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JES
34,2 Consumer over-indebtedness in
the EU: measurement and
characteristics
136
Gianni Betti
University of Siena, Siena, Italy
Neil Dourmashkin
Acacia Consulting, Luxembourg, Luxembourg
Mariacristina Rossi
University of Roma, Rome, Italy, and
Ya Ping Yin
Department of Accounting, Finance and Economics,
University of Hertfordshire Business School, Hatfield, UK

Abstract
Purpose – This paper seeks to measure and characterise the extent of consumer over-indebtedness
among the European Union (EU) member states.
Design/methodology/approach – The study evaluates alternative measures of over-indebtedness
on the basis of the permanent-income/life-cycle theories of consumption behaviour and adopts a
subjective approach in identifying over-indebted households on the basis of European household
survey data. It then investigates the main characteristics of over-indebted households.
Findings – The empirical results reveal that over-indebtedness was a significant problem across EU
member states in the mid-1990s. Moreover, an inverse relationship emerged between the extent of the
over-indebtedness problem and the extent of consumer borrowing across EU countries.
Research limitations/implications – Anecdotal evidence seemed to suggest that some main
factors behind over-indebtedness could be “market failure” on the credit market, the existence of
liquidity constraints and lack of access to formal credit markets. However, a comprehensive and
rigorous investigation of the extent and determinants of over-indebtedness can only be achieved
through analysis of more extended household data sets, particularly panel data.
Practical implications – The EU credit markets exhibited certain symptoms of “market failure”, on
the one hand, and there was also need for further financial liberalisation in the Southern European
countries, on the other hand.
Originality/value – The paper provides a first systematic evaluation of existing measures of
consumer over-indebtedness as well as the first EU-wide empirical investigation of the problem. It
should provide valuable information to the credit industry as well as financial regulatory bodies.
Keywords Consumers, Debt, European Union
Paper type Research paper

Journal of Economic Studies
Vol. 34 No. 2, 2007
pp. 136-156
q Emerald Group Publishing Limited
0144-3585
DOI 10.1108/01443580710745371
This paper is based on a study financed by the European Commission, DG Employment and DG
Health & Consumer Protection. The authors wish to thank Dr Vijay Verma of University of
Siena, Italy and International Social Research Ltd, London, for his considerable help with the
study. The authors bear full responsibility for the contents of this paper, which do not reflect the
views of the European Commission.
1. Introduction Consumer over-
The past two decades have seen widespread financial deregulation across the indebtedness in
Organisation for Economic Co-operation and Development (OECD) countries. Over the
same period, the behaviour of private consumption and saving in these countries has the EU
also changed significantly in several aspects. First, there was a marked acceleration in
the growth rate of consumer expenditure around the beginning of the 1980s in a
number of major industrial countries, led by the USA. Second, consumer borrowing 137
has increasingly become a common source of finance for private households. Third, at
the same time, the household saving ratio has fallen substantially[1].
The continued increase in consumer borrowing in much of the European Union (EU)
has caused an increasing concern among economic analysts and policy makers about
the extent of consumer over-indebtedness. Many developed countries regularly collect
and publish data related to consumer credit and indebtedness and there have been
some limited specific attempts to examine the extent of over-indebtedness in several
countries (e.g., Canada, Sweden and Finland). This paper aims to survey and evaluate
existing approaches to measuring this problem and to propose a method that is both
conceptually sound and practically feasible. Given the current state of the theoretical
framework and the paucity of empirical data, this study adopts a subjective approach
to quantifying and comparing the extent of consumer indebtedness and
over-indebtedness in the EU member countries around the mid-1990s. Moreover, the
study also aims to examine some characteristics of over-indebtedness across
household groups classified by income, age and family structure. Although the dataset
used for the empirical analysis is somewhat dated, the results of the current study
nonetheless have some general implications for future studies on the nature, extent and
possible determinants of consumer over-indebtedness.
The paper is organised as follows. Section 2 provides a survey of existing
approaches and indicators of consumer indebtedness. Section 3 lays out the conceptual
framework for examining over-indebtedness. In this light, Section 4 evaluates the
existing measures. Our proposed method is introduced in Section 5 and the
implementation and empirical findings are discussed in Section 6. Section 7 concludes
the paper.

2. Existing approaches
Despite the increasing concern about consumer over-indebtedness, there has been
hardly any concerted effort to study it systematically within individual countries or
across countries. The current understanding of the problem is largely based on a wide
range of ad hoc statistical indicators compiled by various public and private
organisations. Such indicators are usually based on either the gross stock of household
debt, net household liabilities, capacity to service and repay debt or sustainability of
consumption behaviour. The following list is a summary of the main indicators of
consumer indebtedness used by various organisations[2]:
(1) total stock of debt or debt per capita;
(2) proportion of households with net liabilities;
(3) consumption to income ratio;
(4) debt to income ratio;
(5) debt to asset ratio;
JES (6) number of bankruptcies/arrears;
34,2 (7) rate of credit delinquencies;
(8) average liabilities per bankruptcy; and
(9) number of households self-reporting to be over-indebted.

