HOW WELL DID SOCIAL SECURITY MITIGATE THE EFFECTS OF THE GREAT RECESSION?

• Author: Kamila Sommer,William B. Peterman
• Date: 01 August 2019
• DOI: http://doi.org/10.1111/iere.12392
• Published date: 01 August 2019

INTERNATIONAL ECONOMIC REVIEW

Vol. 60, No. 3, August 2019 DOI: 10.1111/iere.12392

HOW WELL DID SOCIAL SECURITY MITIGATE THE EFFECTS OF THE GREAT

RECESSION?∗

BYWILLIAM B. PETERMAN AND KAMILA SOMMER1

Federal Reserve Board, U.S.A.; Federal Reserve Board, U.S.A.

Using a computational life cycle model, this article assesses how Social Security affects the welfare of different

types of individuals during the Great Recession. Overall, we find that Social Security reduces the average welfare

losses for agents alive at the time of the Great Recession by the equivalent of 1.4% of expected future lifetime

consumption. Moreover, we show that although the program mitigates some of the welfare losses for most

agents, it is particularly effective at mitigating the losses for agents who are poorer and/or older at the time of

the shock.

1. INTRODUCTION

Designed in part to alleviate old-age poverty in the wake of the Great Depression, Social

Security aims to provide inter- and intragenerational consumption insurance for older-age

individuals.2However, the insurance is not without costs: Retirement benefits and payroll taxes

distort agents’ labor and savings decisions. Generally, previous studies found that the economic

costs of the distortions dominate in the long run, leading Social Security to be, on average,

welfare reducing in the steady state.3Despite this well-documented result, little is known about

the welfare implications of Social Security for agents of different ages, incomes, wealth, and

abilities, especially at times of large adverse swings in economic activity. These periods are of

particular interest because the need for the insurance, as well as the effects of the distortions,

may be amplified. Moreover, the change in these effects may not be uniform across all agents.

To help fill this gap, and motivated by the historically large losses in household wealth and

income during the Great Recession, this article examines the role that Social Security plays in

mitigating or exacerbating the welfare consequences of large and broad-based shocks to wealth

and unemployment for agents of different ages and economic backgrounds.

The article documents two salient features of the Great Recession: a sudden, large, and

broad-based decline in household wealth and persistent increases in the rate and duration of

unemployment spells. First, using the 2007–2009 panel of the Survey of Consumer Finances

(SCF), we show that between 2007 and 2009, the median level of household wealth declined by

approximately 20%. Moreover, the percent wealth losses were relatively larger for households

∗Manuscript received August 2016; revised November 2018.

1We thank our editor Dirk Krueger and four anonymous referees, Christopher Carroll, Jonathan Heathcote, Mark

Huggett, Vasia Panousi, and Victor R`

ıos-Rull, as well as seminar participants at the Federal Reserve Board of Gov-

ernors, the Federal Reserve Bank of San Francisco, the Federal Reserve Bank of Atlanta, University of California at

Santa Cruz, and Georgetown University and participants at Midwestern Macroeconomics, Computation in Economics

& Finance and SED Annual Meetings. Views expressed in this article are our own and do not reflect the view of

the Federal Reserve System or its staff. Please address correspondence to: Kamila Sommer, Research Department,

Federal Reserve Board, 20th Street and Constitution Ave, NW, Washington, DC 20551. Phone: 202 452 2909. E-mail:

kamila.sommer@frb.gov.

2In addition to insuring old-age consumption, Social Security provides disability insurance. This article abstracts

from the disability insurance aspect of the program and focuses only on the part of the program that insures postretire-

ment consumption.

3One exception is Imrohoroglu et al. (2003), who show that if preferences are time inconsistent, then the benefits of

Social Security may outweigh the costs.

1433

Published 2019. This article is a U.S. Government work and is in the public domain in the USA. International Economic

Review published by Wiley Periodicals, Inc. on behalf of University of Pennsylvania and Osaka University.

1434 PETERMAN AND SOMMER

who were relatively younger and older at the time of the shocks. Second, using the Current

Population Survey (CPS) micro data, we document that the recession was associated with large

increases in the unemployment rate and average duration of unemployment spells, with the

increases being particularly large for younger and less-educated households. These empirical

facts motivate our choice to model the Great Recession as one-time unexpected age-dependent

depreciation shocks to household wealth, combined with increases in the likelihood and duration

of unemployment spells that, similar to the data, persist over numerous years.

Next, we quantify Social Security’s role in mitigating or exacerbating the adverse effects of

the Great Recession using a computational experiment conducted in four main steps. First, we

build a benchmark Aiyagari–Bewley–Huggett–Imrohoroglu overlapping generations (OLGs)

life cycle model that is augmented to include idiosyncratic productivity shocks, unemployment

risk, endogenous labor supply, endogenous retirement decision, and a realistically modeled

U.S. Social Security program. Second, we build a counterfactual economy that excludes the

Social Security program. Third, in each model, we calculate the welfare lost (relative to their

respective steady states) due to the exogenous wealth and unemployment shocks for agents

alive at time of the shocks. Finally, in the spirit of differences-in-differences (DiD) estimation,

we calculate the difference in welfare losses between the two economies for agents of varying

ages, wealth, income, and abilities. Comparing the welfare losses due to the wealth and unem-

ployment shocks between the two economies identifies the role that Social Security plays in

either mitigating or exacerbating the adverse effects of these shocks for agents of different ages

and economic backgrounds.

