Implications of Financial Market Imperfections for Wealth and Debt Accumulation in the Household Sector

The project is funded for 6 years by Deutsche Forschungsgemeinschaft (DFG)

Our goal is to shed light on the role of limited information and social interactions for asset and debt accumulation in the household sector. The recent financial crisis is a vivid example of how limited information and knowledge about financial products, and multiplicative effects through social interactions can spread suboptimal practices. In the first phase, we pursued three questions. The first studied the effect of social interactions on the tendency of households to borrow and run into financial distress. The second focused on the role of previous familiarity with a financial instrument in asset and debt participation. The third focused on cultural predispositions in household financial behavior and on how exposure to common (or exogenously harmonized) institutions could contribute to harmonization of financial practices. In the proposed extension to the project, we plan to undertake three papers. One will focus on how social interactions can shape household expectations and ultimately financial behavior with emphasis on mortgage debt. This will involve addition of a module to a pioneering Hybrid Data Set on household finances undertaken by the Center SAFE. The second will examine the effects on household financial behavior of interacting with more financially literate neighbors. We will exploit a unique Swedish field experiment that makes allocation to a neighborhood exogenous and thus not subject to the thorny econometric problem of endogenous neighborhood selection. The third paper will focus on stock trading behavior of households and on the extent to which this is influenced by transactions/ opportunity costs versus inattention/information costs. It will use unique administrative data from a widely-based German commercial bank and will shed light on the role of imperfections that can be important for the liquidity and stability of financial markets.