Costs of business cycles

It all began when Lucas (1987) argued that the welfare cost to eliminating business cycles is extremely small: "Eliminating all the fluctuations from a person's consumption path (i.e. eliminating the business cycle entirely) is worth only 1/20 of 1 percent of average annual consumption."

This finding was confirmed by Chris Otrok and yet it is so counter-intuitive that something has to be wrong. Otherwise, why would we implement any kind of stabilization policy at all. Krusell and Smith (1999) wondered if a heterogeneous agent model would help:

We investigate the welfare effects of eliminating business cycles in a model with substantial consumer heterogeneity. The heterogeneity arises from uninsurable and idiosyncratic uncertainty in preferences and employment, where regarding employment, we distinguish among employment and short- and long-term unemployment. We calibrate the model to match the distribution of wealth in U.S. data and features of transitions between employment and unemployment. Unlike previous studies, we study how business cycles affect different groups of consumers. We conclude that the cost of cycles is small for almost all groups and, indeed, is negative for some.

However, there are other ways to establish that the welfare effects are larger than Lucas' estimate. For instance, Barlevy (2003): "...business cycles can have a deleterious effect on the rate at which the economy grows over the long run. The reason is that cycles lead to volatile investment, reducing the efficiency of investment. Essentially, the fact that investment activity is concentrated in booms rather than spread out uniformly over time creates congestion effects that lower the productivity of investment. I estimate that eliminating the cyclical fluctuations that prevailed during the post-War period would have increased the growth rate of real GDP per capita in the U.S. from 2.0% per year to 2.5% per year. The cost of reduced growth from macroeconomic volatility is computed at a rate of 10% of consumption expenditures per year, over 100 times."

At the worker level Mukoyama and Sahin (2005) show that under market incompleteness: "Unskilled workers are subject to a much larger risk of unemployment during recessions than are skilled workers. Moreover, unskilled workers earn less income, which limits their ability to self-insure. We examine how this heterogeneity in unemployment risk and income translates into heterogeneity in the cost of business cycles. We find that the welfare cost of business cycles for unskilled workers is substantially higher than the welfare cost for skilled workers."

More recently, Krusell, et. al (2009) find:
We investigate the welfare effects of eliminating business cycles in a model with substantial consumer heterogeneity. The heterogeneity arises from uninsurable and idiosyncratic uncertainty in preferences and employment status. We calibrate the model to match the distribution of wealth in U.S. data and features of transitions between employment and unemployment. In comparison with much of the literature, we find rather large effects. For our benchmark model, we find welfare effects that, on average across all consumers, are of a bit more than one order of magnitude larger than those computed by Lucas (1987). When we distinguish long- from short-term unemployment, long-term unemployment being distinguished by poor (and highly procylical) employment prospects and low unemployment compensation, the average gain from eliminating cycles is as much as 1% in consumption equivalents. In addition, in both models, there are large differences across groups: very poor consumers gain a lot when cycles are removed (the long-term unemployed as much as around 30%), as do very rich consumers, whereas the majority of consumers---the "middle class"---sees much smaller gains from removing cycles. Inequality also rises substantially upon removing cycles.

This is an example of progress in economic model building - the idea that what is intuitive is hard to model mathematically. Heterogeneity matters but not at first (see Krusell-Smith 1999) Yet, do all these models really jive with what we observe anedoctally? And what are the costs not considered?

Lisa Kahn, an economist at Yale, has studied the impact of recessions on the lifetime earnings of young workers. In one recent study, she followed the career paths of white men who graduated from college between 1979 and 1989. She found that, all else equal, for every one-percentage-point increase in the national unemployment rate, the starting income of new graduates fell by as much as 7 percent; the unluckiest graduates of the decade, who emerged into the teeth of the 1981–82 recession, made roughly 25 percent less in their first year than graduates who stepped into boom times.

But what’s truly remarkable is the persistence of the earnings gap. Five, 10, 15 years after graduation, after untold promotions and career changes spanning booms and busts, the unlucky graduates never closed the gap. Seventeen years after graduation, those who had entered the workforce during inhospitable times were still earning 10 percent less on average than those who had emerged into a more bountiful climate. When you add up all the earnings losses over the years, Kahn says, it’s as if the lucky graduates had been given a gift of about $100,000, adjusted for inflation, immediately upon graduation—or, alternatively, as if the unlucky ones had been saddled with a debt of the same size.