The use of the stock of debt alone, either in aggregate or per capita terms, ignores the
138 debtor’s capacity to service and repay debt. Therefore, most indicators are devised on the
basis of a comparison between the stock of debt and a measure of the capacity to repay,
the latter commonly being taken to be the stock of household assets or the level of
household current income. The above indicators are each consistent in principle with one
or more of three models of measuring consumer over-indebtedness (Ferreira, 2000)[3]:
(1) An objective, quantitative model that defines over-indebtedness to be an
unsustainable level of debt in terms of inability to service or repay the debt with
reference to a defined critical level. Indicators (3) to (5) above typically fall into
this category.
(2) A subjective model that classifies as being over-indebted all those who judge
themselves to be unable to repay their debts without jeopardising their
standard of living. Indicator (9) above is a typical example.
(3) An administrative model that records as over-indebted those cases of
non-payments of debt that have been officially registered or declared before a
court. Indicators consistent with this model include (6) and (7) above.
There is currently no general agreement on the appropriate definition of consumer
over-indebtedness, on how to measure it or on where to draw the line between normal
and over-indebtedness. This situation results partly from the intrinsic conceptual
difficulty and partly from the general lack of data on household income and
particularly household assets. In the next section, we discuss the currently dominant
conceptual framework for examining the consumption/saving behaviour that lays the
foundation for our empirical analyses.

3. Conceptual framework for examining indebtedness

3.1. Nature of consumer indebtedness
Since Modigliani (1966) and Friedman (1957), the life-cycle-permanent-income (LC-PI)
model has become the dominant conceptual framework for understanding the nature of
the consumption/saving behaviour of the representative consumer and, under special
circumstances, the aggregate consumption/saving behaviour in the economy[4]. The
simple LC-PI model is based on a set of well-known assumptions about the behaviour
of the representative consumer and the institutional setting, such as the consumer
being a rational, far-sighted planner and there being unrestricted access to consumer
credit[5]. As shown in Deaton (1992), at any particular point in time in the consumer’s
life span, optimal consumption is a constant fraction of discounted resources (human
and financial) in the current and future periods:
!
r X
1
ytþi
ct ¼ c ¼ þ At ð1Þ
ð1 þ r Þ i¼0 ð1 þ r Þtþi
where r is the real interest rate, yt is the income received at time t and At the asset level Consumer over-
at time t.
However, the absence of any uncertainty regarding future income is a major caveat of
indebtedness in
the original LC-PI model. Hall (1978) has subsequently introduced uncertainty regarding the EU
future income streams into the simple LC-PI model. Let u(ct) be the utility derived from
consumption ct, b the discounting factor for the utility in future periods, and r the real
interest rate. The first order conditions of the maximisation of the lifetime utility given 139
an intertemporal budget constraint give rise to the following Euler equation:



E t 1 þ r tþ1 bu0 ctþ1 ¼ u0 ðct Þ: ð2Þ
If the utility function is quadratic, the demographic factors are constant, and the
discount rate is equal to the interest rate, then optimal consumption evolves in the
following way:


E t ctþ1 ¼ ct ! ctþ1 ¼ ct þ utþ1 : ð3Þ
The above equation represents the stochastic generalisation of the simplest “stripped
down” life cycle model and depicts how the optimal level of consumption will change
from one period to the next. Although the consumer can no longer work out the optimal
consumption level in terms of lifetime resources, the optimal path is still expected to be
rather smooth. However, in contrast to the simple LC-PI model with income certainty
that implies a constant level of consumption over time, consumption smoothing now
states that the expected changes in consumption are zero. In other words, consumption
changes only when the consumer receives new information about his/her resources.
Moreover, if the consumer’s expectations are rational, that is, he/she utilises all the
information that is currently available to forecast the future efficiently, then any new
expected information should have been incorporated into the consumer’s decision
about his/her optimal consumption in all periods. Therefore, if there is any change in
consumption from one period to the next at all, the change cannot arise from any
expected information, such as current income or expected future income. The only
source of any change in consumption must be unexpected new information, and the
consumption change must be purely random. This prediction about how consumption
changes by Hall’s model is known as the Martingale Hypothesis.
More recent theoretical developments of the LC-PI model have experimented with
alternative specifications of the consumer’s utility function (e.g., the
constant-relative-risk-aversion (CRRA) functional form) and stochastic programming
methods to shed further light into the stochastic nature of the optimal consumption
path[6]. It is generally known that in the presence of uncertainty regarding future
income, there is no “closed-form” solution to the consumer’s optimisation problem.
Thus, the focus of the study of consumption behaviour has shifted from analysing the
determinants of the level of consumption to the examination of what factors cause
consumption to change from one period to the next. Following Hayashi (1997), the
change in consumption can be expressed as:



Dct ¼ s log b þ sr tþ1 þ sVart 1tþ1 =2 þ htþ1 ð4Þ
where s is the risk aversion parameter in the CRRA utility function, b is the discount
factor, r is the interest rate, Dct ; logðctþ1 Þ 2 logðct Þ, 1tþ 1 is error term between actual
JES and expected marginal utility in the next period, and htþ 1 is a collection of error terms
34,2 relating to the differences between actual and expected consumption and between
actual and expected interest rate in the next period. The above equation states that the
optimal consumption growth depends on the risk attitude, the discount factor, the real
interest rate in the next period, uncertainty about future income streams, and
unexpected shocks to consumption and the real interest rate in the next period. It is
140 worth noting that any expected changes in the conventional determinants of
consumption, such as income and wealth, have no impact whatsoever on the optimal
consumption growth.
Another point to note is the term Vart(1tþ 1): an increase in this term increases future
consumption growth, or in other words, current consumption must be lower and future
consumption must be higher. Since this term relates to uncertainty in the future, it can
capture the precautionary motive for saving. Compared with the results from Hall’s
model that rules out precautionary saving, the optimal level of current consumption is
lower than that in Hall’s model.
The implication of the LC-PI model for understanding consumer indebtedness is
that it is optimal for a consumer to be indebted under certain circumstances and at
certain stages of the life cycle, particularly the earlier stages. If there is no unexpected
change to total resources or expenditure requirements and in the absence of any
inter-generational transfer mechanism, the consumer’s current assets will be exactly
balanced by the present value of his/her debts over all future periods. This
intertemporal budget constraint will hold and the consumer will never be
over-indebted. Moreover, the existence of future uncertainty and the precautionary
motive should provide further safeguard against over-indebtedness.

