What Can a Life-Cycle Model Tell Us About Household Responses to the Financial Crisis? Sule Alan 1 Thomas Crossley 1 Hamish Low 1 1 University of Cambridge and Institute for Fiscal Studies March 2010
Data: Household Saving Rates Source: IFS
Data: Household Saving Rates Source: IFS
Data: Flight to Cash Net Flows into Equity
Key Questions Sharp rise in savings ratio associated with the current recession and stock market crash 1 Why? Behavioural: Risk aversion soars as growth doubts intensify (FT, 2009) Life-cycle behaviour under uncertainty 2 How permanent?
Understanding the Rise in Saving Why not dissave and use wealth to smooth shocks and smooth consumption?
Understanding the Rise in Saving Why not dissave and use wealth to smooth shocks and smooth consumption? What is a recession? Fall in income (permanent or transitory) Increased uncertainty Possible stock-market crash (wealth destruction)
What is a Recession: Greater Risk? Decompose shocks to income into permanent and transitory How does the variance of each evolve over the business cycle? Use changes in the cross-section variance of consumption to identify the permanent shocks See Blundell, Low, Preston (2009)
What is a Recession: Greater Risk? Figure: Permanent Variance: UK 1979-1997 Source: Blundell, Low, Preston (2009)
Understanding Saving: Life-cycle Framework Standard life cycle dynamic portfolio allocation model Idiosyncratic income uncertainty Uncertainty higher in recessions Possibility of recession: 2 state Markov process Rate of return uncertainty Possibility of stock market crash Heterogeneous agent model, explicit aggregation from micro to macro
Model max E t " T t j=0 # (C h,t+j ) 1 γ 1 1 γ (1 + δ) j X t+1 = (1 + r e t+1)s t + (1 + r)b t + Y t+1 where S t is stock holding, B t is bond holding.
Income Process Y t+1 is stochastic (idiosyncratic) labour income: Permanent income: ln Y t = ln Y P t + u t, u t N(0, σ 2 u) ln Y P t = ln Y P t 1 + d t + η t
Income Process Y t+1 is stochastic (idiosyncratic) labour income: Permanent income: ln Y t = ln Y P t + u t, u t N(0, σ 2 u) ln Y P t = ln Y P t 1 + d t + η t Variance of permanent idiosyncratic shocks driven by aggregate shocks: η t N(0, σ 2 n,l ) in boom η t N( θ, σ 2 n,h ) in recession Business cycle is 2x2 Markov matrix (2/3, 1/3)
Stock Market Process Excess returns are iid where ε t+1 v N(0, σ 2 ε ) r e t+1 r = µ + ε t+1 Crash gives return of φ Probability of a crash is p H in a recession, p L in a boom, p H > p L.
Parameter Values γ = 2.0 δ = 0.08 σ n,l = 0.1 σ n,l = 0.15 coe cient of relative risk aversion discount rate permanent shock in boom permanent shock in recession p L = 0.01 probability of a stock market crash in boom p L = 0.02 probability of a stock market crash in recession φ = 50% size of the stock market crash σ ε = 0.2 standard deviation of stock returns µ = 0.06 mean equity returns r = 0.02 interest rate d = 0.02 dividend yield (non-stochastic)
Baseline No realised recession, no realised stock market crash
Simulated Scenarios Stock market crash occurs: e ects on di erent cohorts depending on age at crash (30,50,70) Recession (increased uncertainty) occurs and lasts 5 periods: e ects on di erent cohorts depending on age at crash (30,50,70) Show deviations from the baseline for consumption, savings rate, asset holdings
Simulations: E ects on Consumption Consumption never recovers following crash Consumption overshoots after recovery from a recession Young cohorts hit more by recession, older cohorts more by crash
Simulations: E ects on Savings Rate
Simulations: E ects on Asset Holdings
Simulations: E ect on Equity Holdings Temporary Flight to Cash
Conclusions Data: increase in savings ratio and ight to cash following current recession Recession characterised by increased uncertainty and stock market crash
Conclusions Data: increase in savings ratio and ight to cash following current recession Recession characterised by increased uncertainty and stock market crash Why has savings spiked? Simple life-cycle model can generate spike either through crash or recession How permanent is the increased savings? Post-stock market crash: savings rate would remain high Post-recession: run down extra precautionary balances - fall in the savings rate will overshoot
Conclusions Ongoing work: relative contributions to saving decline and predict likely persistence of high savings rates 1. FTSE recovered; household less exposed to stock market than model implies
Conclusions 2. Redundancy rates spiked, but are now declining