Before examining the effect of Social Security on the welfare implications of the Great

Recession, it is useful to revisit the welfare effects of the program in the steady state absent

the wealth and unemployment shocks. Social Security increases welfare primarily by providing

intragenerational insurance. Conversely, the program reduces welfare, because the payroll tax

makes it harder for younger and low-wage agents to earn enough after-tax income to both

smooth consumption over their lifetime and to accumulate precautionary savings. Additionally,

the program “crowds out” private savings, thereby reducing the stock of aggregate capital

available for production.4Similar to previous studies, we find that the economic costs outweigh

the insurance benefits in the steady state. We estimate that the program reduces ex ante welfare

by the equivalent of 12.4% of expected lifetime consumption.

Turning to the average effects of the program during the Great Recession, we find that, on

balance, Social Security mitigates a notable portion of the welfare losses induced by the wealth

and unemployment shocks. In particular, we find that Social Security reduces the average welfare

losses for agents alive at the time of the shock by the equivalent of 1.4% of expected future

lifetime consumption. On average, Social Security mitigates some of the welfare losses due to

the Great Recession primarily because it reduces the exposure of agents to the wealth shock. In

the counterfactual model without Social Security, agents are completely exposed to this shock

because all of their postretirement consumption is financed with private savings. In contrast, in

the benchmark economy, agents are less vulnerable to this shock because their postretirement

consumption is partially financed with Social Security benefits that, unlike private savings, are

unaffected by the shock. We also find that the program generally mitigates a similar portion of

welfare losses from the Great Recession when households’ expectations include the potential

for the aggregate shock.

Zooming in on the implications of Social Security on the welfare losses due to the Great

Recession for agents of different ages, we find that Social Security is particularly effective at

mitigating the welfare losses for agents who are older at the time of the shock. Older agents who

are still working at the time of the shock have less time to rebuild their wealth by increasing

their labor supply prior to retirement, leading them to be more vulnerable to the shocks. This

effect is enhanced even further for agents who are retired at the time of the shock and cannot

4In rational-expectations models, the program redirects what would otherwise be private savings in capital into

retirement transfers. This result has been well documented in other studies discussed below.

SOCIAL SECURITY AND THE GREAT RECESSION 1435

offset any of the losses by working more. Therefore, the insurance from Social Security is

more valuable for these agents. Moreover, due to the presence of increasing mortality risk,

Social Security benefits comprise a growing portion of consumption for these retired agents as

they age.5Therefore, the Social Security benefits play an increasingly important role providing

insurance for older agents during the Great Recession.

In contrast, we find that Social Security slightly exacerbates the welfare losses for agents

who are younger at time of the shock. The negligibly larger welfare losses for these younger

agents arise from the presence of the payroll tax that is particularly painful for these agents

during the economic downturn when incomes are depressed, budget constraints are tighter, and

unemployment risk rises.

Slicing the welfare effects by wealth, income, and labor productivity, we find that Social

Security mitigates welfare losses due to the recession somewhat more for agents with lower

lifetime incomes, wealth, and labor productivity because Social Security makes up a relatively

larger portion of their postretirement consumption.6Moreover, we do not find any specific age,

income, wealth, or labor productivity group for which Social Security substantially exacerbates

the welfare consequences of the Great Recession.

The ability of Social Security to mitigate welfare losses for some of the most vulnerable de-

mographic groups during this type of a business cycle episode without significantly exacerbating

the welfare consequences of the shock for other agents indicates that this program is particularly

effective at providing insurance against these episodes. Nevertheless, welfare losses attributed

to the program in the steady state are large. Therefore, we explore the ability of a scaled-down

program, with a potentially lower steady-state welfare cost, to mitigate the welfare losses due

to the Great Recession. In particular, we examine a counterfactual program (in the spirit of

the Supplemental Security Income [SSI] program) that provides a smaller benefit than Social

Security and is means tested. Although we find that this smaller scale program only mitigates

the equivalent of 0.7% of expected future lifetime consumption for agents alive at the time of

the shock (relative to 1.4% for the Social Security), the ex ante welfare costs in the steady state

are significantly reduced, with the consumption equivalent variation (CEV) of 1 vs. 12.4%.

Our work is related to three strands of the literature. The first strand focuses on the welfare

consequences of the Great Recession. Most closely related to our work, Glover et al. (2017)

and Hur (2018) use a calibrated OLG model to quantify how welfare costs of severe recessions,

such as the Great Recession, are distributed across different age groups. This article advances

this research agenda by not only focusing on the welfare effects of the Great Recession but

also by exploring how effective the Social Security program is at mitigating these losses across

different cohorts.

The second strand tries to measure the long-run implications on welfare of a Social Security

program. These works weigh the expected relative benefit to newborns from providing partial

insurance against expected future risks for which no market option exists against the welfare

costs of distorting these individuals’ incentives to work and save. Among these studies, a large

body of literature focuses on quantifying the benefit of providing intragenerational insurance

for idiosyncratic earnings and mortality risks (see, e.g., Auerbach and Kotlikoff, 1987; Hubbard

and Judd, 1987; Hubbard, 1988; Imrohoroglu et al., 1995; Storesletten et al., 1999; Fuster et al.,

2007; Hong and R`

ıos-Rull, 2007).7

Other research has explored the role of Social Security in insuring intergenerational risk

(i.e., insuring aggregate business cycle risk across generations). In particular, in their influential

paper, Krueger and Kubler (2006) examine the welfare implications of Social Security in a two-

period economy with aggregate (but not idiosyncratic) risk. The authors find that in expectation,

5Optimizing, rational agents rely more heavily on the benefit as they age, and their expected probability of sur-

vival decreases.

6This finding is particularly interesting since the program has been associated with a large reduction in elderly poverty

rates over the last century (see Engelhardt and Gruber, 2004).

7For a theoretical discussion of the different types of risks that Social Security can provide insurance against, see

Shiller (1999).