Federal Reserve Economists May Have Discovered Another Cause Of Bankruptcy

See Why You Might Go Bankrupt If Your Next-Door Neighbor Wins the Lottery by Ben Leubsdorf at The Wall Street Journal blog. In case that link does not work, try Here’s why winning the lottery makes your neighbors go broke by the same author in The New York Post. Excerpts from the WSJ blog:

"Winning the lottery can be hazardous to your neighbors’ financial health.

Research released this month by the Federal Reserve Bank of Philadelphia found a significant jump in bankruptcies among households living near someone who won a big lottery jackpot. The economists theorized that people may have seen the good fortune next door and felt pressure to accumulate more assets of their own, especially flashy purchases like cars, that they simply could not afford.

“Income inequality induces poorer neighbors to consume more visible (rather than invisible) commodities to signal their abilities to ‘keep up with the Joneses’ to their richer neighbors,” economists Sumit Agarwal, Vyacheslav Mikhed and Barry Scholnick wrote. “This tendency can lead to additional and unsustainable borrowing among the relatively poor to finance this additional conspicuous consumption, which can eventually result in financial distress and bankruptcy.”"

"The headline finding: For every $1,000 increase in the lottery prize, there was a 2.4% increase in bankruptcy filings by the winner’s neighbors over the next few years. “These results are more pronounced for low-income neighborhoods and high income-inequality areas,” they wrote.

Why would someone winning the jackpot cause someone living down the street to go bankrupt a year or two later? The economists argued that people who feel they are poorer than their peers may spend more in a conspicuous fashion, financing their purchases with debt. But that debt will need to be repaid, potentially leading to financial difficulties and even bankruptcy.

Messrs. Agarwal, Mikhed and Scholnick analyzed the Canadian bankruptcy data and found “evidence that those who filed for bankruptcy after a larger lottery win of a close neighbor have significantly larger holdings of visible assets (e.g., cars, motorcycles, houses) relative to the holdings of these same visible assets by those who filed for bankruptcy after smaller lottery wins of a close neighbor,” they wrote. There was no similar difference for “invisible assets” like cash or pensions, they said.

In other words, when someone wins a big lottery prize, neighbors appear more likely to buy cars and remodel their houses to show that they can keep up—and go broke in the process."

I put conspicuous consumption in red because that is a well known term in economics and sociology. See Thorstein Veblen and What is Conspicuous Consumption .Veblen first coined the term over 100 years ago. The idea is that rich people buy things just to show how rich they are.

Adam Smith may have beaten Veblen to the punch. In The Wealth of Nations, he wrote:

"With the greater part of rich people, the chief enjoyment of riches consists in the parade of riches, which in their eyes is never so complete as when they appear to possess those decisive marks of opulence which nobody can possess but themselves. In their eyes the merit of an object which is in any degree either useful or beautiful, is greatly enhanced by its scarcity, or by the great labour which it requires to collect any considerable quantity of it, a labour which nobody can afford to pay but themselves. Such objects they are willing to purchase at a higher price than things much more beautiful and useful, but more common." (the entire book is online)

See also an earlier blog post I did called Conspicuous Consumption, Conspicuous Virtue, Thorstein Veblen (and Adam Smith, too!) . See also Doctoral Thesis Says Rich People Spend More on Conspicuous Things