What personal financial stress can do to the economy

Americans are pretty stressed out. In the American Psychological Association's 2022 Stress in America Survey, respondents cited violence and crime, and the current political and racial climate as significant sources of stress. The biggest stressor of all, however, was economic: 83 percent of people said they were stressed out by inflation.

Which means that we're only going to be more stressed in the coming year. Why? Because we're almost certainly headed into a recession. The Conference Board, a non-profit business research group, puts the likelihood at 99 percent in the next 12 months. The National Bureau of Economic Research's models say there's a 67 percent possibility. Bankrate's experts say there's a 64 percent chance. The Wall Street Journal puts it at 61 percent. Clearly the numbers are all over the place. But however you slice the data, whether we go in sooner or later, hard or soft, it does look as though we're going in.

Which means a lot more stress, for a lot more people. And stress is bad news for the economy. More than a quarter of adults told the APA that when they are stressed, they cannot bring themselves to do anything. At all. That kind of paralysis, at home, at work, and when handling one's finances, has profound implications for all of us.

Stress And The Economy

A new working paper, "The Economics of Financial Stress," looks at what stress can do to a household's financial situation. Spoiler alert: it's not good. And it has profound implications for a nation that is likely about to become extremely stressed-out in the next year.

The paper is by economists Dmitriy Sergeyev of ​​Bocconi University in Milan, Italy, and Chen Lian and Yuriy Gorodnichenko of the University of California, Berkeley. They polled a group of 10,000 prime-age, employed American workers, which are representative of the population in terms of gender, age, region, total household income, and education. They asked them a bunch of questions about their current financial situation, and asked them to speculate about how they would behave if certain financial conditions prevailed in their lives. And they found that the respondents fell into two rough groups: financial sophisticates, who understand that financial stress can impact future earnings and are thus more likely to cushion themselves by saving; and financial naifs, who don't internalize the threat of financial stress, and continue to spend and save (if they do save) as normal.

Most households, the researchers found, are naifs — around three quarters of respondents. Given the levels of financial literacy in the U.S. that we've reported on previously, this won't be a surprise to readers. And there were some other findings that might resonate. For example, the idea that the more debt a household has, the more stressed it will be, and vice versa. Having children in the household and being married are associated with more stress. Also the finding that our stress levels fluctuate with our current accounts: the share of Americans who feel financially stressed rises steadily over the course of the month, as cash-on-hand dwindles, and then drops sharply by 53 percent at the start of the next month when paychecks arrive.

Rubber, Meet Road

What might be surprising to many is the way in which sophisticates and naifs respond to financial stress. Sophisticates first: having saved a lot of money in the past, in anticipation of some kind of adverse financial event, you might expect these squirrely saver types to hunker down and start drawing down the cushion. Instead, they double down and save even more, "despite the negative direct effect of financial stress on earnings," the economists write.

Naifs, meanwhile — and remember, that's most Americans — "do not have the extra saving motive," the researchers say. They have a lower net saving than no-stress households, because of the negative direct effect of financial stress on earnings. And even if they do understand that "lower saving results in increased future financial stress, they fail to understand that financial stress incurs negative economic consequences in the future." So, even with the clouds of financial stress looming on the horizon, they don't save.

Instead, naifs often go in the other direction.

"To alleviate financial stress, the household may spend on items that it would not buy if it were not financially stressed," the researchers say, noting that "impulse spending increases with the qualitative measure of financial stress."

In other words, the more stressed a household is, the more spending it tends to do, to induce comfort immediately, rather than saving to ensure a certain level of comfort in the future.

Unless the household is financially sophisticated, then, financial stress can drain its bank accounts, inducing even more stress, and driving the household into a downward spiral that can end in a poverty trap. And it's not just the household's bottom line that can be impaired. Financial stress can affect all aspects of a person's life.

"Financial stress drains valuable time and cognition from productive work," the report notes. "Because financial stress affects her performance, a stressed worker may face a lower chance of being promoted to a higher-salary job and a higher chance of being demoted to a lower-salary job. Financial stress can also lead to worse economic decisions."

Impact On The Economy

The knock-on effect — and the implications for an economy poised on the cliff's edge of recession — are obvious. The majority of Americans are already stressed out. The financial shock of a recession will likely put many more people under stress, and increase the stress levels of those who are already suffering. Given that more than a quarter of Americans say that they're so stressed that they can barely function right now, what might that mean for the economy when we're really under the gun?

Sergeyev, Lian and Gorodnichenko say financial stress can mean lower earnings, an impact on the labor supply and impaired productivity. They also note that financial stress tends to impact the most vulnerable, including older people, women, and the less well educated, and therefore the more financially insecure.

What can we do about it? "Policies such as default choices that encourage saving and the promotion of financial literacy could be powerful antidotes to the negative consequences of financial stress," the researchers say. And an examination of the business cycle is in order. "There could be more scope for targeted countercyclical policies to ensure that recessions do not push vulnerable households into poverty traps."

But that's for the next cycle, because a recession is coming, and that right soon. Inevitably, as during the Covid 19 emergency, all eyes will be on the government. And there will no doubt be a highly charged debate as to what the government should do. Sergeyev, Lian and Gorodnichenko appear to be on the Keynesian side of the fence here: "The positive wealth effect on labor supply for stressed households is a new transmission mechanism for fiscal policy," they say. "Public debt-financed stimulus checks boost private assets and alleviate financial stress. This increases effective labor supply and boosts aggregate output."

Are we talking about helicopter money here? Like the $5 trillion handed out during Covid? Now that's stress spending!