3.2. Nature of consumer over-indebtedness

The only explanation of consumer over-indebtedness that is consistent with the LC-PI
model is unexpected adverse shocks to the consumer’s expenditure requirements
and/or total resources, particularly future income streams[7]. In the real world, both
positive and negative unexpected events occur to employment, interest rates, the value
of household financial and fixed assets, health, family structure, and hence to both
household resources and basic expenditure requirements. There are a number of
mechanisms that exist to protect a consumer from becoming over-indebted once
negative shocks occur. Such mechanisms typically include:
.
self-insurance through precautionary saving;
.
market insurance through debt-financing and debt-rescheduling schemes and
the consumer’s participation in market-provided insurance schemes against
unemployment and long-term illness;
.
social safety network; and
.
informal insurance mechanisms such as inter-generational transfers and family
support.

Nevertheless, due to uncertainty, moral hazard and information problems, such

mechanisms are inadequate or incomplete for accommodating the impact of negative
shocks of a sufficient scale. Consequently over-indebtedness can arise: the consumer’s
current assets are no longer sufficient to offset the present value of future debts. In
such a situation, the predetermined optimal consumption path is no longer sustainable Consumer over-
and the consumer would be forced onto a lower consumption path that could mean a indebtedness in
severe disruption to the pre-established standard of living.
This type of over-indebtedness does not arise from irrational consumer behaviour in the EU
the conventional (Bernoullian) sense, but the nature of uncertainty. Therefore,
over-indebtedness could be regarded as a natural phenomenon that inevitably touches
a proportion of the population at any time and in any economic circumstance. An 141
over-indebted consumer could still manage to meet his/her debt-servicing obligations
but only by suffering a substantial shock to the established normal level of
consumption. Any indicator of over-indebtedness based on defaults or legally declared
bankruptcy omits people in this situation.
The above analysis precludes the possibility of over-indebtedness arising from
within the consumer’s consumption/saving plan. However, alternative theories of
consumer behaviour allow for the possibility of the consumer’s consumption/saving
plan to be intrinsically unsustainable, due to various factors including consumer
perception problems; limitations to rationality or irrational behaviour of consumers
(e.g. myopia or behavioural inertia); or market imperfections (e.g. the liquidity
constraint). There is no general model that explains the mechanisms of
over-indebtedness arising from these factors; nor is it clear in what way the implied
consumption/saving path would differ from the smooth path associated with the LC-PI
model. Given the lack of a rigorous theoretical framework for understanding such
“irrational” aspects of the consumption plan[8], the focus here is to make a modest
attempt to discuss qualitatively various circumstances and factors that could lead to
sub-optimal or “irrational” consumption/saving decisions.
In the LC-PI model, consumer taste, risk attitude and time preference are
represented by predetermined parametric values and the representative consumer’s
optimal consumption/saving plan is derived independently of other agents’ plans and
specific contexts (e.g., family structure or social and economic groups within which the
consumer falls). However, there is a large literature on the endogenous or
interdependent nature of preference formation and consumption/saving decision, e.g.
the relative income hypothesis by Duesenberry (1952) and the prospect theory that
explains seemingly “irrational” decision making under uncertainty (Kahneman and
Tversky, 1979). According to the prospect theory, for example, in situations where the
outcome of a decision is unknown or uncertain, people’s optimistic inclination or
positive rather than negative outcomes unduly influence their decision making. Others
have argued that individuals’ habits and preferences are constantly evolving and social
institutions and information provision affect this process (see, Hodgson, 2003; Ekelund
et al., 1995). Such an evolving and inter-dependent nature of preference formation and
decision making could generate behavioural inertia or inappropriate risk attitude and
time preference, which in turn could lead to downward rigidity in consumption levels,
excessive risk-taking or myopia. Myopic consumers may mismanage resources, are
more susceptible to external shocks and hence fall victims to over-indebtedness more
readily than consumers who are far-sighted planners. As Krusell and Smith (1998)
illustrate, although the introduction of idiosyncratic risks and incomplete insurance
markets does not generate significantly different results from those of the standard
LC-PI model, the aggregate consumption behaviour of myopic (or “hand-to-mouth”
type) consumers is markedly distinct from that of the far-sighted consumers.
JES An optimal planner could also be frustrated by the existence of a “liquidity
34,2 constraint” when the consumer is not permitted to borrow when current income is
temporarily below the permanent-income level. Although the existence of a liquidity
constraint may lead to “under-borrowing” when income is expected to rise, it can also
exacerbate the debt problem when negative shocks occur as the consumer’s potential
ability to smooth consumption is severely curtailed.
142 If one or more of these factors is present, individual consumers’ consumption/
saving plans may be non-optimal and become unsustainable even with negative
shocks of a relatively modest scale. Although it is unclear how the consumption path
looks like under such circumstances, it is expected to be subject to larger variability
than the smooth path associated with the LC-PI model.

