Does boom and bust really matter?

Boom and busts in asset prices and credit and, more generally, ‘financial imbalances’ have been the subject of a lot of public attention in the wake of the global financial crisis and the Eurozone crisis. All major jurisdictions have been establishing macroprudential authorities and there is a lively discussion on whether financial stability should be an objective for central banks alongside price stability. However, nobody seems to have asked the person in the street whether they care about financial imbalances at all.

The ideal way to conduct this analysis would be to design an appropriate survey, where respondents would be asked whether financial stability is a direct source of concern for them. Short of this ideal solution, one can look at proxies of household welfare available in large surveys such as the Eurobarometer survey. One frequently used proxy for household welfare is life satisfaction. In pioneering work published in 2003, Di Tella, MacCulloch and Oswald analyse the impact of macroeconomic variables, such as the unemployment rate, on life satisfaction. However, their analysis is silent on the role of financial variables.

Life satisfaction

Clearly, life satisfaction is not the only possible measure of household-subjective wellbeing. In particular, it mainly measures the overall attitude towards one’s life from a cognitive standpoint, rather than current feelings. However, life satisfaction is closely correlated with other measures of happiness and wellbeing (Graham 2006) and is considered to be a reliable measure by psychologists. It is therefore an interesting variable at least as a first pass in a welfare analysis.

Macroeconomic developments, in particular crises, clearly have an impact on life satisfaction. The chart below reports a measure of ‘net’ life satisfaction at country level derived from the bi-annual Eurobarometer survey, where the measure shown is based on the question ‘On the whole, are you very satisfied, fairly satisfied, not very satisfied, or not at all satisfied with the life you lead?’. In a recent paper (Stracca 2013), I subtract the share of respondents in each country who answer ‘Not very’ and ‘Not at all’ from those who answer ‘Very’ or ‘Fairly’. It is striking that while net life satisfaction has sailed through the crisis practically unchanged in Eurozone low-yield countries, it has plummeted in Eurozone high-yield countries, in particular those who have been subject to an EU/IMF lending program (Portugal, Ireland and Greece). Just to give an idea of the sheer magnitude of the effect, in 2007 in programme countries about 50% more people reported to be satisfied with their life than not satisfied, while the number was about the same in 2012. By contrast, the gap is as high as 80% in low-yield countries.

Figure 1. Life satisfaction in Eurozone countries

Note: Eurozone low-yield countries include Germany, France, Belgium, the Netherlands, Finland and Luxembourg; the Eurozone programme countries include Ireland, Greece and Portugal; the euro area low yield countries include the program countries plus Italy and Spain. All data are averages; they report the difference between the share of responses ‘Very’ and ‘Fairly’ vs. ‘Not very’ and ‘Not at all’ to the Eurobarometer question ‘On the whole, are you very satisfied, fairly satisfied, not very satisfied, or not at all satisfied with the life you lead?’.

Financial imbalances and life satisfaction

Understanding the determinants of life satisfaction at macro level is no easy task, in particular as far as financial imbalances are concerned. In my recent paper (2013) I have considerably extended Di Tella et al.’s work (2003) to cover for financial imbalances, using data on life satisfaction from the Eurobarometer survey from 26 EU countries (all except Malta). Financial imbalances could matter for citizens in several ways:

• First, financial imbalances could affect macroeconomic variables that are important for household welfare, such as employment (the so-called ‘indirect channel’).
• Second, financial imbalances resulting from distortions or externalities could imply a mis-pricing of variables such as asset prices and credit (the ‘mis-pricing channel’).

For example, the welfare of a young family who wants to buy a house might be negatively affected by inefficiently high house prices, though this may be compensated by higher welfare of current homeowners.

• Third, both financial imbalances and household welfare could reflect a third factor, which needs to be controlled for, such as optimism or pessimism about the future, say ‘animal spirits’ (third factor channel).
• Finally, when financial imbalances unravel and the financial system becomes unstable there may be a breakdown of financial intermediation, which is an essential service to citizens and such a breakdown may therefore impinge on their welfare (the ‘financial intermediation channel’).

Empirically, it is important to control for the indirect channel and the third factor channel if one wants to understand whether financial imbalances matter on their own for life satisfaction.

In the above mentioned paper I control for the indirect channel by including the macroeconomic variables that have been shown by Di Tella et al. (2003) to matter for life satisfaction, such as the unemployment rate. I also use some sub-components of the consumer confidence indicator based on the European Commission’s consumer survey, in particular the intention to undertake major purchases in the following year and respondents’ views about the general economic situation in the next year, in order to control for possible swings in the degree of optimism about the future (both the own economic future and the economic future of the country). In order to measure financial imbalances, I look at a number of indicators based on the deviation of real asset price and credit from previous trends, as well as excess returns on financial sector stocks and a banking crisis dummy by Laeven and Valencia (2010).

The key results and policy implications

Once controlling for key macroeconomic variables and ‘animal spirits’ through consumer confidence, overall I find that generally life satisfaction does not systematically depend on a number of financial-imbalance measures. There is some evidence, which is not very robust, that citizens care about the absolute value of a measure of stock price gap (a proxy for the deviation of the real stock price from an equilibrium level).

All in all, the main message is that financial imbalances are not a main and direct concern for citizens. From a policymaking point of view, this of course does not exonerate the responsible authorities from trying to prevent booms and busts, because these have substantial costs in terms of macroeconomic stability defined in the standard way (say, real GDP growth and the unemployment rate). It does suggest, however, that their focus should be to prevent the fallout of booms and busts for macroeconomic stability rather than trying to stabilise the ‘financial cycle’ (Borio 2012) as an end in itself.

This article first appearedin voxeu.org

Author: Livio Stracca is Senior Adviser, Directorate General International and European Relations, European Central Bank

Image: A man walks across the trading floor of Frankfurt’s stock exchange REUTERS/Ralph Orlowski