The Great Moderation vs. Rising Household Income Volatility

Just last week I revisited the question of how to reconcile the findings from the "Great Moderation" literature that shows a significant decline in aggregate economic volatility since the early-to-mid 1980s with the findings of Jacob Hacker and others that show there has been a marked increase in household income volatility over this same period. One would think some of the decreased macroeconomic volatility would be experienced and observed at the household level. The data, however, says otherwise. How is this possible? A new paper on the "Great Moderation" by Steven Davis and James Kahn attempts, among other things, to answer this question.

From their paper, Interpreting the Great Moderation: Changes in the Volatility of Economic Activity at the Macro and Micro Levels, we get the following discussion of this issue:

[A] puzzle that research on the Great Moderation has yet to confront: Why has the dramatic decline in the volatility of aggregate real activity, and the roughly coincident decline in firm-level volatility and job-loss rates, not translated into sizable reductions in earnings uncertainty and consumption volatility facing individuals and households?

We do not know the answer to this question, but we conjecture that greater flexibility in pay setting for workers played a role, possibly a major one. Greater pay flexibility is consistent with the rise in wage and earnings inequality in U.S. labor markets since 1980 and with increases in individual income volatility and earnings uncertainty. If these developments involve a rise in the variance of idiosyncratic permanent income shocks to households, then household consumption volatility also rises according to permanent income theory. Greater wage (and hours) flexibility also leads to smaller firm-level employment responses to idiosyncratic shocks and smaller aggregate responses to common shocks, because firms can respond by adjusting compensation rather than relying entirely on layoffs and hires. By the same logic, wage adjustments can substitute for unwanted job loss. So, at least in principle, greater wage flexibility offers a unified explanation for the rise in wage and earnings inequality, flat or rising volatility in household consumption, a decline in job-loss rates, and declines in firm-level and aggregate volatility measures.

In short, their argument is that greater wage volatility has been traded for reduced output and employment volatility. If true, this interpretation has two implications: (1) labor markets are working better since the price of labor is now more flexible; (2) more economic risk has been shifted to labor.

Read the rest of the article.

Update I: See further discussion of this posting here.

A Question for Jacob Hacker

Jacob Hacker is back with revised estimates on family income volatility (ht Mark Thoma). In his earlier work he found a marked increase in the volatility of family income between 1973 and 2004. These conclusions were later challenged by findings from the CBO. In turn, Hacker responded to CBO here. Now, if Hacker could be so kind as to respond to another question, one that I raised earlier:

[W]hat role does the 'Great Moderation' play in this debate? A well documented fact is that there has been less volatility in aggregate economic activity since the early 1980s and this development is called the 'Great Moderation.' One study has found real economic activity volatility has fallen 50% over this time. Would not some of this decline in aggregate economic volatility be felt at the household or individual level? Is not the low U.S. household saving rates one indication of this development?

Some observers may look at the low U.S. saving rate and say it is the result of the global saving glut or the U.S. asset price booms. I am not convinced, though, these answers can provide the full explanation for the sustained downward trend in U.S. household savings. A more complete answer has to account for the possibility of improved household expectations arising from the long economic expansions of the past two decades that were interrupted by only mild economic downturns (i.e. the 'Great Moderation').

Clearly, this question reflects my macro background. But it is the question that keeps coming up in my mind when I read this family income volatility debate.

The 'Great Moderation' and the Income Volatility Question

Over at the CBO Director's Blog we read that based on the CBO's own research "household income is much less volatile than individual worker’s earnings, and that household income volatility has not increased over time — and perhaps even declined slightly." The period being studied here is from the early 1980s to the present. These results run contrary to the work of Jacob Hacker of Yale University who finds that the volatility of family income doubled between 1973 and 2004. Professor Hacker's response to the CBO Directors Blog can be found here.

A question: what role does the 'Great Moderation' play in this debate? A well documented fact is that there has been less volatility in aggregate economic activity since the early 1980s and this development is called the 'Great Moderation.' One study has found real economic activity volatility has fallen 50% over this time. Would not some of this decline in aggregate economic volatility be felt at the household or individual level? Is not the low U.S. household saving rates one indication of this development?

Some observers may look at the low U.S. saving rate and say it is the result of the global saving glut or the U.S. asset price booms. I am not convinced, though, these answers can provide the full explanation for the sustained downward trend in U.S. household savings. A more complete answer has to account for the possibility of improved household expectations arising from the long economic expansions of the past two decades that were interrupted by only mild economic downturns (i.e. the 'Great Moderation'). Any thoughts?