4. Evaluation of existing measures

We are now in a position to evaluate the existing indicators in the light of the above
discussion of the nature of consumer indebtedness and over-indebtedness.

4.1. Administrative/legal measures

These measures are the by-product of official/legal functions and examine all cases
where non-payment of debts have been registered officially or declared before a court.
They record the various stages of the legal procedure that deals with consumer debt
default, often starting with the initial deposition with the competent authorities of
notification that the consumer is in arrears. Since the administrative model is linked to
a specific judicial system, the variations in the data between EU member states
collected on this basis are very considerable. Moreover, as the administrative model
deals with cases of actual realisation of consumer bankruptcy or debt default but does
not consider cases of severe disruption to the established consumption/saving pattern,
it is a measure that considers the outcome rather than the situation of indebtedness.
For both of these reasons, this is at best a partial measure of indebtedness.

4.2. The objective measures

There is currently no unified approach to constructing objective measures of consumer
indebtedness. The existing “objective” indicators are based on the notion of
unsustainable spending behaviour (consumption/income ratio) or unsustainable level
of debt (debt/asset ratio) or inability to service debt (debt payment/income ratio). Such
indicators are widely used by commercial credit institutions that rely largely on micro
data and central banks that rely on both macro and micro data. However, there is no
established methodology for determining the critical level of these ratios beyond which
a consumer/household is defined to be over-indebted.
Insofar as the consumption/income ratio is concerned, an “excessively” high value
(e.g., above unity) is generally regarded as an indication of over-indebtedness.
However, as the LC-PI model suggests, a high consumption/income ratio is normal
among the young and the retired. Moreover, as is argued above, over-indebtedness is
more likely to be observable by a low ex-post consumption/income ratio than a high
one ex-ante.
The most commonly used indebtedness indicators refer to two different aspects of
debt: the stock of debt and the flow of debt payments. The debt/asset ratio considers
the overall stock of debt that is compared with the household’s total stock of assets.
This first measure captures the overall net worth or net debt of a household. However, Consumer over-
this measure gives no indication of households’ potential difficulty in servicing the indebtedness in
debt in each period using their resources available at that time. In contrast, a second
measure compares income (the flow of positive resources of a household) with debt
the EU
payments (the flow of debt service that households potentially have to pay in order to
repay the total debt stock) in each debt payment period. This measure can be regarded
as the debt-servicing burden to households. The problem with these indicators is 143
apparent: by confining households’ capacity to service debt to current resources only,
they may misinterpret a household as over-indebted whereas in fact it behaves
“rationally” towards the risk of indebtedness.
Naturally a better measure is to replace the consumer’s current sources by his/her
lifetime resource as his/her capacity to pay. However, even if we can obtain a practical
measure of lifetime resources as a measure of capacity to pay, there is still the problem
of establishing the critical level of indebtedness beyond which a consumer is defined to
be over-indebted. Since the level of consumption is smooth but the future income
stream changes, the implied optimal debt/resource ratio will vary over the consumer’s
life cycle, implying that the threshold level also varies over the life cycle. A further
difficulty in establishing the threshold debt/resource ratio arises from the presence of
uncertainty. When lifetime resources are uncertain, the optimal consumption path and
the optimal indebtedness path are also uncertain. There is no “closed-form” solution to
the consumer’s optimal plan in terms of obtaining the optimal levels of consumption or
indebtedness over time. In other words, there is no unique path that the consumer can
follow to optimise his/her consumption and debt[9]. In this situation, it is unclear how
the optimal or threshold debt/resource ratios can be calculated at all. Even if a critical
level of indebtedness can be established, it is likely to fluctuate widely through the life
cycle of an individual consumer.
This indeterminacy is even more acute at the macro level. While lending institutions
can take household age and other measurable personal characteristics into account to
determine credit-worthiness to a (subjectively) reasonable approximation,
policy-oriented aggregate measures generally establish indebtedness thresholds for
consumers as a whole. However, people of different ages have different levels and
compositions of wealth and debt. Moreover, having different planning horizons, they
have different time preferences and different propensities to consume out of current
income and wealth. Therefore, different age cohorts will have different optimal
consumption or wealth/debt accumulation/reduction plans. Other heterogeneous
household characteristics and behaviour patterns such as the inter-dependence of
preferences and habit formation will further complicate individual plans. Therefore,
there is no simple aggregate consumption/saving pattern and hence no simple
aggregate measure of “normal” or “excessive” consumer indebtedness for the economy
as a whole. A simple aggregate measure of consumer indebtedness that covers all age
groups together does not contain much absolute information about how much
consumers as a whole are indebted. Modigliani (1966) first pointed out this fallacy of
composition in his study of the aggregate consumption function. It is no surprise that
the use of different “objective” aggregate indicators of consumer indebtedness in the
USA around the mid-1990s gave contradicting results.
JES 4.3. The subjective model
34,2 The subjective approach considers that individual households are the best judges of
their own net debt/wealth position. Such an approach was adopted in a study on the
indebtedness situation of Finnish households. Because such model measures consumer
indebtedness on the basis of micro survey-based information, it also makes the
assumption that consumers are generally honest in revealing their debt/income
144 situation. As we discuss in the empirical analysis, such an assumption can be partially
tested against the LC-PI model predictions. It is possible that the subjective model may
be an appropriate operational implementation of an LC-PI approach using data that are
relatively easily available.

