Earn More Tomorrow: Overconfidence, Income Expectations, and Consumer Indebtedness

By Antonia Grohmann, Lukas Menkhoff, Christoph Merkle, and Renke Schmacker

Overborrowing is a problem in many advanced economies. According to the OECD, between 5 and 10 percent of households are regarded as overindebted. Too much debt is not just problematic for individual households, but it can also have negative consequences for the economy as a whole. Nevertheless, the reasons for consumer overborrowing are not well understood.

According to neoclassical economic theory, overindebtedness should only occur as a result of economic shocks that exceed the shock absorbing capacity of a household, such as unemployment, divorce, or death of a family member. However, this does not explain the high level of overindebtedness observed in some countries. One possible contributing factor is overconfident income expectations: if people expect their income to rise in the future, they may overconsume early in life, thus accumulating too much debt, even without experiencing economic shocks.

In this paper, BCCP Fellows Antonia Grohmann, Lukas Menkhoff, and Renke Schmacker, together with their co-author Christoph Merkle, perform a lab experiment to study the impact of overconfident income expectations on borrowing decisions. In the experiment, subjects can earn money by outperforming others in a general knowledge quiz. Income expectations are exogenously manipulated by priming subjects with hard and easy quiz questions. Before income is realized, subjects can purchase products on loan. The results show that subjects with higher income expectations are more likely to take out debt than participants with low income expectations. The authors provide additional survey evidence for a link between overconfidence and debt taking using the innovation sample of the GSOEP.

The full paper is available as CRC TRR 190 Discussion Paper No. 152 (Open access pdf download).