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Why It Pays to Protect Households from Personal Economic Shocks
- October 12, 2021
- CBR - Economics
When a pandemic or other event delivers a shock to the US economy and business activity shrinks—potentially leading to a recession—the federal government can, if politics permits, roll out a variety of big-bucks fiscal and monetary tools to cushion the blow to the public’s welfare.
But what about household welfare when the primary wage earner dies, or becomes disabled, or loses employment for reasons unrelated to a recession? That’s where policy makers could dramatically bolster the economy and the well-being of families, according to Chicago Booth’s George M. Constantinides. It would require weaving a better social safety net, he argues, to provide insurance against such events.
Constantinides constructed a model to analyze the costs of such idiosyncratic events, as compared with aggregate shocks that affect the whole economy. These kinds of individualized disruptions can have a considerable long-term effect at the household level.
He gathered quarterly household-level consumption data from the Consumer Expenditure Survey from the first quarter of 1982 to the fourth quarter of 2019 and took into account interest rates, asset prices, and dividends. With these, he was able to compare the family-level benefits of easing the effects of these idiosyncratic consumption shocks, whether they were dependent on the business cycle or not, with those of smoothing out fluctuations in aggregate consumption growth.
Constantinides finds that buffering shocks unrelated to the business cycle gives households greater satisfaction (welfare, in economic terms), far more than cushioning against business cycle–specific shocks.
Specifically, he estimates that eliminating aggregate shocks, such as an economic downturn, would create a benefit to the average household member of about 7.7 percent of utility, an economic measure of satisfaction. In other words, households would increase their satisfaction by the same amount as if they were to increase their future consumption by 7.7 percent.
Eliminating idiosyncratic shocks that are related to the business cycle—think of losing your job during a downturn—would yield benefits of just 3.4 percent. But if a household could avoid idiosyncratic shocks unrelated to the business cycle—such as losing a job during an economic boom—that would lead to far bigger benefits, 47.3 percent, representing almost half of a person’s utility.
This implies that policies designed to ease idiosyncratic shocks not caused by a recession yield substantially greater benefits than those policies aimed at addressing recession-driven shocks. The Coronavirus Aid, Relief, and Economic Security (CARES) Act is an example of such a policy, he explains. The government sought to cushion the blow of unemployment during the pandemic, which occurred contemporaneously with a recession but was not necessarily caused by one.
The takeaway for policy makers is that in addition to trying to address economic shocks with a broad brush, they should also focus on providing relief at the household level for dramatic losses of income unrelated to the downturns of the business cycle.
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