Understanding household financial distress: The role of noncognitive abilities

Gianpaolo Parise, Kim Peijnenburg 03 May 2017

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Policymakers try to improve the financial wellbeing and resilience of households, especially of the most vulnerable. A recent Federal Reserve Board survey finds that almost half of US households would not be able to cope with an unexpected expense of $500 (Federal Reserve Board 2016). What drives heterogeneity in financial wellbeing in the first place? Recent research has shown that income differences are driven, in part, by noncognitive abilities (Heckman et al. 2006, Lindqvist and Vestman 2011). Using household survey data from the Netherlands, we find that these 'character' skills influence the financial wellbeing of households beyond the income differences they cause (Parise and Peijnenburg 2017) .

It is hard to measure the strength of noncognitive abilities, particularly because there is no exact definition of what they are. We use emotional stability and conscientiousness as measures of noncognitive abilities, which are both derived from the 'big five' personality traits. This is a model of personality developed in psychology in the 1980s (Costa and McCrae 1985, Goldberg 1992), in which survey questions can measure personality traits, that has been applied in economics. 'Emotional stability' is the ability to remain calm when faced with pressure and stress, and also means not becoming anxious easily, or acting impulsively. This skill is important for making carefully thought-through financial decisions. 'Conscientiousness' describes the tendency to be organised, practical, dependable, and self-disciplined. This skill is important for keeping household finances in check and assessing the feasibility of purchases, for example whether it a good idea to buy a car on credit.

Noncognitive abilities as a source of heterogeneity in financial choices

A savings buffer to cope with future bad times is key to protecting a household from financial fragility. Conscientious people are better planners and organisers, and this may mean they build up a savings buffer so they are less financially fragile. If these households are faced with job loss or unexpected health expenses, they tend to cope better. In our study, we find that people with lower noncognitive abilities tend to save less. Figure 1 illustrates this.

Figure 1 Percentage of individuals who save, by noncognitive ability

The rise in unsecured borrowing over the last decade has led many households to face severe financial distress, and even bankruptcy (Carrell and Zinman 2014). The annual costs of unsecured borrowing are sometimes more than 100% of the loan amount, leading to a vicious circle of financial strain. Figure 2 shows that noncognitive ability explains in part why some households refrain from building up this costly debt, while others decide to borrow.

Figure 2 Percentage of individuals with unsecured debt, by noncognitive ability

The difference in character skills has important implications for inequality in income, wealth, and health. People with less-developed character skills not only have lower incomes and make worse financial choices, but also tend to be in worse health (Heckman et al. 2017). In aggregate, differences in character skills have a significant detrimental effect to equality. This comes at a time in which polarisation is already considered a problem.

The detrimental effect of low abilities on financial distress

Our research shows that households that fall in the lowest categories of noncognitive abilities are nine times as likely to be in financial distress than people in the highest category (Figure 3). Financial distress can be measured in several ways, but all paint the same picture. Noncognitive abilities influence payment delinquency – both in the short and long term – the probability of having been visited by a debt collector, or of not being able to pay an unexpected expense of €500.

Figure 3 Percentage of individuals in financial distress, by conscientiousness and emotional stability

Where do abilities originate from and why do abilities matter for households’ finances?

Character skills are part genetics and part the influence of early childhood experience. In adulthood, these skills are hard to change. Using panel data, we find that a person's noncognitive skills are highly correlated over time. More research, however, should be devoted to whether traumatic events can alter a person’s abilities, either in the short run or even permanently.

By what channel do noncognitive abilities influence financial choices? An answer would suggest how to incorporate noncognitive abilities in economic models, and would provide insight for policymakers on if, and how, noncongitive abilities could be improved. We find evidence that character skills influence the productivity of effort, and the cost of effort of financial decision making. For example, a more conscientious person is better at gathering and processing information on different investment opportunities, and at making an informed decision. A more emotionally stable person can calmly decide how to invest pension wealth.

Opportunities to improve households’ financial health

Two types of policies might enhance household financial wellbeing. Since in adulthood character skills are harder to change, policies for adults should be geared towards limiting the negative effect of existing low abilities. For example, people could be provided with stimuli to save sufficiently for retirement, or advice on how to invest their pension.

Also targeting young children to design educational programs that develop noncognitive abilities would be highly cost-effective. Recent research shows the return on investment in education from birth to age five is 13% (Garcia et al. 2016). High-quality education should not only foster cognitive skills, such as the ability to acquire and retain knowledge (Heckman et al. 2013, Cunha et al. 2010). Character – perseverance, motivation, self-esteem, emotional stability, and conscientiousness – is important too, as this research has shown. Improved noncognitive abilities will greatly influence financial wellbeing, income, education, and health throughout the life of an individual.

References

Carrell, S, and J Zinman (2014), “In harm’s way? Payday loan access and military personnel performance”, Review of Financial Studies 27, 2805–2840.

Cunha, F, J Heckman, and S Schennach (2010), “Estimating the technology of cognitive and noncognitive skill formation”, Econometrica 78, 883–931.

Federal Reserve Board (2016), “Report on the economic well-being of US households in 2015”, Discussion paper 1-164.

Garcia, J L, J Heckman, D E Leaf, and M J Prados (2016), “The Life-cycle benefits of an influential Early Childhood Program", working paper.

Goldberg, L (1992), “The development of markers for the Big-Five factor structure”, Psychological Assessment 4, 26–42.

Heckman, J, J Stixrud, and S Urzua (2006), “The effects of cognitive and noncognitive abilities on labor market outcomes and social behaviour”, Journal of Labor Economics 24, 411–482.

Heckman, J, J E Humphries, and G Veramendi (2017), “Returns to education: The causal effects of education on earnings, health and smoking”, forthcoming in Journal of Political Economy.

Heckman, J, R Pinto, and P Savelyev (2013), “Understanding the mechanisms through which an influential early childhood program boosted adult outcomes”, American Economic Review 103, 2052–2086.

Lindqvist, E, and R Vestman (2011), “The labor market returns to cognitive and noncognitive ability: Evidence from the Swedish enlistment”, American Economic Journal: Applied Economics 3, 101–128.

McCrae, R R and O P John (1992), "An introduction to the five‐factor model and its applications", Journal of Personality 60.2: 175-215.

Parise, G, and K Peijnenburg (2017), “Understanding the Determinants of Financial Outcomes and Choices: The Role of Noncognitive Abilities”, CEPR Discussion Paper No. 11900.

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Topics:  Education Poverty and income inequality

Tags:  saving, financial wellbeing, noncognitive skills, household debt

Economist, Bank for International Settlements

Associate Professor in Finance, HEC Paris

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