Association for Public Policy Analysis & Management

We present new evidence on how households adjust to income drops following job loss, and analyze the implications of our findings for the adequacy and design of unemployment insurance and other transfer programs aimed at helping families cope financially with job loss. Using data from the 1996 through 2008 panels of the Survey of Income and Program Participation, we show that most households are unlikely to be able to avoid substantial reductions in consumption during very long spells of unemployment. Neither drawing down of financial assets; or increasing debt, increased receipt of social welfare transfers, increased earnings of other household members, nor other methods of adjustment are adequate by themselves. Even taking them all together very few households avoid significant drops in consumption. Although most households do not have the financial capacity to smooth consumption over long spells of unemployment, many of those with substantial asset holdings do not draw them down to the extent that one might expect. To gauge the extent to which the observed data is consistent with plausible optimizing behavior, we construct a simple life-cycle consumption model. Uncertainty regarding the duration of ongoing unemployment spells, and the possibility of experiencing future spells in the near future, implies that household will not aim to fully deplete their financial assets. Moreover, the tendency for long spells to end in reemployment with substantially reduced earnings implies that households’ optimal consumption path may be pushed downward. Our preliminary results suggest that a substantial fraction of households undergoing a long spell of unemployment experience a decrease in consumption that is greater than optimal. The implied losses of well-being to these households indicates that the aggregate cost of the increase in the incidence of long unemployment spells during deep recessions is much larger than commonly recognized.

We explore the reasons for this. We find that the take-up rate of government transfer payments implies that large “transaction costs” prevent many from taking advantage of existing programs. Transaction costs might include the perceived stigma of program participation, lack of information regarding eligibility or how to apply for benefits, and the time and monetary costs of the actual application process. Borrowing to smooth consumption is not a practical solution, as we find evidence that many unemployed are severely credit constrained even when they have significant equity in their homes.

What further can be done to ameliorate the problems facing those who lose jobs during severe recessions? We consider policies such as default application for UI and other social benefits when an employer lays an employee off, better targeting of extended unemployment benefits, and special credit lines for unemployed workers with good work histories. We also consider programs to buy people’s houses (thus freeing up house equity for consumption purposes) and rent them back to them.