How much does Consumption Smoothing Contribute to the Welfare of Families?

Last week, FAI asked:  Does financial access--evaluated in typical settings with a long enough time horizon to see change--substantially improve the well-being of customers? Today, the series continues to probe for insights into the questions we need to ask in order to  make informed decisions on how to improve financial access.

Question 2: How much does consumption smoothing contribute to the welfare of families?

There are clear theoretical linkages between consumption smoothing, financial access, and improved wellbeing. Modern economics is built around the premise that households seek to maximize utility, not income.  A core economic task of a household, rich or poor, is matching the availability of resources with the timing of consumption needs. This task is especially burdensome for poor households who have to piece together uneven cash flows using a handful of imperfect financial tools. A key role of access to predictable, reliable and convenient financial services is thus be to smooth consumption.

All the same, the links are not well-established empirically. People with more assets appear better able to smooth consumption, but it is unclear how much of that is self-insurance, how much is help from neighbors and relatives, and what the costs of the strategies are.  Households can go to great lengths to smooth consumption, often using expensive or risky alternatives (such as moneylenders or asking neighbors to hold cash), but we don’t have good measures of how much consumption smoothing affects household welfare. Even if average consumption over the year is unchanged, welfare can rise substantially if its distribution improves within the year. At present, we have little handle on relative magnitudes.

As to the reverse chain of causation, we have much further to go in describing the path from consumption smoothing to asset-holding and profitability. We have bits of evidence (e.g., Samphantharak and Townsend 2010 for Thai data), and need more on the ways that having a stable, predictable, reliable financial life carries over to investment choices.

The series has been compiled as a framing note on the FAI site now and will later appear as part of a collection of studies to be published in a forthcoming book.