Rising indebtedness and temptation : a welfare analysis

Is the observed large increase in consumer indebtedness since 1970 beneficial for U.S. consumers? This paper quantitatively investigates the macroeconomic and welfare implications of relaxing borrowing constraints using a model with preferences featuring temptation and self-control. The model can capture two contrasting views: the positive view, which links increased indebtedness to financial inno- vation and thus better consumption smoothing, and the negative view, which is associated with consumers’ overborrowing . I find that the latter is sizable: the calibrated model implies a social welfare loss equivalent to a 0.4 percent decrease in per-period consumption from the relaxed borrowing constraint consistent with the observed increase in indebtedness. The welfare implication is strikingly dif- ferent from the standard model without temptation, which implies a welfare gain of 0.7 percent, even though the two models are observationally similar. Although both models imply welfare gains from a tighter borrowing limit than in 2000s, theoptimal borrowing limit is tighter according to the temptation model, as a tighter borrowing limit helps consumers avoiding overborrowing.