Do Borrowing Constraints Matter? An Analysis of Why the Permanent Income Hypothesis Does Not Apply in Japan

Transcription

1 Do Borrowing Constraints Matter? An Analysis of Why the Permanent Income Hypothesis Does Not Apply in Japan Miki Kohara and Charles Yuji Horioka August 2005 Abstract In this paper, we use micro data on young married households from the Japanese Panel Survey of Consumers, conducted by the Institute of Research on Household Economics, to shed light on (1) the prevalence of borrowing constraints in Japan, (2) what households are borrowing-constrained in Japan, (3) whether the life cycle/permanent income hypothesis (LCPIH) holds in Japan, and (4) whether the presence of borrowing constraints, the presence of income risk, or the presence of precautionary motives for saving is the reason why the LCPIH does not hold in Japan. To summarize our main ndings, we nd (1) that about 8 percent of young married Japanese households are borrowing-constrained, (2) that the husband s educational attainment is the most important determinant of whether or not a household is borrowing-constrained, (3) that the Euler equation implication is rejected for both the full sample and for the subsample of unconstrained households, (4) that the Euler equation implication is rejected for both low income volatility and high income volatility households, and (5) that the Euler equation implication is rejected for households with precautionary motives for saving but cannot be rejected for households without precautionary motives for saving. These results suggest that the LCPIH does not apply in Japan and that the presence of precautionary motives for saving (not the presence of borrowing constraints or the presence of income volatility) is the main reason for why it does not apply. 1

2 1 Introduction If the life cycle/permanent income hypothesis (hereafter LCPIH) holds, changes in consumption should not be sensitive to changes in current income. On the other hand, if this hypothesis does not hold (for example, because households are borrowing-constrained), changes in consumption will be sensitive to changes in current income. Thus, a commonly used test of the validity of the LCPIH is to estimate an Euler equation to see whether changes in consumption are sensitive to changes in current income. If the LCPIH does not hold and the reason is the existence of borrowing constraints, we would expect changes in consumption to be sensitive to changes in current income in the case of borrowing-constrained households but not in the case of unconstrained households. In this paper, we use micro data on young married households from the Japanese Panel Survey of Consumers, conducted by the Institute of Research on Household Economics, to shed light on (1) the prevalence of borrowing constraints in Japan, (2) what households are borrowing-constrained in Japan, (3) whether the LCPIH holds in Japan, and (4) whether the presence of borrowing constraints, the presence of income risk, or the presence of precautionary motives for saving is the reason why the LCPIH does not hold in Japan. To summarize our main ndings, we nd (1) that about 8 percent of young married Japanese households are borrowing-constrained, (2) that the husband s educational attainment is the most important determinant of whether or not a household is borrowing-constrained, (3) that the Euler equation implication is rejected for both the full sample and for the subsample of unconstrained households, (4) that the Euler equation implication is rejected for both low income volatility and high income volatility households, and (5) that the Euler equation implication is rejected for households with precautionary motives for saving but cannot be rejected for households without precautionary motives for saving. These results suggest that the LCPIH does not apply in Japan and that the presence of precautionary motives for saving (not the presence of borrowing constraints or the presence of income volatility) is the main reason for why it does not apply. The paper is organized as follows: in section 2, we present the theoretical model; in section 3, we describe the data and analyze what households are borrowing-constrained in Japan; in section 4, we present the results of our Euler equation tests; and section 5 concludes. 2

3 2 The Model 2.1 Consumption Smoothing Consumption smoothing behavior is characterized by the Euler equation. Assume that the consumer holds A t of total assets at the beginning of period t and purchases a total of N t of assets at (the end of) t. These are real expenditure on total assets 1. The consumer earns labor income of w t h t, where w is the exogenous real wage that is constant across individuals and h is work hours, and spends it on the consumption of goods, c, and the purchase of assets, N. The saving constraint faced by the consumer is described as S t = N t A t = w t h t c t : The consumer also faces an asset accumulation constraint of A t+1 = N t (1+r t+1 ) where r t+1 is the interest rate at the beginning of period t + 1. Assume that all agents face the same interest rate. Individuals live for a nite lifetime T and leave no bequests at T + 1. Consumers allocate all of their time, say 24 hours a day, between work, h t, and leisure, l t, which creates another constraint (a time constraint). Standardizing time to one, h t + l t = 1: These constraints can be combined into one constraint as follows N t N t 1 (1 + r t ) = w t h t c t : Suppose that the individual s n utility is stationary and additively separable PT o 1 over time and written as E t k=t u(c (1+) k t k ) ;where E t is an expectation operator conditional on information available at t, u is a function that is increasing and concave in c t and is the rate of time preference, which is assumed to be homogeneous over individuals and time. We assume that utility is not a function of leisure. The representative consumer s maximization problem can be written as a dynamic programming problem. Maximizing V t = u(c t ; l t ) + 1 E 1+ tv t+1 (A t+1 ; w t+1 ), we obtain the rst order condition (the Euler equation for 1 + r t+1 E t = 0; t 1 t+1 implying consumption at t should be chosen so that the expected discounted gain of saving now for the future is equal to marginal utility in this period. In addition, assume, as is often done, that utility is isoelastic, u(c it ) = c 1 it =1, where is the risk aversion parameter. Marginal utility is convex and allows for precautionary saving as a special case. If it is assumed 1 We can write the multiple asset case in the same way but using a vector, N k (N 1;k ; :::; N J;k ), where N j;k is the j th asset the household holds at the end of k. 3