5. The proposed subjective approach

Current economic theory cannot provide any clear guidance on how an “objective”
measure of consumer over-indebtedness can be constructed. Given the conceptual
difficulty and the lack of data on household income and assets in practice, for the
current study, we have to adopt a subjective approach to the measurement of consumer
over-indebtedness. Nevertheless, our empirical work experimented with objective
measures using household survey data sets for the EU. Because of the lack of
robustness in the results, the “objective” approach had to be abandoned (see Betti et al.,
2001, for a more detailed discussion of the “objective” approach). The remaining
sections discuss details of the subjective approach and the empirical results.
The main sources of micro-data available for the present study include the
European Community Household Panel Survey (ECHP) and the (European) Household
Budget Surveys (HBS). Details of the data sets and how differences in the two data sets
are reconciled are discussed in Betti et al. (2001). In our study, we analyse the two data
sets using an approach that aims at developing comparable “subjective” measures of
indebtedness and over-indebtedness following the LC-PI line of enquiry. We define
indebted households as those that have some consumer debt (e.g., consumer credit
borrowing but excluding mortgages). Over-indebted households are identified as those
that expressed difficulty or serious difficulty in making debt payments, including
credit debt, mortgage payments and hire purchase instalments as recorded in
household surveys. We consider that these households have weighed their debt level
against their current income, liquid assets plus expected earnings and have decided
that the debt service and repayment exceed what the households can pay without
reducing their other expenditure below their normal minimum levels. In other words,
the debt has become unsustainable. Although we cannot determine the accuracy of the
survey information on an a priori basis, there does not appear to be a substantial group
of people who attempt to hide debt-related difficulties from household surveys,
particularly since the information required is largely qualitative. Moreover, our
analyses can provide some guidance on the ex post assessment of the general quality of
the information contained in household surveys, as we discuss in more detail in a later
section.
We derived estimates for the numbers and proportions of over-indebted households
for those EU member countries for which sufficient data is available for the reference
year, 1996. We also examined how subjective over-indebtedness is distributed across
different household groups classified by various characteristics, such as income, age,
and family structure. Our objective was to verify whether the structure of consumption
and indebtedness shown in the data support the predictions of the LC-PI model and Consumer over-
whether any discrepancy can be explained. If the LC-PI model is a good description of indebtedness in
the data, we would expect to observe the following characteristics of consumption and
indebtedness: the EU
. The proportion of indebted consumers declines with age.
.
There is no apparent link between income level and indebtedness after
controlling for the age effect, as a rational consumer would consume at a level
145
that is commensurate with his/her permanent income or lifetime resources
whatever his/her current level of income is.
. There is a “U-shaped” age profile of consumption/income ratio. Since the
consumption stream is relatively stable but the income stream has a hump shape,
the consumption to income (C/I) ratio will follow a “U” shape over the life cycle.
In absolute terms, this ratio should be above unity at both the beginning and the
end of the life cycle, reflecting the borrowing and dissaving that characterise
these two stages of the life cycle.
.
Over-indebtedness cannot occur in the absence of unexpected shocks to or a
myopic view of resources or consumption.

In the real world, such characteristics will be complicated by departures from the LC-PI
assumptions. The first complication arises from uncertainties in the economy and
household circumstances. Hall’s extended LC-PI theory does not support the belief that
any age or income group is particularly susceptible to over-indebtedness arising from
negative macroeconomic shocks or uncertainties regarding household circumstances.
Thus, uncertainties in the economy or household circumstances per se should not cause a
strong correlation between the proportion of households being over-indebted and the age
or income level of the households. If the data reveal a strong correlation for a particular
income or age group, then it is worth investigating the underlying factors more closely.
Another complication is the existence of the liquidity constraint. Households with
low and/or uncertain incomes often have limited access to credit or rapidly exhaust the
credit that they have. Households in this situation are particularly vulnerable to
negative shocks. It is expected that liquidity constraints lower the C/I ratios for the
younger cohorts in particular as borrowing to finance consumption or asset acquisition
makes up a greater proportion of younger age groups” current resources. The U-shape
of the profile of C/I ratios across age groups will therefore be flattened in the presence
of a liquidity constraint.
Perfectly myopic behaviour can mean one of two things: extreme risk aversion
through absolute avoidance of debt or extreme risk taking by maximising current
consumption through debt at the expense of both future consumption and the ability to
resist negative shocks. High-risk myopic behaviour will lead to higher C/I ratios among
young cohorts. In this situation, the C/I ratio then declines compared with other
households in the same age group. Old-age cohorts will have lower stocks of assets and
thus lower consumption and a lower C/I ratio. Thus, the U-shape of the age profile of
the C/I ratios tends to be accentuated by the presence of high risk-taking myopic
behaviour. Nevertheless, high-risk myopic behaviour does not necessarily imply
over-indebtedness: it simply gives less weight to future consumption or risk. However,
if it is the result of unrealistic expectations about the future, then these will probably
JES fail to be realised and the consumer will become over-indebted. In contrast, risk-averse
34,2 myopia will flatten the U-shape of the age profile of the C/I ratios in the same way as
the “liquidity constraint”: it is voluntary submission to this constraint.
Having discussed the expected LC-PI characteristics of consumption and
indebtedness, these are now used as the benchmark against which our empirical
results are compared, interpreted and validated.
146
6. Empirical results
Our empirical results cover the following aspects:
.
percentage of indebted and over-indebted households among total households;
.
distribution of indebted and over-indebted households by equivalised household
income and age of head of household;
.
consumption/income ratios by income and age groups;
.
consumption/income ratios by age group with different household structure; and
.
over-indebtedness of one-adult households with children.
6.1. Summary of indebtedness and over-indebtedness in the EU
Table I provides a summary of the situation of consumer indebtedness and
over-indebtedness across the EU member states. The year 1996 was the latest for
which we had comparable and consistent data sets for most of the EU member states.
Table I shows that, in 1996, the situation of indebtedness and over-indebtedness
differed substantially across individual member countries. The first column shows the
proportion of households that had consumer debts (excluding mortgages). The second
column reports the percentage of such households that were identified to be
over-indebted. The final column shows the proportion of over-indebted households
among all households. In general, we can classify these countries into high-borrowing,
medium-borrowing and low-borrowing countries according to the figures in the first
column. The high-borrowing countries include Denmark, the UK, Luxembourg,

