Loss aversion, economic sentiments and international consumption smoothing

We examine an unexplored connection between loss aversion and international consumption smoothing. In the face of expected income declines, loss-averse behaviour implies that any adjustments in consumption are delayed until they are necessary. However, if the expected fall in income materialises, the eventual adjustments in consumption are larger. Therefore, loss aversion could weaken international consumption smoothing. We test this mechanism using measures of economic sentiment. These provide a sense of the expected direction of future income changes. We demonstrate that prevailing confidence and uncertainty, our proxies for economic sentiment, reduce the degree of international consumption smoothing. We provide evidence that this effect arises from loss-averse behaviour, using a test of the asymmetric response of consumption to positive and negative output fluctuations that occur following periods of weak economic sentiment. Our findings have important implications for public institutions and private initiatives that aim to improve cross-country risk sharing.