4 that lnc i;t+1 and r t+1 have a joint normal distribution, equation (1) becomes lnc i;t+1 E t ln c i;t+1 = 1 (E t r t+1 ) + 1 2!2 i;t: (2) In the last term,! 2 i;t is a measure of uncertainty, is equal to the variance of ( ln c i;t+1 r t+1 =), and shows a precautionary motive for saving. There are at least two ways to test the validity of equation (2). The rst way is to test a structural form, estimating utility function parameters using Generalized Method of Moments (nonlinear instrumental variable) estimation. This is a direct test using the Euler equation, whose error term should be orthogonal to information before t. GMM estimation is bene cial in the sense that we can avoid the approximation of linear marginal utility in consumption, the assumption of distribution, and the assumption of income exogeneity. However, many researchers have for a long time used another way to test the Euler equation implication. This is a test of the reduced form Euler equation with additional variables in past information sets. It tests the validity of this additional information (for example, income changes) predicted by previous information. Additional variables should not explain consumption changes if the Euler equation holds. For example, consumption changes should not react to predicted income changes. That is, we test whether = 0 in the equation ln c i;t+1 = 1 F t + 2 X i;t !2 i;t + ln y e i;t+1 + " i;t+1 ; (3) where ln yi;t+1 e is income predicted by individuals using the information available to them. This is calculated as tted values from the rst stage estimation of ln y i;t+1. F t is a time-varying variable including 1 (E t r t+1 ). Preference shifts, described as X i;t, could a ect the consumption plan at any point in time. The third term is the conditional variance of the uncertain components. One of our main focuses is to review past studies using proper data on consumption smoothing. Thus, we conduct this reduced form exclusion test. The null hypothesis is that the Euler equation holds and individuals smooth consumption changes against predicted income changes. That is, = 0: consumption does not react to predicted income changes. Most past studies drop the term of precautionary motive for savings, 1 2!2 i;t, simply assuming that it is the same across individuals. In many cases, we cannot avoid assuming this because information is seldom available 4

5 on precautionary motives. The exception is Jappelli and Pista erri (2000), where a nominal (observable) income variance is included as a proxy for the uncertainty term! 2 i;t into one of the explanatory variables. Jappelli and Pista erri (2000) emphasize the importance of including this term; if we ignore this term and if ln y e i;t+1 is related to uncertainty or precautionary saving motives, measures not the sensitivity of consumption to income but the e ect of uncertainty on consumption. This method could, however, be problematic for the following reasons. First, income uncertainty is only one of many uncertainties individuals face and is not a su cient indicator of general uncertainty. Second, even if uncertainty consists only of income uncertainty, using actual income uncertainty as a proxy for! 2 i;t as well as ln y e i;t+1 may raise a problem due to the correlation between the two. Fortunately, our data set collects the data needed to calculate income variances as a proxy of income uncertainty and also collects data on the existence of precautionary motives for saving. Therefore, we test the Euler equation implication using equation (3) dropping the third term of 1 2!2 i;t, but estimating the equation separately for high and low uncertainty groups Violation of Consumption Smoothing If markets are complete and there exist appropriate securities against any future state, each household s consumption is fully insured against any idiosyncratic shock. Households can smooth consumption changes completely, sharing risks with each other. Previous studies have tested this implication of consumption full insurance and most have rejected it. Although it is important to nd a situation (if any) where full insurance holds, the rejection of the implication is not surprising. A more interesting issue is what can and what cannot explain the violation of the implication. For example, the existence of borrowing constraints may cause the Euler equation implication to be rejected. Many studies have, for a long time, inquired into the existence of borrowing constraints and the di erences in consumption behavior between borrowing-constrained and unconstrained households. Households would fail to smooth consumption if they encountered an 2 Since our data are panel data on households, we conduct IV estimation controlling for household-speci c di erences by: (a) taking the rst di erence of all variables in the speci cation of the equation (3), (b) applying xed e ects estimation, and (c) applying random e ects estimation. 5