Households with consumer Proportion of households Over-indebted households

debt as percentage of total with consumer debt that as percentage of total
households are over-indebted (%) households

Austria 15 79 12
Belgium 18 64 15
Denmark 43 45 19
Germany 22 72 13
Greece 9 96 49
Spain 19 94 23
France 33 42 15
Ireland 29 77 25
Italy 8 88 11
Table I. Luxembourg 35 29 12
Summary of Portugal 13 84 13
indebtedness and Finland 29 65 21
over-indebtedness in the UK 34 50 18
EU, 1996 EU-15 23 68 16
France, Ireland and Finland, with between 30 per cent and 48 per cent of the Consumer over-
households having consumer debts other than mortgages. The low-borrowing indebtedness in
countries include Italy, Greece and Portugal with around 8 per cent to 13 per cent of the
households having consumer debts. The remaining countries are medium-borrowing the EU
countries, with 15 per cent to 30 per cent of households having consumer debt.
It is clear that there was a significant over-indebtedness problem among the
households with consumer debts in most of the EU countries included in the study. In 147
all but three countries (Luxembourg, France and Denmark), over half to nearly all such
households reported to have serious debt repayment problems. Moreover, this
over-indebtedness problem seems to be severer where credit borrowing is more
restricted. For example, in Denmark, where 43 per cent of households had consumer
debts, 45 per cent of such households were over-indebted. In Greece, in contrast, where
only 9 per cent of households borrowed, 96 per cent of them had a serious problem with
debt repayment. Therefore, there appears to be a significant problem of market
imperfection in the consumer credit market across the EU member states. The modern
financial instrument of consumer credit seems to be a double-edged sword. On the one
hand, if used sensibly, it could improve household utility by smoothing consumption
over the life cycle. On the other hand, abuse of the instrument could lead to financial
stress and loss of utility. The proportion of those households that borrowed and then
found themselves facing difficulties in repaying the debts seems to be extraordinarily
high across the EU countries. The underlying reasons for this phenomenon certainly
warrant further investigation.
Turning to the final column, it is clear that the over-indebtedness problem was still
quite significant among all the households, as the proportion of over-indebted
households ranged from 11 per cent (Italy) to 49 per cent (Greece). There again appears
to be a weakly inverse relationship across countries between the proportion of indebted
households and the proportion of those households that were over-indebted. In
Denmark, where 43 per cent of households had credit debts, 19 per cent of households
were over-indebted. In Greece, where only 9 per cent of households declared a credit
debt, 49 per cent of households had a serious problem with debt repayment. Although
it is not our intention to offer a rigorous explanation of the problem of
over-indebtedness, we make the casual observation that where the consumer credit
market is restricted, only those households who have a pressing need for funds will
borrow. These households are more prone to debt difficulties. It appears that the use of
debt as a financial instrument to smooth consumption over time, together with a
developed consumer credit market, may be a factor in lowering the proportion of
indebted households that have difficulties in servicing their debts.

6.2. Indebtedness by income and age groups

In these estimations, we group households by equivalised income (income adjusted to
take into account the size and composition of the household) and by the age of the
oldest member or ”head” of household. The empirical results are shown in Figures 1-4.
Figure 1 shows the percentage of households that have debts by income quintile. The
proportion of households with loans tends to decrease in most countries as income
increases. However, this does not hold for all countries. For the low- and
medium-borrowing countries, the proportion of borrowers is fairly constant across
income groups. This evidence suggests that low-income households in countries with
JES
34,2

148

Figure 1.
Proportion of households
that have loans by income
quintile

Figure 2.
Proportion of indebted
households that are
over-indebted by income
quintile

more liberalised credit markets have a higher propensity to borrow than low-income
households in countries with less liberalised credit markets, as access to credit for
households in the former countries is easier. However, it is noted that a significant
proportion of the low-income households falls within the young age group. After
allowing for the impact of age, the proportion of indebted households is quite evenly
distributed across the income groups in all countries, as suggested by the LC-PI model.
Figure 2 shows the percentage of those indebted households that are over-indebted by
income quintile. One main finding is that there are significant variations of
over-indebtedness by income groups across member states. High-borrowing countries
 Consumer over-
indebtedness in
the EU