... Mossakowski has found that people who were unemployed for long periods in their teens or early 20s are far more likely to develop a habit of heavy drinking (five or more drinks in one sitting) by the time they approach middle age. They are also more likely to develop depressive symptoms. Prior drinking behavior and psychological history do not explain these problems—they result from unemployment itself. And the problems are not limited to those who never find steady work; they show up quite strongly as well in people who are later working regularly.

... Glen Elder, a sociologist at the University of North Carolina and a pioneer in the field of “life course” studies, found a pronounced diffidence in elderly men (though not women) who had suffered hardship as 20- and 30-somethings during the Depression. Decades later, unlike peers who had been largely spared in the 1930s, these men came across, he told me, as “beaten and withdrawn—lacking ambition, direction, confidence in themselves.” Today in Japan, according to the Japan Productivity Center for Socio-Economic Development, workers who began their careers during the “lost decade” of the 1990s and are now in their 30s make up six out of every 10 cases of depression, stress, and work-related mental disabilities reported by employers.

... Till Von Wachter, an economist at Columbia University, and Daniel Sullivan, of the Federal Reserve Bank of Chicago, recently looked at the mortality rates of men who had lost their jobs in Pennsylvania in the 1970s and ’80s. They found that particularly among men in their 40s or 50s, mortality rates rose markedly soon after a layoff. But regardless of age, all men were left with an elevated risk of dying in each year following their episode of unemployment, for the rest of their lives. And so, the younger the worker, the more pronounced the effect on his lifespan: the lives of workers who had lost their job at 30, Von Wachter and Sullivan found, were shorter than those who had lost their job at 50 or 55—and more than a year and a half shorter than those who’d never lost their job at all.

... unemployed men are vastly more likely to beat their wives or children. More common than violence, though, is a sort of passive-aggressiveness. In Identity Economics, the economists George Akerloff and Rachel Kranton find that among married couples, men who aren’t working at all, despite their free time, do only 37 percent of the housework, on average. And some men, apparently in an effort to guard their masculinity, actually do less housework after becoming unemployed.

... joblessness corrodes marriages, and makes divorce much more likely down the road. According to W. Bradford Wilcox, the director of the National Marriage Project at the University of Virginia, the gender imbalance of the job losses in this recession is particularly noteworthy, and—when combined with the depth and duration of the jobs crisis—poses “a profound challenge to marriage,” especially in lower-income communities.

... “We already have low marriage rates in low-income communities,” Edin told me, “including white communities. And where it’s really hitting now is in working-class urban and rural communities, where you’re just seeing astonishing growth in the rates of nonmarital childbearing. And that would all be fine and good, except these parents don’t stay together. This may be one of the most devastating impacts of the recession.”

Many children are already suffering in this recession, for a variety of reasons. Among poor families, nutrition can be inadequate in hard times, hampering children’s mental and physical development. And regardless of social class, the stresses and distractions that afflict unemployed parents also afflict their kids, who are more likely to repeat a grade in school, and who on average earn less as adults. Children with unemployed fathers seem particularly vulnerable to psychological problems.

... Communities with large numbers of unmarried, jobless men take on an unsavory character over time. Edin’s research team spent part of last summer in Northeast and South Philadelphia, conducting in-depth interviews with residents. She says she was struck by what she saw: “These white working-class communities—once strong, vibrant, proud communities, often organized around big industries—they’re just in terrible straits. The social fabric of these places is just shredding. There’s little engagement in religious life, and the old civic organizations that people used to belong to are fading. Drugs have ravaged these communities, along with divorce, alcoholism, violence. I hang around these neighborhoods in South Philadelphia, and I think, ‘This is beginning to look like the black inner-city neighborhoods we’ve been studying for the past 20 years.’ When young men can’t transition into formal-sector jobs, they sell drugs and drink and do drugs. And it wreaks havoc on family life. They think, ‘Hey, if I’m 23 and I don’t have a baby, there’s something wrong with me.’ They’re following the pattern of their fathers in terms of the timing of childbearing, but they don’t have the jobs to support it. So their families are falling apart—and often spectacularly.”