6 unexpected shock and could not borrow to carry out their original plans. Thus, unconstrained households do not react to income shocks, while constrained households react strongly. Based on this analogy, many researchers have tested the Euler equation such as equation (3) and have interpreted as the proportion of borrowing-constrained households. There exist many other auxiliary assumptions that are imposed to derive the Euler equation and its test implication. For example, we ignore the possibility of the existence of precautionary saving (the di erence in uncertainty among households) on the assumption that it is same across time and individuals. Once we have rejected the Euler equation implication, we should seek the reason for it, checking each possible explanation one by one. The following parts focus on the existence of borrowing constraints, which is the most frequently used explanation for the violation of the Euler equation implication. Speci cally, we identify unconstrained households using unique information on households borrowing constraints and test the Euler equation implication using this subsample. If the existence of borrowing constraints is the primary explanation for the violation of the Euler equation implication, we should nd evidence of the Euler equation implication for this sample but not for the full sample. However, if other explanations for the violation of the Euler equation implication matter, we will not nd support for this implication even for the unconstrained sample. We will discuss other possible explanations for the violation of the Euler equation implication later after we have examined the empirical results for borrowing constraints. 3 The Data 3.1 JPSC Data This paper uses micro data from the Japanese Panel Survey of Consumption, (hereafter the JPSC) (in Japanese, Shouhi Seikatsu ni kansuru Paneru Chousa), a panel survey conducted by the Institute for Research on Household Economics (in Japanese, Kakei Keizai Kenkyuusho). This survey has surveyed young married and unmarried women (those between the ages of 24 and 34 in 1993) once a year since 1993, and this paper uses the waves from this survey. Because JPSC is a panel survey, we can calculate changes in consumption from year to year, which is precisely the variable we 6

7 need to test our theoretical model. We con ne our analysis to the subsample of married women because most young single Japanese women live with their parents and rely on their parents income but precise information is not available on their parents income and consumption. Note that married women are asked not only about themselves but also about other household members. Borrowing constraints. The rst and most important variable used in our analysis is the one pertaining to borrowing constraints. The JPSC asks three unique questions about borrowing constraints: (1) Have you (or your spouse) ever had a loan application turned down? (2) Have you (or your spouse) ever had the loan amount reduced when you applied for a loan? (3) Have you (or your spouse) ever decided against applying for a loan because you expected your loan application to be turned down? Following Jappelli (1990), we refer to households answering "yes" to these questions as "rejected," "reduced," and "discouraged" borrowers, respectively. Households that replied "yes" to one or more of these questions were regarded as being borrowing-constrained. Unfortunately, this information is available only for the rst survey. Thus, we had no choice but to assume that borrowing constraints remain unchanged over the sample period. This is exactly what Jappelli (1990) and Jappelli, Pischke, and Souleles (1998) assume, even though it may be too strong an assumption. We will return to this point in the last part of this section. Consumption. The JPSC collects data on consumption (living expenses) by all household members during the month of September. In the regressions, we use the growth rate of monthly consumption. The data on monthly consumption have at least two advantages: rst, they include all consumption goods and services, unlike in the case of PSID, which collects data only on food consumption. Thus, we need not make any assumptions about the separability of consumption. Second, using the change in consumption between two non-sequential months has the advantage of avoiding, to some extent, potential serious problems raised by consumption durability and habit formation 3. Income. The JPSC collects data on several measures of income, includ- 3 The change in monthly consumption could be biased if the household engages in purchases of big-ticket items such as homes and cars. The JPSC asks about spending on living expenses during the previous month excluding spending on most big-ticket items. The survey asks separately about purchases nanced by loans. Thus, we can exclude the possibility that consumption growth is overestimated as a result of purchases of big-ticket items. 7

8 ing annual (total) income, annual labor income, and monthly labor income. Annual (total) income and annual labor income are inclusive of taxes so we need to estimate taxes in order to calculate after-tax income. We use after-tax monthly labor income in the main Euler equation for at least three reasons: rst, we wanted the period and timing of consumption and income to match. If we use annual income, there is a danger of underestimating the degree of consumption smoothing simply because annual income is more stable than monthly income or consumption. Another reason for using monthly income is that using annual income would require us to waste the last year of data since the survey asks about annual income in the previous year. Finally, the use of monthly labor income helps to reduce the amount of household heterogeneity because data on monthly labor income are not available for the self-employed. We sum the monthly labor incomes of all household members and use the growth rate of total monthly labor income in the regressions. Household characteristics. Following the past literature on testing the LCPIH and the existence of borrowing constraints by estimating an Euler equation, we take the husband s age, the household s consumption needs, as proxied by the number of family members, and year dummies. Although we tried including many other time-variant and time-invariant variables that might possibly in uence consumption, particularly that of young Japanese households such as those included in our sample, all of the variables we tried including had little e ect and their inclusion was not supported statistically 4. Time-invariant variables such as residential area dummies are anyway dropped from xed e ects estimation. In estimating expected income change, we use previous year s income change and husband s educational attainment as instruments, adding to the explanatory variables for consumption. The total number of married women (households) was about 1000 in most years. We kept an observation if it contained enough information for at least a one-year panel. Thus, the sample we used is unbalanced panel. After eliminating observations with missing values for one or more of the variables included in the regressions, we were left with 1058 households (5674 household-years) in the full sample and 980 households (4243 householdyears) in the unconstrained sample 5. 4 For example, neither a dummy variable for those who had their rst baby during the current year, which could make a big di erence in consumption patterns, nor a dummy variable for those who starting living with their parents during the current year, which is often observed in Japan as the parents get older, did not change the results below. 5 Observations lying outside of the mean plus or minus two standard deviations range 8