149

Figure 3.
Proportion of households
having consumer loans by
age

Figure 4.
Proportion of indebted
households that are
over-indebted by age
group

(e.g., UK, Luxembourg, Denmark and France) tend to have lower proportions of
over-indebted households across all income groups than low-credit countries. This may be
because more households face a liquidity constraint in countries where the consumer debt
market is less liberalised. As discussed above, the existence of liquidity constraint will
limit consumers’ ability to smooth consumption, particularly in the presence of negative
shocks and changing personal/household circumstances. Another significant finding is
related to the problem of market imperfection as we discussed above. In most countries
and particularly in high-borrowing countries, households with high incomes who borrow
JES are noticeably more likely to be over-indebted than low-income households. This evidence
34,2 contradicts the LC-PI model prediction, which suggests that over-indebtedness is
invariant across income groups. Since high-income households enjoy a much better access
to consumer credit than low-income households, the market imperfection may have arisen
from either the supply of credits by lending institutions or the behaviour of high-income
households or both. Again, a clear understanding of the nature and causes of market
150 imperfection can only be gained through further investigation.
Figure 3 shows the proportion of indebted households by age. In the youngest age
group, the proportion of borrowing households ranges widely from Italy and Greece on
14 per cent to Denmark on 64 per cent. In all countries, consumer borrowing then
declines with age: the slope is steeper for the countries that have higher proportions of
young households with loans. All countries show that fewer than 10 per cent of
households whose “head of household” is 65 years or older have loans. This pattern is
consistent with the LC-PI hypothesis. However, the proportion of young households
that borrow is significantly lower in low-borrowing countries than in high-borrowing
countries. It would thus appear that restrictions on borrowing fall disproportionately
on young families.
Figure 4 shows the percentage of over-indebted households by age groups. There does
not seem to be any common upward or downward trend in the age over-indebtedness
profile. The LC-PI prediction of a lack of a relationship between loan problems and age
appears to be largely borne out by these results in most of the countries. Nevertheless,
there seems to be a declining trend with age for those countries with greater levels of
consumer borrowing. As we noted in Figure 3, the proportion of households over 64 years
having loans is small. In Figure 4 we see that the probability of having difficulties with
loan payments is similar to other age groups. However, for these households, difficulties
with over-indebtedness are compounded by the fact that their future prospects of being
able to escape these problems are far more limited than those of the younger cohorts.

6.3. The consumption/income ratio and indebtedness

We now add a further element from the LC-PI analysis: the consumption/income ratio.
Figures 5 and 6 illustrate the consumption/income ratio for households analysed by
income quintile and by age. Superficially, consumption becomes a smaller part of
income as income increases and in all countries the lowest income quintile group
consumes more than its income. Variations in the C/I ratios across income quintiles are
largely explained by the age effects: a large proportion of low-income households tends
to fall within the young cohorts. Thus it is more revealing to examine the age profile of
the C/I ratios, which is shown in Figure 6. The U-shaped curve that is expected from
the life-cycle analysis is only apparent in countries with well-developed consumer
credit markets, such as Denmark, Sweden, the UK and The Netherlands. Countries that
have limited consumer borrowing (e.g. Greece, Spain and Portugal) do not show any U
shape in the age profile of the C/I ratios as these tend to decline with age. Moreover, the
C/I ratios in the latter group of countries are significantly higher across all age groups
than those in the high borrowing group of countries. This result is consistent with our
conceptual analysis that consumers in countries with more restricted credit markets
have to rely on current income as the main source or even the only source of finance for
their current consumption.
 Consumer over-
indebtedness in
the EU

151

Figure 5.
Consumption/income ratio
by income quintiles

Figure 6.
Consumption-income ratio
versus age

We next examine whether there is a substantial difference between the

consumption/income ratio of the over-indebted households and that of other
households. We observe a common pattern across member countries: the
over-indebted households have a lower consumption/income ratio than that of the
normal households. In absolute terms, even though their income level is not much
different from that of the average household, their level of consumption appears to be
significantly lower than that of the average household. Thus it appears that
over-indebted households have had to reduce their consumption to repay their debts.
JES This vindicates our earlier analysis that using a high consumption/income ratio as an
34,2 indicator of over-indebtedness could be totally misleading.

6.4. Analysis of a contrasting group: “the under-indebted” households

Our empirical analysis has shown clear evidence to indicate the existence of a liquidity
constraint on a large proportion of households in low-borrowing countries. To
152 investigate this issue further, we examined a contrasting group of households that did
not have loans but nevertheless reported in the ECHP that they had difficulty in
making ends meet. We observe that these households show a very high
consumption/income ratio and more importantly, a low level of current income in
absolute terms. In particular, it is very clear that, unlike the “over-indebted” group, the
resources earned by this group are, in every country and in almost every age group
(except Greece over 64), considerably lower than both the population as a whole and
the over-indebted group.
The under-indebted households have a low level of consumption in absolute terms
and consume all or more than they earn (possibly resorting to intergenerational
transfers, other informal or unreported sources of credit). These families could be
characterised as facing a liquidity constraint and are excluded from the loan market,
perhaps as a result of their low level of income being used as a signal of their poor
capacity to repay debts. Putting together the group’s low income and high
consumption/income ratio, we assert that members of this group are much more likely
to be in poverty than the “over-indebted” group as a whole. Their wellbeing would be
potentially improved if they could also benefit from the access to the financial
instrument of debt financing to the same extent as the other groups.
Figure 7 shows for each country the proportion of households that are considered as
“over-indebted” and “under-indebted”. The figure suggests that under-indebtedness is
also significant in all the countries. Moreover, the general pattern of
under-indebtedness is very similar to that of over-indebtedness: the extent of
under-indebtedness (and thus liquidity constraint) is also higher in countries with less
liberalised credit markets than in countries with more liberalised markets.

