PRELIMINARY ASSET-RELATED MEASURES OF POVERTY AND ECONOMIC STRESS by Andrea Brandolini *, Silvia Magri * andTimothy M. Smeeding ** 7th March 2009 Abstract Poverty is generally definedas income or expenditure insufficiency, but the economic condition of a householdalso depends on its real andfinancial asset holdings as well as on the possibility to access the credit market. This paper investigates measures of poverty which rely on indicators of householdnet worth. We review andassess three main approaches followed in the literature: income-net worth measures, asset-poverty, financial vulnerability. We provide fresh cross-national evidence basedon data from the LuxembourgWealth Study and the European Union Survey of Income andLivingConditions. JEL Classification : D31, I32. Keywords : poverty, vulnerability, income, net worth, financial stress. Contents 1. Introduction .....................................................................................................................2 2. Asset-relatedmeasures of poverty andeconomic stress: some definitions..........................5 2.1. Income-net worth measures .......................................................................................5 2.2. Asset-poverty............................................................................................................7 2.3. Financially vulnerable households...............................................................................8 3. Data issues .......................................................................................................................9 3.1. The LWS database.....................................................................................................9 3.2. EU-SILC.................................................................................................................12 4. Income-net worth measures............................................................................................13 5. Asset-poverty.................................................................................................................16 6. Households in arrears in their payments ..........................................................................17 6.1. Total housingcost ratio: an analysis of the extreme values of the distribution...........20 7. Discussion andconclusions.............................................................................................22 Appendix ............................................................................................................................35 References ..........................................................................................................................46 * Bankof Italy, Department for Structural Economic Analysis. ** Institute for Research on Poverty andLa Follette School of Public Affairs, University of Wisconsin, Madison. 1. Introduction 1 Researchers in social sciences have growingly emphasisedthe importance of moving beyondincome in the analysis of poverty andinequality, andmany have contendedthat assets andliabilities also play a central role of (e.g., Bourguignon 2006). The global crisis which has explodedin 2008has dramatically confirmedthis assertion. The collapse of stockmarket values has hurt the wealthy by causinglarge capital losses on their wealth holdings, but has potentially harmedall retirees whose pensions are paidby private intermediaries suffering considerable losses in financial markets. Plummetinghouse prices have hit almost all middle- class households for which ownedhomes account for the largest part of their personal wealth. Andit has zeroedout possibilities of consumingfrom increasedhousingvalues while also lesseningability to borrow against home equity for other uses. In turn, the lesser flexibility in housingdue to stalledsales has limitedgeographic mobility andlikely also the ability of younger adults to leave the family home. As the financial crisis has infectedthe real economy, job losses andfallingincomes have impairedthe livingconditions of many households, only in part offset by welfare states put under considerable stress (Atkinson 2009). They have also spreada sense of insecurity andvulnerability across families, which may have ledthem to reduce consumption andsave more to cope with sudden negative income shocks. These cursory observations all point to the close linkbetween stocks andflows andto the needto better grasp how net worth affects the economic position, real income flows, consumption possibilities andmore generally the economic well-beingof the households. The standardapproach, in research as well as policy analysis, is to define poverty as income, or expenditure, insufficiency relative to some minimally acceptable level. Many measurement aspects, prominently the choice between an absolute anda relative line, can be dealt with in different ways, but in both developedanddevelopingcountries a consumer unit is generally taken as poor if its income, expenditure or consumption falls below a predefined 1 Paper preparedfor the Joint OECD/University of MarylandInternational Conference “MeasuringPoverty, Income Inequality, andSocial Exclusion. Lessons from Europe”, Organization for Economic Cooperation and Development, Paris, 1617March 2009. The views expressedhere are solely ours; in particular, they do not necessarily reflect those of the Bankof Italy or the Institute for Research on Poverty. 3 poverty threshold. In the UnitedStates (US), for instance, a family andevery individual in it are consideredin poverty if the family’s total money income before taxes is less than a thresholdthat varies by family size andcomposition andis updatedannually for inflation (US Census Bureau2008). This measure has fallen from almost 50percent of the median income in the early 1960s to less than 30percent in the early 2000s (Blank2008; Smeeding2006). In the European Union (EU), the population at riskof poverty comprises all persons with equivalised disposable income below 60per cent of the median value in each country (European Commission 2008a). In Italy, Istat (2008) classifies as poor all households whose equivalised expenditure falls below a line set on the basis of per capita expenditure. These definitions account for householdwealth only through the cash income flow it generates in the current year. Income generally includes cash rent, interests, dividends and other returns on financial assets, possibly net of interest paidon mortgages andother householddebts. The inclusion of noncash imputedrent for owner-occupieddwellings is uncommon in almost all poverty measures, although it has been made mandatory in EU statistics since 2007.2 Realizedcapital gains andlosses are rarely includedin the income concept, especially when one considers the calculation of poverty statistics. The commonly usedincome-flow measures of poverty are correctly defined, but therefore fail to represent the full amount of resources on which a consumer unit can rely to cope with the needs of everyday life as well as in times of economic expansion andnow severe contraction. This practice is also somewhat at odds with the standardeconomic theory of consumption behaviour, where the budget constraint typically embodies current net worth together with the discountedvalue of current andfuture income streams. There are two main reasons why we may want to go beyonda purely income-based measure of poverty. First, consumer units with total earnings below the poverty thresholdmay have considerably different standardof livingdependingon the value of their net assets, includingbusiness assets as well as homes, private pensions andother financial wealth. A sudden income drop neednot result in lower livingconditions if they can decrease accumulated 2 Imputedrent tendto benefit a wide range of low to high income units, especially the elderly, but their overall effect may vary across countries, dependingon the level of housingprices andthe diffusion of home-ownership (FrickandGrabka 2003). 4 wealth, or can borrow. As stressedby Morduch (1994), the case of a householdwith current consumption below the poverty line but permanent income above it is radically different from that of a householdwhose fundamental earningcapacity has been impairedso that consumption andpermanent income both fall below the poverty line: for the former poverty only occurs because it cannot borrow against future incomes, whereas for the latter is has a more structural nature. On the other hand, income can be above the poverty threshold, yet a family can feel vulnerable because it lacks the financial resources to utilise in the case of an adverse income shock. Assets andliabilities are fundamental to smooth out consumption patterns when income is volatile; their insurance role is intertwinedwith the existence of and access to private or public insurance mechanisms. There is a second, somewhat deeper, reason to broaden our focus andembody wealth into the analysis of poverty andinequality. The chances in one’s life much dependon the set of opportunities open to a person which are, in turn, a function of the person’s endowments both intellectual andmaterial. Bowles andGintis (2002) show the importance of material wealth in the intergenerational transmission of inequalities both inter-vivos andas bequests/inheritances. Thus, whenever the policy objective is to level the playingfieldmore than to ensure a decent standardof living, wealth redistribution may be more effective than income redistribution in creatingequality of opportunity. This concern is at