9 3.2 Who is Constrained? Before estimating the Euler equation, we summarize the characteristics of borrowing-constrained households. Table 1 summarizes the borrowing motives of households that are currently in debt. Although housing and car purchases are the main reasons for borrowing, a few households do in fact borrow to nance living expenses. More than half of the sample is currently in debt, which suggests that borrowing plays an important role in household planning. Many past studies have tried to distinguish borrowing-constrained households from unconstrained households. Since direct data on borrowing constraints are usually not available, most previous studies have tried to predict who is borrowing-constrained using a variety of indicators. In our case as well as in the case of Jappelli (1990), however, direct information is available on whether or not a given household is borrowing-constrained. Thus, following Jappelli (1990), we analyze what determines whether a given household is borrowing-constrained by regressing a dummy variable that equals one if the household is borrowing-constrained and zero otherwise on various household characteristics using probit estimation. The household characteristics we use include assets, income, husband s age and educational attainment, household size, homeownership, debt, city size, and region. We use two measures of assets: Asset1, which is de ned as holdings of bank and postal deposits, bonds, and equities, and Asset2, which is de ned as Asset1 plus life and non-life insurance, land, and housing. Debt is de ned as the amount of outstanding debt. The other variables are described in the last section. Table 2 shows the characteristics of borrowing-constrained and unconstrained households separately. Borrowing-constrained households, especially "reduced" households have lower incomes, assets, husband s employment rate, and husband s educational attainment than unconstrained households. "Discouraged" borrowers also have similar characteristics to "denied" and "reduced" households. This nding underscores the importance of differentiating "discouraged" households from those completely free from borrowing constraints and grouping them together with borrowing-constrained households. Who is borrowing-constrained? Table 3 shows the estimation results of our probit analysis of who is borrowing constrained. The left-hand column of Table 3 shows the results based on the narrower de nition of assets (Asset1), were regarded as outliers and dropped from the sample. 9

10 while the right-hand column shows the results based on the broader de nition of assets (Asset2). Household assets and income are two variables of interest since most past studies have used the ratio of assets to income as an indicator of whether or not a given household is borrowing-constrained, but neither assets nor income are major determinants of whether or not a given household is borrowing-constrained, regardless of which measure of assets is used. Income and Asset2 are not relevant at all, and Asset1 has very little effect on reducing the probability of being borrowing-constrained 6. Our results are very di erent from the results Jappelli (1990) obtained using U.S. data that households with less income or assets indeed face a higher probability of being borrowing-constrained. By contrast, the most relevant variable in the case of Japan is not income or assets but the husband s educational attainment. Educational attainment could be an indicator of current as well as future income, and a household in which the educational attainment of the husband (usually the household head and main income earner) is relatively low might be regarded as having insu cient ability to repay loans. These results have important implications for analyses of borrowing constraints. Although asset holdings may be a signi cant determinant of the probability of being borrowing-constrained in the U.S., it is not a signi cant determinant in Japan. We turn now to a check of the accuracy of indicators used by previous studies to identify borrowing-contrained and unconstrained households. Following previous studies, we group the sample into hypothetically borrowingconstrained and unconstrained households using various indicators and then compare these households to actually borrowing constrained and unconstrained households. The results are shown in Table 4. The rst three indicators, which were originally proposed by Zeldes (1989), are the most frequently used indicators in many countries and are constructed by taking the ratio of asset holdings to income. Since households who have adequate amounts of assets relative to income can dissave their assets when necessary and protect their consumption against unexpected income shocks, households with a high asset-income ratio are regarded as being 6 The self-employed may need to borrow and may face borrowing constraints more frequently than others. Also, employment conditions such as tenure and rm size often a ect household decisions in Japan. Thus, we conducted the estimation including variables relating to the husband s self-employement, tenure, and rm size, but none of their coe cients were signi cant. 10

