GUEST AUTHOR BLOG by Michael S. Barr, a CNBC contributor and author of "No Slack: The Financial Lives of Low-Income Americans."
These are tough times for most American households.
The financial crisis wiped out savings and home equity, cut millions of jobs, and shuttered businesses. And the financial system often seems to benefit the wealthy while providing little solace to the broad middle of our country.
For those further down the income scale, the financial system often does even worse—with banks often shunning low-income clientele or charging high overdraft and other fees, and prepaid debit cards, a potential alternative to bank accounts for some individuals, often loaded up with hidden and high cost fees themselves.
Low- and moderate-income families must deal with abrupt fluctuations in income and expenses that occur because of job changes, instability in working hours, illnesses and emergencies, or divorce. Because these families have limited access to savings, credit, or insurance, even small income or expense fluctuations may create serious problems in their ability to pay rent, utilities, and other bills.
That is because many families often lack the financial “slack” that can permit other households to ride out tough times. Financial slack can be thought of as breathing room provided to households by the ability to make relatively costless adjustments to align resources with needs. The costlier or more difficult these adjustments are, the less slack these households can be said to have. Some amount of slack can be generated internally (as by increasing work or reducing expenditures), but generally speaking, households need to use the financial system to facilitate slack (as by holding savings, accessing credit, or buying insurance).
It’s not just that incomes are often too low to meet expenses, although that is certainly the case. It’s also that these families often have only limited access to the sound financial products that could help them save—and generate financial slack to deal the volatility in their lives.
Using data from a survey I designed and that was administered by the Survey Research Center at the University of Michigan to more than a thousand households in the Detroit area during the lead up to the financial crisis, my new book, "No Slack,"analyzes the financial constraints and choices of low- and moderate-income families.
Surprisingly, given their low-incomes, many families we interviewed save and many more would like to save, but lack a ready mechanism to do so. About a third of families contributed to savings each month, while 42 percent never saved. More than two-thirds of families chose to over-withhold on their taxes in order to pre-commit to savings—even though they effectively earn a negative interest rate from the government. We can tell from the data that these households want to put their money aside for savings but don’t have access to a formal way to do that.
Shouldn’t we make it easier for households to save?
A bank account is the entry point for saving, but nearly 30 percent of the adults we interviewed were “unbanked.” Higher-cost financial services can reduce the slack available to households, by eating into income and making it harder to save. Many low wage individuals see their take-home pay reduced by the high transaction costs they face when using check-cashing services to obtain their income. Lack of direct deposit to a bank account contributes to taxpayers’ using refund anticipation loans that diminish the value of the earned-income tax credit.
Even for those with bank accounts, surprise overdraft and other fees—which millions of Americans experience as annoying and unfair—can wipe out the end-of-month food budget for a low-income household.
Middle- and upper income families regularly save for education, health care, home ownership, and retirement. Savings are important for low-income households too, mostly because they help to smooth short-term income and expense fluctuations. As one woman we interviewed put it, “If you don’t save or give yourself a little gap just in case, … you are going to be stuck and lose a lot. You’ll lose a whole lot more because you didn’t leave that gap.”
Without savings, low-income households facing fluctuations in income and expenses may need to resort to high-cost borrowing, such as payday loans, because they lack lower-cost ways of generating financial slack. It is not easy for them to reduce expenditures; it is often difficult for them to get access to lower cost debt; they are likely to lack insurance; and they are less likely to have precautionary savings. They may be able to fall back on friends and family for help, but such borrowing can often put strains on those who lend, who are likely to be lower income themselves.
Of course, better access to savings vehicles will not, in and of itself, transform the lives of low-income individuals. Good jobs are essential for family stability.
But better access would give even low-wage households useful tools to manage their finances in order to generate more financial slack. They would be less vulnerable to serious disruptions stemming from income and expense shocks, and perhaps better able to take advantage of new opportunities, such as job training or a better job.
Helping families improve their financial capability is part of the answer. So too is consumer protection, based on a real-world understanding of the choices these families face. The new Consumer Financial Protection Bureau has the authority, for the first time, to supervise the bank and nonbank financial sectors and to clean up practices from prepaid cards to bank overdraft that bedevil low-income households.
The announcement by the Consumer Financial Protection Bureau that it may regulate prepaid debit cards comes none too soon for hard-pressed families. Federal regulators need to focus on transparent fees, lost and stolen card protection, error resolution, credit bureau reporting, and deposit insurance as key issues. In our study, households found federal consumer protections to be as important to them as monthly cost in their decisions on whether to use payment cards.
But we need to do more: Both the private sector and the government can use low-cost technology to make financial services more affordable and sustainable.
For example, the Treasury Department now provides an affordable “Direct Express” debit card for unbanked Social Security recipients to receive their benefit payments. A similar type of product could be offered at tax time for households to get their refunds. Banks can offer low-cost debit card products, without check writing or overdraft, to unbanked low-income households. And these card-based products can include an automatic savings feature to make it easier for families to build up a cushion in the event of an emergency. In fact, in our study, having an automatic savings plan increased low-income households’ desire to use a payment card.
The financial crisis from which the United States is emerging caused widespread harm to our economy and devastated the savings of many families. Low- and moderate-income households were least able to weather the crisis. A number of key reforms have been put in place. But our financial system is still not well designed to meet the needs of these families. And it doesn’t have to be that way.
Michael S. Barr, a CNBC contributor, is professor of law at the University of Michigan and former assistant secretary of the Treasury for financial institutions. He is the author of "No Slack: The Financial Lives of Low-income Americans"(Brookings Press 2012).