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Thursday, December 14, 2006

Barro: On the Welfare Costs of Consumption Uncertainty

Interesting paper from Robert Barro "On the Welfare Costs of Consumption Uncertainty." The paper shows that previous measures of the welfare cost of consumption uncertainty understate the welfare cost. Thus, the benefit from eliminating consumption uncertainty is larger than previously believed, an important result.  Barro goes on to discuss how this result relates to macroeconomic stabilization policy, fluctuations in consumption from natural disasters, wars, disease, and other potential sources of aggregate fluctuations. Here's the abstract,introduction, and conclusion to the paper:

On the Welfare Costs of Consumption Uncertainty, by Robert J. Barro, NBER WP 12763, December 2006 [open link]: Abstract Satisfactory calculations of the welfare cost of aggregate consumption uncertainty require a framework that replicates major features of asset prices and returns, such as the high equity premium and low risk-free rate. A Lucas-tree model with rare but large disasters is such a framework. In a baseline simulation, the welfare cost of disaster risk is large -- society would be willing to lower real GDP by about 20% each year to eliminate all disaster risk, including wars. In contrast, the welfare cost from usual economic fluctuations is much smaller, though still important -- corresponding to lowering GDP by around 1.5% each year.

Introduction Lucas (1987, Ch. 3; 2003, section II) argued that the welfare gain from eliminating uncertainty in aggregate consumption is trivial. He got this answer by using parameters for the time series of real per capita consumer expenditure from U.S. post- World War II macroeconomic data, along with plausible values for the coefficient of relative risk aversion. One problem with this calculation, apparent from Mehra and Prescott (1985), is that simulations with the same model and parameters do not get into the right ballpark for explaining well-known asset-pricing puzzles, such as the high equity premium and low risk-free rate. These failures with respect to asset returns suggest, as observed by Atkeson and Phelan (1994), that the model misses important aspects of consumption uncertainty. Hence, the model’s estimates of welfare effects from consumption uncertainty are likely to be inaccurate. A possibly satisfactory framework, used here, is one with rare economic disasters, as in Rietz (1988). Barro (2006) shows that this model replicates prominent features of asset returns. Salyer (2007) demonstrates that the allowance for low-probability crash states amplifies the welfare costs computed by Lucas. The present analysis builds on this work to show that, in a rare-disasters setting, changes in consumption uncertainty that reflect shifts in the probability of disaster have major implications for welfare.

...

Concluding Observations The baseline parameter value σ = 0.02 per year represents the extent of business fluctuations during the tranquil post-World War II years in the United States and other OECD countries. This period was calm for the OECD countries when considered in comparison to the first half of the 20th century, a turbulent time that featured World Wars I and II and the Great Depression. Hence, a reduction in σ amounts to making milder the business fluctuations that were already strikingly tame. Not surprisingly, the benefit from this change—corresponding to around 1.5-2% of GDP each year—is only moderate (though still important).

In contrast, the probability parameter p and size parameter b refer to major economic disasters, such as those that occurred in many countries during World Wars I and II and the Great Depression. Outside of the OECD, we can also think of p and b as relating to events such as the Asian financial crisis of the late 1990s, the Latin-American debt crisis of the early 1980s, and the Argentine exchange-rate crisis of 2001-02. A reduction in p amounts to lowering the chance of repeating these kinds of extreme events, and a fall in b amounts to decreasing the likely size of these events. To go further, decreases in p or b constitute reductions in the probability or size of disasters not yet seen or, at least, not seen in the 20th century. Included here would be nuclear conflicts, large-scale natural disasters (tsunamis, hurricanes, earthquakes, asteroid collisions), and epidemics of disease (Black Death, avian flu). My estimates indicate that the welfare effects from eliminating all uncertainty of this kind are large—10 times or more the effects for normal economic fluctuations.

Macroeconomic stabilization policies, including monetary policy, relate to both types of uncertainty—σ on the one hand and p or b on the other hand. The policies may also affect the long-term expected growth rate, g*. Well known is the success of OECD countries in achieving low and stable inflation since the mid-1980s. This success is sometimes argued to have contributed to milder business fluctuations (lower σ) and perhaps to stronger average economic growth (higher g*). However, commentaries on monetary policy frequently also stress the roles of central banks in exacerbating or moderating major economic crises. For example, Friedman and Schwartz (1963) blame the Federal Reserve for the severity of the Great Depression in the United States, as well as for the sharp recession of 1937-38. Observers of Alan Greenspan’s tenure as Fed chair often focus on his role in apparently moderating the consequences of the global stock market crash of 1987 and the Long-Term Capital Management/Russian crisis of 1998. These policy actions—if they really were effective—have more to do with lowering p and b than decreasing σ. A key, unresolved issue is whether and how a monetary authority can act to reduce the probability, p, and size, b, of economic collapses.

Other governmental institutions and policies can also affect disaster probabilities and sizes. For example, the formation of the European Union and the adoption of the euro have often been analyzed as influences on the extent of business fluctuations (σ) and the average rate of economic growth (g*), sometimes focusing on the role of international trade in goods and assets. However, from a political perspective, the main force behind the adoption of these institutions was likely the desire to avoid a repetition of World War II; that is, to reduce the disaster probability, p, applicable to war. This perceived impact on disaster probability related to war is likely to be a key element in explaining why these institutions exist in Western Europe. Of course, this perception may be inaccurate—forcing Germany and France to share monetary, fiscal, and other policies may ultimately create more conflict than it eliminates. Thus, an important research topic is the actual influence of various policies and institutions on the probability and size of disasters, including wars.

    Posted by on Thursday, December 14, 2006 at 04:32 PM in Academic Papers, Economics, Macroeconomics | Permalink  TrackBack (0)  Comments (1)

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