How Well Did Social Security Mitigate the Effects of the Great Recession?

Kamila Sommer and William Peterman
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Kamila Sommer: Federal Reserve Board

No 1150, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: This paper studies the effectiveness of the social security program as an insurance mechanism against unanticipated catastrophic shocks to the household balance sheets. Our framework is an overlapping generations (OLG) life cycle model with uninsurable idiosyncratic earnings risk, lifetime uncertainty, endogenous labor supply and endogenously determined retirement. To analyze the efficacy of the social security in mitigating welfare losses during times of severe and unforeseen economic distress, we consider a social security system that mimics that of the U.S. economy. The calibrated model is used to study the effects of a one-time, unanticipated, large wealth shock on the welfare of households in economies with and without social security. While massive in both economies, we find that the welfare losses for older individuals due to the shock are partially mitigated by the presence of the social security program. This insurance channel is particularly important for older individuals who have already retired because they are unable to rebuild their wealth by working. Although we find that social security is particularly effective in mitigating the losses over the transition for individuals who are old at the time of the shock, the program does not come without welfare costs in the steady state. We estimate that, in the steady state economy with social security, the welfare is lower by the equivalent of 9.5 percent of total expected lifetime consumption than in the economy without the social security program.

Date: 2013
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