Figure 7.
Proportion of over- and
under-indebted
households
6.5. Analysis of single-parent household with young children Consumer over-
The final part of our empirical investigation concerns the examination of a particular indebtedness in
household type that has been identified by other studies as having a higher propensity
to be over-indebted: single parents with young children. We identify households that the EU
have single parents with at least one child aged less than 16. Figure 8 shows for each
country the proportion of households in this category that are defined as over-indebted
and under indebted. The main result of this analysis is that among this group of 153
households the proportion of over-indebted plus under-indebted ranges from about 35
per cent (Italy) to over 90 per cent (Greece). In the overall sample of households
(Figure 7) the comparable results range from about 20 per cent (Denmark) to about 70
per cent (Greece). This suggests that single parents with young children appear to be
particularly vulnerable to financial problems, whether or not they have access to debt.

7. Conclusion
Having evaluated and experimented with a number of indicators of household
over-indebtedness, we have adopted a subjective approach using information from EU
household surveys. Our empirical results do seem to be broadly consistent with the
LC-PI model predictions and our conceptual analysis. This lends support to both our
assumption that households are generally honest in reporting their debt situations in
household surveys and our subjective approach.
Our empirical findings suggest that over-indebtedness was a significant problem
across the EU countries in the mid-1990s, although the extent of over-indebtedness
varied considerably. There is clear evidence to support the existence of a liquidity
constraint, particularly in European countries where consumers have less access to
credit market. In these countries, over-indebtedness seemed to be severer and more
widespread than in countries with accessible consumer credit markets. Therefore,
further financial liberalisation in these countries could potentially benefit a significant

Figure 8.
Single adults with
children:
over-indebtedness and
under-indebtedness
JES proportion of households, particularly young households that might be liquidity
34,2 constrained.
In general, over-indebtedness affects all age groups and all income groups. Low
income cannot be used as evidence that over-indebtedness exists. In fact, in a number
of countries, particularly those with wider access to consumer credit, it is the
high-income, young-age groups that are more likely to be over-indebted. This evidence
154 could suggest the existence of market imperfection in the consumer credit market,
which warrants further investigation. It is worth noting that such groups of
households are usually expected to have a greater capacity to service debt and their
debt levels may be more sustainable compared with some other groups, e.g.
low-income, old age households. Therefore over-indebtedness is not necessarily a good
indicator of the extent of poverty in society. Nevertheless, over-indebtedness and
poverty are inescapably linked. The over-indebted are very similar to the
non-over-indebted in their income conditions but they consume a markedly smaller
proportion of their income. As a result, over-indebtedness can be a factor, even a major
factor, in creating and sustaining poverty, particularly among low-income, old age
households and single-parent households with young children.
In contrast, the under-indebted households are predominantly though not always
from low-income groups. This group of households has a higher consumption/income
ratio than other households and presumably constitutes a significant proportion of the
“hand-to-mouth” type of households. We find that there are proportionately more of
these households in countries where there is a lower level of consumer lending. One
explanation of this group’s apparent struggle to make ends meet is that many
households in countries with restricted access to formal channels of consumer credit
are severely constrained in their ability to borrow and to smooth out fluctuations in
income and other adverse impacts. Households in this group, to the extent that they are
creditworthy, could thus benefit from more accessible consumer credit.
Finally, our empirical results tend to confirm the finding by other studies that
single-adult households with children are particularly likely to be excluded from the
credit market and, even if they do have access to consumer credit, are more likely to
have difficulty in paying back the loans.

Notes
1. For empirical evidence on the aggregate consumption and saving behaviour over the past
two decades, see Bayoumi (1993) and Alessie et al. (1997) for example.
2. These indicators are usually adopted by both public and private institutions in unpublished
reports to government bodies, on-line central bank publications or business briefings.
3. Here we have adopted the same terminology used by Ferreira, but we have clarified the
distinctions among these models much further.
4. Deaton (1992) and Blanchard (1985) have discussed the issues regarding aggregation over
goods and agents.
5. In order to make the model results analytically tractable, the LC-PI model makes the typical
technical assumptions about the consumer’s objective function and the (sub-) utility function,
such as intertemporal separability and concavity. There is also a subtle difference between
the LC model and the PI model in their treatment of the planning horizon – it is finite in the
former and infinite in the latter (see, for example, Deaton (1992) and Hayashi (1997) for a
fuller discussion).
 6. Examples of recent studies include Caballero (1990), Weil (1993) and Mason and Wright Consumer over-
(2001).
7. The literature seems to focus exclusively on the uncertainty regarding future income
indebtedness in
streams, although in reality the value of other components of total resource such as the EU
accumulated financial and fixed assets is also uncertain.
8. Although some aspects such as the endogenous formation of consumer preferences can be
readily incorporated into the consumer’s utility function (see, e.g. Deaton, 1992; Kam and 155
Mohsin, 2006).
9. In technical terms, the optimal consumption level follows a “random walk”.

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Corresponding author
Ya Ping Yin can be contacted at: y.p.yin@herts.ac.uk

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