Credit Smoothing

Standard economic theory suggests that high-interest, unsecured, short-term borrowing, e.g., borrowing via credit cards and overdraft facilities, helps individuals smooth consumption in the event of transitory income shocks. This paper shows that - on average - individuals do not use such borrowing to smooth consumption when they experience a typical transitory income shock due to unemployment. Rather, it appears as if individuals smooth their roll-over credit card debt and overdrafts. We first use detailed longitudinal information on debit and credit card transactions, bank account balances, and limits from a financial aggregator in Iceland to document that unemployment does not induce a borrowing response at the individual level. We then replicate this finding in a representative sample of U.S. credit card holders, instrumenting local changes in employment using a Bartik (1991)-style instrument. The absence of a borrowing response occurs even when credit supply is ample and liquidity constraints do not bind (as captured by credit limits). This finding is difficult to reconcile with theories of consumption smoothing, which predict a strictly countercyclical demand for credit. On the contrary, the demand for credit does not appear to lean against business cycle fluctuations, leading to greater consumption volatility than what would be observed otherwise.