11 unconstrained. The rst indicator is whether or not the household s holdings of nancial assets are more than twice as much as their monthly income, and the second one is whether or not the household s holdings of total assets ( nancial assets plus housing equity) are more than twice their monthly income. The third indicator classi es households with no nancial assets as being borrowing-constrained and households whose holdings of nancial assets are more than twice their monthly income as being unconstrained. The fourth indicator is whether or not the household owns one or more credit cards. If it owns one ore more credit cards, it can nance its consumption even when it experiences an unexpected income decline. This indicator is close to the one suggested by Shintani (1994), who classi es households as being unconstrained if they own one or more credit cards or one or more cards with a free-loan feature because they need to pass a credit check in order to receive one or both kinds of cards. The fth indicator, proposed by Hayashi (1985b), classi es households as unconstrained if they consume less than 85% of their annual disposable income (minus all debt outstanding plus 20% of their nancial assets). Finally, since we found from Table 3 that educational attainment is a signi cant indicator of being unconstrained, we propose a new indicator identifying college graduates as being unconstrained. In addition, we construct another new indicator that is the same as the rst indicator suggested by Zeldes (1989) except that nancial assets are replaced by a broader concept of assets namely, nancial assets plus housing equity plus life insurance. Table 4 shows the results. The shaded areas indicate the proportion of households identi ed properly. The results are summarized in Table 5. As expected, the husband s educational attainment identi es unconstrained households well, as does Hayashi s indicator (his consumption-income ratio). By contrast, Zeldes s asset-income ratio is better at identifying borrowingconstrained households, but even so, about 50% are misclassi ed. This nding is similar to Jappelli s (1990) nding for U.S. households that using the asset-income ratio leads to serious misclassi cation of constrained and unconstrained households. Moreover, misclassi cation is even more serious in the case of Japanese households. We should identify unconstrained households using information on educational attainment or the consumption-income ratio rather than using information on the asset-income ratio. Moreover, it may not be possible to identify borrowing constrained households regardless of what indicator is used. 11

12 4 The Results 4.1 Euler Equation Test In this section, we present the results of our Euler equation tests, but we rst present the descriptive statistics for the sample used in the estimation in Table 6. First, we estimated the Euler equation for the full sample using simple IV estimation. The results are reported in part (a) of Table 7 (see Appendix for the rst stage regression results), and as can be seen from this table, the coe cient of expected income changes is 0.12 and it is signi cant at the one percent signi cance level. We strongly reject the applicability of the Euler equation implication. Parts (b) and (c) of Table 7 are the results of IV estimations controlling for individual e ects as xed e ects model, or rondom e ects model, respectively. Although the Wu-Hausman test shows that individual e ects are not correlated with the explanatory variables so that the random e ects model is good enough to be estimated, the xed e ects model estimator is still consistent (but ine cient) and may still be preferred if individual e ects relating to the household s consumption and income changes is correlated with the other explanatory variables. The coe cient of expected income is about 0.13 and 0.12 in the xed e ects and random e ects models, respectively. Both coe cients are signi cant at the one percent signi cance level. Thus, we again reject the Euler equation implication. The coe cient of expected income changes in (b) might be upward biased because the process of taking the di erence from the mean (withinestimator) to remove xed e ects makes income changes "transitory or surprising" rather than "expected or permanent" whereas we want to see the reaction of consumption to the latter. A larger coe cient in the xed e ects model relative to the random e ects model may re ect this possibility. A coe cient of at least 0.12 is broadly consistent with previous studies for many countries. However, we will show soon that comparing coe cients in this way is not meaningful. Although there is variation in the magnitude of the coe cients, the test implications are the same: the Euler equation implication is rejected. Households do not smooth consumption changes over even expected income changes. 12

13 4.2 Do Borrowing Constraints Matter? Most of the past literature attributes the violation of the Euler equation implication to the existence of liquidity constraints. Using this analogy, the coe cient of expected income changes, such as the 0.12 value shown in Table 7, is sometimes interpreted as the ratio of constrained households. However, this is not correct. As we have already shown, 8% of our sample is actually constrained, while the results in Table 7 suggest that at least 12 percent of our sample is constrained. If the existence of borrowing constraints are the reason for the violation of the Euler equation implication, we would expect to nd that the Euler equation implication is applicable or close to applicable in the sample of unconstrained households. Table 8 shows the results for the sample of unconstrained households, and as this table shows, the coe cient of expected income changes stays at about the same magnitude and signi cance level. The di erence in the coe cients of expected income changes between the full and unconstrained samples is quite small and not signi cant at a one percent signi cance level (see the bottom row of Table 8). Thus, the Euler equation does not hold even for unconstrained households, which suggests that the existence of borrowing constraints are not the reason for the violation of the Euler equation implication. Many past studies that identify unconstrained households using the level of the asset-income ratio make the conclusions even more ambiguous. In the previous section, we found that splitting the sample by the asset-income ratio itself is questionable, especially when we are interested in the behavior of unconstrained households. In addition to this problem, the sensitivity of consumption to expected income changes as measured by the above type of Euler equation does not show what proportion of households are borrowingconstrained. The results obtained in this paper suggest that the existence of borrowing constraints are not be a major reason for the violation of Euler equation implication. 4.3 Other possible explanations If borrowing constraints are not the explanation, what is the explanation for the violation of the Euler equation implication? The existence of precautionary saving or di erences in households level of uncertainty are possible explanations of the violation of the Euler equation implication. Our basic 13

