollar assets, but one has those assets tied up in their house, and the other has them in a bank account, they’ll respond to a drop in income very differently,” says Baker.

To avoid these problems, Baker obtained access to a database containing detailed (but anonymized) transaction records from 150,000 households between 2008 and 2012, courtesy of a popular consumer-finance website. Baker used direct-deposit records to match families with the companies that employed them, and then connected the effects of so-called “firm shocks” (such as layoff announcements or lower-than-expected earnings reports) with drops in income to the associated households. This let Baker establish that the income drops in his household data (and any associated changes in spending patterns) were driven by unexpected events external to the household. The data also offered detailed snapshots of a household’s balance sheet: its cash flow, liquid assets, investments, and debts.

Caught without an Emergency Fund

Baker used these unusually detailed records to demonstrate that a household’s debt position was “strongly linked” to how much its spending patterns changed in the wake of an income fluctuation. The more indebted the household, the larger the change: highly “leveraged” families shrank their spending by 25% compared to their more-liquid counterparts. But while some economic theories often cite reasons like rule-of-thumb accounting or greater uncertainty about future income for this shrinkage—“if a recession hits and I’m worried that something bad will happen to me, I might reduce my spending even though I’m not constrained by my balance sheet,” Baker says—the data showed that the variance in consumption had one primary cause: illiquid assets.

“If you look at two households with the same level of dollar assets, but one has those assets tied up in their house, and the other has them in a bank account, they’ll respond to a drop in income very differently,” Baker explains. “The household that has their savings in illiquid form will have to change their consumption to a greater degree, because it’s harder to access the money they need to cushion the blow to their income.”

Credit and Leverage: A Double-Edged Sword

These major reductions in consumption can amplify the negative effects of a recession already in progress, Baker says. And because of the boom and subsequent crash of consumer credit in the last several decades, “a large amount of households are living pretty close to the edge as far as cash flow,” Baker says.

“Maybe they have a lot of home equity, but they have barely any money in their bank accounts—even at a fairly high level of income. There was a big expansion in the supply of credit in the years leading up to 2007 and 2008, but then a huge number of banks and credit card companies froze all their consumer credit. That left these households exposed to reductions in income, because they didn’t have liquid savings to fall back on.”

Baker says his findings have two clear implications for policy. At the macroeconomic level, given that many households are operating on thin margins, “offering stable access to credit is very important,” he says. “A big expansion in the supply of credit can contribute to a bubble and make a resulting recession much harder to get out of if that expansion of credit suddenly flows away.” Baker adds that his research is consistent with the work of fellow Kellogg School finance professor Janice Eberly, who advocates for automatic mortgage refinancing when interest rates fall, allowing households to redirect spending from fixed debt expenditures to current consumption during recessions.

Meanwhile, individual households should maintain an ample cash reserve in addition to whatever debts, illiquid assets, or leveraged positions they might hold—regardless of how wealthy they are on paper. “There are a lot of rich households that are on a paycheck-to-paycheck lifestyle,” Baker says. “If you have lots of money in your 401K or your house, you may feel like you’re safe, but if you’re forced to tap that, it can be very expensive in terms of paying financial advisors or penalties to the IRS. If you had some extra money in your checking account or savings account, that’d be free to access in an emergency.”

About the Writer
John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Portland, Oregon.
About the Research

Baker, Scott R. “Debt and the Consumption Response to Household Income Shocks.” Working Paper.

Read the original

Most Popular This Week
  1. One Key to a Happy Marriage? A Joint Bank Account.
    Merging finances helps newlyweds align their financial goals and avoid scorekeeping.
    married couple standing at bank teller's window
  2. Take 5: Yikes! When Unintended Consequences Strike
    Good intentions don’t always mean good results. Here’s why humility, and a lot of monitoring, are so important when making big changes.
    People pass an e-cigarette billboard
  3. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  4. Will AI Eventually Replace Doctors?
    Maybe not entirely. But the doctor–patient relationship is likely to change dramatically.
    doctors offices in small nodules
  5. Entrepreneurship Through Acquisition Is Still Entrepreneurship
    ETA is one of the fastest-growing paths to entrepreneurship. Here's how to think about it.
    An entrepreneur strides toward a business for sale.
  6. Take 5: Research-Backed Tips for Scheduling Your Day
    Kellogg faculty offer ideas for working smarter and not harder.
    A to-do list with easy and hard tasks
  7. How to Manage a Disengaged Employee—and Get Them Excited about Work Again
    Don’t give up on checked-out team members. Try these strategies instead.
    CEO cheering on team with pom-poms
  8. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  9. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  10. The Appeal of Handmade in an Era of Automation
    This excerpt from the book “The Power of Human" explains why we continue to equate human effort with value.
    person, robot, and elephant make still life drawing.
  11. 2 Factors Will Determine How Much AI Transforms Our Economy
    They’ll also dictate how workers stand to fare.
    robot waiter serves couple in restaurant
  12. When Do Open Borders Make Economic Sense?
    A new study provides a window into the logic behind various immigration policies.
    How immigration affects the economy depends on taxation and worker skills.
  13. Why Do Some People Succeed after Failing, While Others Continue to Flounder?
    A new study dispels some of the mystery behind success after failure.
    Scientists build a staircase from paper
  14. Sitting Near a High-Performer Can Make You Better at Your Job
    “Spillover” from certain coworkers can boost our productivity—or jeopardize our employment.
    The spillover effect in offices impacts workers in close physical proximity.
  15. How the Wormhole Decade (2000–2010) Changed the World
    Five implications no one can afford to ignore.
    The rise of the internet resulted in a global culture shift that changed the world.
  16. What’s at Stake in the Debt-Ceiling Standoff?
    Defaulting would be an unmitigated disaster, quickly felt by ordinary Americans.
    two groups of politicians negotiate while dangling upside down from the ceiling of a room
  17. What Happens to Worker Productivity after a Minimum Wage Increase?
    A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
    employees unload pallets from a truck using hand carts
  18. Immigrants to the U.S. Create More Jobs than They Take
    A new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
    Immigrant CEO welcomes new hires
  19. How Has Marketing Changed over the Past Half-Century?
    Phil Kotler’s groundbreaking textbook came out 55 years ago. Sixteen editions later, he and coauthor Alexander Chernev discuss how big data, social media, and purpose-driven branding are moving the field forward.
    people in 1967 and 2022 react to advertising
  20. 3 Traits of Successful Market-Creating Entrepreneurs
    Creating a market isn’t for the faint of heart. But a dose of humility can go a long way.
    man standing on hilltop overlooking city
Add Insight to your inbox.
More in Finance & Accounting