The Great Moderation and Household Income Volatility

David Beckworth looks at a paper by Steven Davis and James Kahn that tries to solve a puzzle. If, as shown by the Great Moderation, aggregate income volatility is decreasing, how can individual household income volatility be increasing as many have claimed? Shouldn't the increased stability in GDP cause household income be more stable? Not necessarily:

The Great Moderation vs. Rising Household Income Volatility, by David Beckworth: 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.]

Coincidentally, Jacob Hacker and Elisabeth Jacobs just released a detailed briefing paper on their findings on household income volatility. Here's a summary:

The main results reported in this brief are:

• The instability of family incomes has risen substantially over the last three decades. Although the precise magnitude of the increase depends on the approach to measuring income variance that is used, we estimate that short-term family income variance essentially doubled from 1969-2004. Much of the rise in income volatility occurred prior to 1985, and volatility dropped substantially in the late 1990s. It has, however, risen in recent years to exceed its 1980s peak.

• The proportion of working-age individuals experiencing a large drop in their family income (50% or greater) has climbed more steadily—from less than 4% in the early 1970s to nearly 10% in the early 2000s. The probability of large income drops varies predictably with the business cycle. Yet it has also trended strongly upward over time. For instance, the 2001 recession, which was mild in macroeconomic terms, was associated with a higher chance of large income drops than the recession of the early 1980s, which was the worst economic downturn since the Great Depression.

• There is an important distinction between family income (total earnings, asset income, and transfer income for all members of a family) and individual earnings. While the instability of individual male workers' earnings rose sharply between the 1970s and 1980s, it has been more or less stable since then, trending up and down with the business cycle through the 1980s and 1990s, and rising again in the early 2000s. This basic trend—a rise in earnings variability in the 1970s, little clear trend from the early 1980s to the late 1990s, and an upswing in the early 2000s—has been confirmed by numerous analyses, including a recent study by the Congressional Budget Office (CBO). Moreover, this same basic pattern can be seen in data from both the survey-based Panel Study of Income Dynamics (PSID) (which is used in this brief) and the administratively collected Continuous Work History Sample (CWHS) of the Social Security Administration (used by the CBO).

• Contrary to assertions in the popular press, women's increased workforce participation has not been a major factor contributing to the rise in family income volatility. Female earnings have, if anything, become more stable since the 1980s. Male workers have experienced a larger and more sustained rise in earnings instability. Because men's earnings account for a larger percentage of total household income than do women's earnings, on average, rising instability in male earnings helps account for the increase in family income volatility. In short, the stabilizing influence on family income of the decrease in female earnings instability is overwhelmed by the rise in men's earnings instability.

• In addition to the increase in male earnings variability, other likely causes of rising family income volatility include the growing variability of cash transfers and the limited cushioning effect of having a second earner in the household. Although the evidence is limited, there is reason to believe that a second family earner is less of a benefit in terms of income protection today than it was prior to the 1990s. Indeed, in 2004, if a male worker's earnings fell, on average his spouse's earnings fell as well, exacerbating, rather than offsetting, the loss.

• While less educated and poorer Americans have less-stable family incomes than their better-educated and wealthier peers, the increase in family income volatility affects all major demographic and economic groups. Indeed, Americans with at least four years of college experienced a larger increase in family income instability than those with only a high-school education over the past generation, with most of the rise occurring in the last 15 years.

• Finally, levels of family income volatility appear to be extremely high. Family income drops of 50% or greater affected nearly one in 10 non-elderly adults during the early 2000s. Meanwhile, earnings in the United States are also quite variable. The CBO's recent analysis of earnings variance using the CWHS suggests that around 15% of workers experience a drop in their earnings of 50% or greater every year—a level comparable to what we find using the PSID.

The remainder of this Briefing Paper is divided into five sections. First, it lays out the method used and the approach to the major data issues that researchers working in this area must confront. Second, the paper presents the main results and shows that the finding of rising family income instability is robust to alternative analytic choices. Third, it demonstrates that—but for a relatively short period in the early to mid-1990s, when the PSID was changing its procedures—the data appear highly representative and reliable. Fourth, it compares these results with other studies, including a forthcoming study of family income volatility from the CBO that purports to find lower levels of and no rise in family income volatility between 1985 and 2002. Fifth, it briefly discusses some of the potential causes of the rising family income instability that are found. It concludes, finally, by drawing out the broader implications of this analysis for contemporary efforts to address deepening public concern about economic security.