Rising indebtedness and temptation: a welfare analysis

By Makoto Nakajima

http://d.repec.org/n?u=RePEc:fip:fedpwp:11-39&r=dge

Is the observed large increase in consumer indebtedness since 1970 beneficial for U.S. consumers? This paper quantitatively investigates the macroeconomic and welfare implications of relaxing borrowing constraints using a model with preferences featuring temptation and self-control. The model can capture two contrasting views: the positive view, which links increased indebtedness to financial innovation and thus better consumption smoothing, and the negative view, which is associated with consumers’ over-borrowing. The author finds that the latter is sizable: the calibrated model implies a social welfare loss equivalent to a 0.4 percent decrease in per-period consumption from the relaxed borrowing constraint consistent with the observed increase in indebtedness. The welfare implication is strikingly different from the standard model without temptation, which implies a welfare gain of 0.7 percent, even though the two models are observationally similar. Naturally, the optimal level of the borrowing limit is significantly tighter according to the temptation model, as a tighter borrowing limit helps consumers by preventing over-borrowing.

As a foreigner living in the United States, I have puzzled why Americans are holding so much debt, and sometimes to buy goods that do not seem that essential. Lack of self-control may be the reason, and thus the fact that all these unsecured debt instruments are available may be welfare-decreasing, as detailed in this paper. I still wonder whether this could be generalized to other countries. Is temptation that much of a problem elsewhere?

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