14 estimation model excludes this possibility, assuming that time and individual xed e ects can control for it, which may be too strong an assumption. Thus, we split the sample into low income volatility and high income volatility households and into households with precautionary motives for saving and households without precautionary motives for saving and estimated the Euler equation for each subsample. When splitting the sample by the amount of income volatility, income volatility was measured as the variance in the husband s annual labor income during the previous four years. High income volatility households were de ned as households whose income volatility is higher than the median, and low income volatility households were de ned as households whose income volatility is lower than the median. When splitting the sample by the presence or absence of precautionary motives for saving, households with precautionary motives for saving were de ned as households with a positive amount of precautionary saving and households without precautionary motives for saving were de ned as households with no precautionary saving. The high (low) income volatility sample has 728 (775) households and 2269 (2762) household-years, while the sample with (without) precautionary motives for saving has 908 (727) households and 3651 (2023) household-years. The estimation results are shown in Table 9, and as this table shows, the coe cient of expected income changes is statistically signi cant and of roughly the same magnitude for both low income volatility and high income volatility households. It is slightly higher for high income volatility households when IV with rst di erences is used but somewhat higher for low volatility households when IV with xed e ects or IV with random e ects are used. Thus, it appears that income volatility is not the explanation for the violation of the Euler equation implication either. Turning to the impact of precautionary motives for saving, Table 10 shows that the coe cient of expected income changes is statistically signi cant and in the 0.15 to 0.16 range in the case of households with precautionary motives for saving but statistically insigni cant and in the 0.05 to 0.09 range in the case of households without precautionary motives for saving. This suggests that precautionary motives for saving are the primary explanation for the violation of the Euler equation implication. The existence of consumption durability is another possible explanation for the rejection of the Euler equation implication. If a commodity is durable and expenditure on that commodity is increased in the present period, expenditure will be depressed in the next period although people indeed enjoy 14

15 consuming that commodity. Households can derive bene ts from consuming now rather than later, showing excess sensitivity of consumption 7. In this case, the error terms in the equation (3) contains the e ects past consumption and are correlated with the explanatory variables (Mankiw (1982), Hayashi (1985b, 1999)). This is, however, less serious in our results, since the survey we used measures consumption at separate time periods one year apart). Furthermore, data problems are also a possible explanation for the rejection of the Euler equation implication. If we do not have data on total consumption but only on consumption of a certain good, we need to assume separability between goods. If we cannot obtain the appropriate micro data to test the Euler equation implication, we have to assume that aggregation is possible. If we cannot nd valid instruments in the limited information set, there exists misspeci cation of the stochastic structure of income. The last problem is related to informational constraints on households. However, these problems are not critical in the present analysis. Our consumption data is total consumption expenditure, and moreover, our data set contains data on a large number and variety of household attributes, making it easier to nd appropriate instruments. Thus, the only explanation for the violation of the Euler equation implication that is potentially relevant in the case of the present analysis and that we have not yet investigated is the assumption of separability between consumption and leisure. 5 Conclusion In this paper, we used micro data on young married households from the Japanese Panel Survey of Consumers, conducted by the Institute of Research on Household Economics, to shed light on (1) the prevalence of borrowing constraints in Japan, (2) what households are borrowing-constrained in Japan, (3) whether the life cycle/permanent income hypothesis (LCPIH) holds in Japan, and (4) whether the presence of borrowing constraints, the 7 The misspeci cation of the assumption that consumption and leisure are separable is yet another possible explanation for the violation of the Euler equation implication. Unless this assumption is imposed, we cannot derive the above type of Euler equation test, where the consumption decision is made independently of the leisure decision. Habit formation is also an example of nonseparable consumption over time. In this case, consumption must increase over time and households try to save now for future consumption, showing excess smoothness of consumption. 15

16 presence of income risk, or the presence of precautionary motives for saving is the reason why the LCPIH does not hold in Japan. To summarize our main ndings, we found (1) that about 8 percent of young married Japanese households are borrowing-constrained, (2) that the husband s educational attainment is the most important determinant of whether or not a household is borrowing-constrained, (3) that the Euler equation implication is rejected for both the full sample and for the subsample of unconstrained households, (4) that the Euler equation implication is rejected for both low income volatility and high income volatility households, and (5) that the Euler equation implication is rejected for households with precautionary motives for saving but cannot be rejected for households without precautionary motives for saving. These results suggest that the LCPIH does not apply in Japan and that the presence of precautionary motives for saving (not the presence of borrowing constraints or the presence of income volatility) is the main reason for why it does not apply. Turning to the policy implications of our ndings, our nding that the presence of precautionary motives for saving is the main reason why the LCPIH does not apply in Japan implies that the best way to make Japanese consumers better o and to enable them to optimize their consumption paths is to reduce uncertainties about the future so that households do not feel the need to do saving for precautionary motives. Possible ways to achieve this would be to improve the safety net for those who experience job loss, income loss, illness, accidents, natural disasters, and other unforeseen emergencies, to relax borrowing constraints so that those experiencing unforeseen emergencies can borrow as much as they need to tide them over, and to revamp the public old-age pension, health insurance, and long-term care insurance programs so that worry about life during retirement is alleviated. 16

