Income, Psychological Well-Being, and the Dynamics of Poverty

Evidence across disciplines suggests a bi-directional causal relationship between an individual’s psychological and economic well-being. Together, these studies suggest a feedback loop that may trap some in poverty. However, estimating these causal links is difficult due to this simultaneous causality. In this paper, I overcome this endogeneity with a panel GMM approach that estimates a dynamic system of equations where income and psychological well-being are simultaneously determined. Using a nationally representative dataset from South Africa, I find evidence of nonlinear impacts in both directions. The average effect of changes in psychological well-being on income is mainly driven by a large effect near the clinical depression threshold where I estimate that a 1 standard deviation decrease in psychological well-being leads to 17% loss in earnings. Meanwhile, the results estimate that a 20% decrease in household income leads to 0.1 standard deviation decrease in psychological well-being – or a 0.4% point increase in the likelihood of depression. I find that these estimates are larger among the poor. These results indicate the possibility of a strong feedback loop among an especially vulnerable subgroup – the poor with low levels of psychological well-being. An impulse response function analysis shows that this bi-directionality can nearly double the long-term impact of shocks, while simulations show that this relationship can explain prolonged poverty spells and low resilience to shocks. Further analysis suggests that individuals vulnerable to depression exhibit markedly different income dynamics that suggest the existence of a psychological poverty trap. ∗I am grateful for the support and guidance of my advisors Michael Carter, Travis Lybbert, Dalia Ghanem, and Ashish Shenoy throughout this project. This paper has benefited from discussions with and feedback from Bulat Gafarov, Frank Schilbach, Malcolm Keswell, Michael Gechter, Seema Jayachandran, and Takuya Ura among other conference and seminar participants. I thank Murray Leibbrandt and the team at the South Africa Labor and Development Research Unit for their helpful comments and for their commitment to keeping the psychological well-being module in the National Income Dynamics Study of South Africa. †University of California, Davis, Department of Agricultural and Resource Economics. One Shields Ave, Davis, CA 95616. Email: mmism@ucdavis.edu