Academic journal article Federal Reserve Bank of St. Louis Review

Economic Vulnerability and Financial Fragility

Academic journal article Federal Reserve Bank of St. Louis Review

Economic Vulnerability and Financial Fragility

Article excerpt

Unfortunately, many families with the greatest exposure to the economic dislocations of the recent recession also had very risky balance sheets beforehand that were characterized by low levels of liquid assets, high portfolio concentrations in housing, and relatively high balance-sheet leverage. The authors argue that economic vulnerability and risky balance sheets are correlated because they derive from common factors. These factors include a low stock of human capital, inexperience (relative youth), and, in some cases, the legacy of discrimination in housing, education, and employment. Innate cognitive ability interacts with formal education and on-the-job experience to build human capital, while the legacy of discrimination may attenuate the translation of cognitive ability and education into human capital. Acquiring financial knowledge of risk management also requires time and experience and is more valuable to those with high levels of human capital and savings available to invest. Given the combination of these factors, individuals and families who are young, less cognitively able, and/or members of historically disadvantaged minorities are more likely to be economically vulnerable and to hold risky balance sheets because they lack financial knowledge and experience. Moreover, balance sheets of economically vulnerable families before the recent recession were especially risky after a decade of financial liberalization and innovation that increased the access of such families to homeownership and historically high leverage. Economically vulnerable families should avoid "doubling down" with risky balance sheets to enhance their future household financial stability. (JEL D14, D11, D12)

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The recent financial crisis and recession inflicted substantial economic and financial harm on millions of families, but the effects were not uniform across the population. The hardest-hit groups included individuals or families who were the young, the less educated, and members of a minority group. Unemployment rates among all these groups increased sharply and remain elevated more than four years into the recovery (Bureau of Labor Statistics, various years; Figure 1). (1)

These economically vulnerable groups also suffered greatly in financial terms. For example, the 2010 average wealth of households younger than 40 years of age, with a two- or four-year college degree, and within an historically disadvantaged minority group (black or Hispanic) was $33,154. This is 66 percent lower than their 2007 average. (2) The 2010 average wealth of households younger than 40 years of age, but with less than a high school education and not a part of an historically disadvantaged minority group (primarily white or Asian) was $22,008. This is 74 percent lower than their 2007 average. Most other subgroups with one or more of these demographic characteristics also suffered above-average wealth losses. (3)

Why did the demographic groups hardest hit by the recession also suffer enormous financial losses? The answer is not as obvious as it might at first appear. Economic and financial crosscurrents--including rising unemployment, falling asset prices, and different wealth accumulation patterns--affected various households in different ways. Households at greater ex ante risk of job loss and other economic setbacks--the economically vulnerable--indeed suffered more unemployment spells and other income interruption than other groups. (4) On the other hand, these same households presumably knew they were at greater risk of job loss than other families. They might have had higher precautionary savings and chosen relatively safe balance sheets to compensate for their elevated economic risk. (5) Such circumstances would imply relatively high saving propensities; large stocks of safe and liquid assets relative to income to respond to emergencies; a broadly diversified asset portfolio to hedge against the collapse of any asset class; and low balance-sheet leverage (i. …

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