The Persistence of Financial Distress

How persistent is financial distress? We answer this question using data on the proximity to debt limits, household debt-income ratios, and the probability that given a past default, a household experiences repayment difficulties. We show that all of these measures indicate that household financial distress is an extremely persistent phenomenon. To what extent can standard theory, as represented by a basic incomplete-markets model in which consumers face state contingent borrowing limits, arising from default risk capture this observed persistence of financial distress? We show that the answer is “not well†: None of a wide array of model variants is capable of capturing this aspect of consumer credit use. This is important, as these baseline models have informed policy discussions on how best to provide debt relief to mitigate consumer financial distress. We then show that a plausible extension of standard approach yields a better account for the persistence of financial distress.