Credit Smoothing

• Main Authors: Sean Hundtofte, Arna Olafsson, Michaela Pagel
• Format: Report
• Language: unknown
• Subjects: Iceland
• Online Access: http://www.nber.org/papers/w26354.pdf

Standard economic theory says that unsecured, high-interest, short-term debt — such as borrowing via credit cards and bank overdraft facilities — helps individuals smooth consumption in the event of transitory income shocks. This paper shows that — on average — individuals do not use such borrowing to smooth consumption when they experience a typical transitory income shock of unemployment. Instead, individuals smooth their credit card debt and overdrafts by adjusting consumption. We first use detailed longitudinal information on debit and credit card transactions, account balances, and credit lines from a financial aggregator in Iceland to document that unemployment does not induce a borrowing response at the individual level. We then replicate this finding in a representative sample of U.S. credit card holders, instrumenting local changes in employment using a Bartik (1991)-style instrument. The absence of a borrowing response occurs even when credit supply is ample and liquidity constraints, captured by credit limits, do not bind. Standard economic models predict a strictly countercyclical demand for credit; in contrast, the demand for credit appears to be procyclical which may deepen business cycle fluctuations.