17 References [1] Arellano, M., and Bond, S., (1991), Some Tests of Speci cation for Panel Data: Monte Carlo Evidence and an Application to Employment Equations, Review of Economic Studies, 58, [2] Campbell, J. H. and Mankiw, G. N. (1991), The Response of Consumption to Income: A Cross-Country Investigation, European Economics Review, 35, [3] Hayashi, F. (1985a), The Permanent Income Hypothesis and Consumption Durability: Analysis Based on Japanese Panel Data, Quarterly Journal of Economics, 100, [4] Hayashi, F. (1986), An Extension of the Permanent Income Hypothesis and Its Test (in Japanese) Keizai Bunseki (Economic Analysis), 101, 1-23, Institute of Economic Reserach, Economic Planning Agency of the Japanese Government. [5] Hayashi, F. (1997), Understanding Saving (Cambridge, Massachusetts: The MIT Press). [6] Institute for Research on Household Economics, Japanese Panel Survey of Consumers, 1993 through [7] Jappelli, T. (1990), Who Is Credit Constrained in the U.S. Economy? Quarterly Journal of Economics, 105, [8] Jappelli. T., and Pistaferri, L., (2000), Using Subjective Income Expectations to Test for Excess Sensitivity of Consumption to Predicted Income Growth, European Economic Review, 44, [9] Jappelli, T., Pischke, J., and Souleles, N. S. (1998), Testing for Liquidity Constraints in Euler Equations with Complementary Data Sources, Review of Economics and Satistics, 80, [10] Mankiw, N. G., (1982), Hall s Consumption Hypothesis and Durable Goods, Journal of Monetary Economics, 10, [11] Ogawa, K. (1990), Cyclical Variations in Liquidity-Constrained Consumers: Evidence from Macro Data in Japan, Journal of the Japanese and International Ecnomy, 4,

18 [12] Runkle, D. E., (1991), Liquidity Constraints and the Permanentincome Hypothesis, Journal of Monetary Economics, 27, [13] Shibata, A. and Shintani, M. (1998), Capital Mobility in the World Economy: An Alternative Test, Journal of International Money and Finance, 17, [14] Shintani, M. (1994), Nippon no Shouhisha to Ryuudousei Seiyaku, (Japanese Consumers and Liquidity Constraints: A Test Based on Credit Information), Osaka Economic Papers, 44, [15] Wakabayashi, M., and Horioka, C. Y. (2005), "Borrowing Constraints and Consumption Behavior in Japan," Discussion Paper No. 640, Institute of Social and Economic Research, Osaka University. [16] Zeldes, S. P. (1989), Consumption and Liquidity Constraints: An Empirical Investigation, Journal of Political Economy, 97,

19 Table 1. Borrowing Motives All 784 households Borrowing? No / Yes 47.59% / 52.41% If yes, housing 45.9% to finance: car 39.1% durables 10.1% clothing 8.7% leisure 4.6% children' s education 3.6% children's marriage 1.4% payment for accidents 5.6% living expenses 5.3% repayment of debt 5.1% new business 1.2% others 4.3% Note. 1. Households answering "yes" to "Borrowing?" are households that are currently in debt, and the figures in the second line and below show the proportion of households currently in debt that are borrowing for each motive. Since some households are borrowing for more than one motive, the figures sum to more than These data are from the first wave of the Japanese Panel Survey of Consumers, 1993.

20 Table 2. Characteristics of Constrained and Unconstrained Households All Sample Unconstrained Constrained 541 households 92.23% 7.76% Denied (59.52%) Reduced (11.90%) Gave up (71.43%) Mean Std.Dev. Mean Std.Dev. Mean Std.Dev. Mean Std.Dev. Mean Std.Dev. Mean Std.Dev. HusAge HusCollege % 36.8% 48.3% 39.7% 49.0% 2.4% 15.4% 4.0% 20.0% 0.0% 0.0% 3.3% 18.3% HusEmployed % 99.6% 6.1% 99.8% 4.5% 97.6% 15.4% 96.0% 20.0% 100.0% 0.0% 96.7% 18.3% NumFamily Homeown % 23.7% 42.6% 24.0% 42.8% 21.4% 41.5% 20.0% 40.8% 0.0% 0.0% 23.3% 43.0% Asset1 (\10 thousand) Asset2 (\10 thousand) Debt (\10 thousand) Income (\10 thousand) Consumption (\ thousand) Notes. 1. The data are from the first wave of the Japanese Panel Survey of Consumers, "Constrained" households include 'rejected, 'reduced' and 'discouraged' households. Since some households experienced two or more of the three events, the totals sum to more than 100%. 3. HusAge, HusCollege and HusEmployed denote the husband's age, college graduation, and employment status, respectively. 4. NumFamily denotes the number of family (household) members. 5.. Asset1 denotes the household's total holdings of bank and postal deposits, bonds, and equities. Asset2 includes, in addition to Asset1, the paid-in value of life and non-life insurance and the value of land and housing they own. In units of 10,000 yen. 6. Income is the annual disposable income of all household members (in units of 10,000 yen). 7. Consumption is monthly expenditure (in units of 1,000 yen). ]

21 Table 3. Who Is Constrained? Dependent Variable: "Constrained" =1 if either rejected, reduced, or discouraged. Coefficient Coefficient HusAge (0.0046) (0.0069) HusAge*HusAge (0.0001) (0.0001) Income (0.0001) (0.0003) Income*Income (0.0000) (0.0000) Income*HusAge (0.0000) (0.0000) Asset ** (0.0002) Asset1*Asset (0.0000) Asset1*Income (0.0000) Asset1*HusAge (0.0000) Asset (0.0000) Asset2*Asset (0.0000) Asset2*Income (0.0000) Asset2*HusAge (0.0000) HusCollege *** *** (0.0165) (0.0202) HusEmployed (0.2376) NumFamily (0.0023) (0.0041) Homeown (0.0074) (0.0572) Debt * (0.0000) (0.0000) AreaScale_med ** * (0.0115) (0.0156) AreaScale_small ** * (0.0075) (0.0104) Number of obs (households) Log likelihood Likelihood Ratio Notes: 1. The coefficients show marginal effects. 2. For the definitions of the variables, see the text and the notes to Table AreaScale_med and AreaScale_small are dummy variables indicating that the household lives in medium-sized and and small-sized cities, respectively, rather than in a large metropolitan area. Metropolitan areas denote the thirteen ordinance-designated cities. 4. The equation also includes eight regional dummies.

22 Table 4. Indicators of Constrained Households used in the Past Literature PanelA- appropriateness of the past indicators PanelB- other possible indicators Asset (Basic Split)* Actually Basic Split by widely defined assets** Actually 701sample unconstrained constrained 535sample unconstrained constrained The indicator unconstrained The indicator unconstrained predicts: (71.81) (35.59) predicts: (90.06) (66.67) constrained constrained (28.19) (64.41) (9.94) (33.33) Asset (Total Wealth Split) Actually 462sample unconstrained constrained College Graduates (husband) Actually The indicator unconstrained sample unconstrained constrained predicts: (79.50) (56.52) The indicator unconstrained constrained predicts: (96.90) (92.54) (20.50) (43.48) constrained (3.10) (7.46) Asset (Extreme Split) Actually 582sample unconstrained constrained The indicator unconstrained *Saving accounts and time deposits predicts: (85.69) (47.73) **Saving accounts and time deposits, life and non-life insurance, and land constrained and house values (14.31) (52.27) Credit Card Holders Actually 816sample unconstrained constrained The indicator unconstrained predicts: (91.07) (93.94) constrained (8.93) (6.06) Consumption-Income Ratio Actually 581sample unconstrained constrained The indicator unconstrained predicts: (92.50) (83.33) constrained (7.50) (16.67)

23 Table5. Which indicator should be used? Asset (Basic Split) Asset (Extreme Split) Basic Split by widely defined assets* Asset (Total Wealth Split) Basic Split by widely defined assets* Basic Split by widely defined assets* Asset (Extreme Split) Asset (Extreme Split) Asset (Total Wealth Split) Asset (Total Wealth Split) Asset (Basic Split) Asset (Basic Split)

24 Table 6. Descriptive Statistics for the Euler Equation Estimation The entire sample (number of the observations (households) = The unconstrained sample (number of the observations 5674 (1058) ) (households) = 4243 (980) ) Mean Std. Dev. Min Max Mean Std. Dev. Min Max Consumption change rates Income change rates Income Change rates at one year before Income Change rates at two years before HusAge family size change rates Husage*HusCollege The sample with high income volatility (number of the The sample with low income volatility (number of the observations observations (households) = 2269 (728) ) (households) = 2762 (775) ) Mean Std. Dev. Min Max Mean Std. Dev. Min Max Consumption change rates Income change rates Income Change rates at one year before Income Change rates at two years before HusAge family size change rates Husage*HusCollege The sample with precautionary motives (number of the The sample without precautionary motives (number of the observations (households) = 3651 (908) ) observations (households) = 2023 (727) ) Mean Std. Dev. Min Max Mean Std. Dev. Min Max Consumption change rates Income change rates Income Change rates at one year before Income Change rates at two years before HusAge family size change rates Husage*HusCollege Note 1. HusCollege and Husage are same definitions in table 2. Husage*HusCollege is intersection term between Husage and HusCollege. Family size is the number of faily members. Consumption and income changes are changes in monthly values. Changes are all taken as growth rates.