Stability illusions

What's so great about macroeconomic stability? Gordon Brown thinks it's a self-evident ideal. He's said:

Of all the economic duties of government the greatest and pre-eminent challenge is the creation and entrenchment of economic stability and taking the hard decisions to lock stability in, even in difficult times in the world economy.

However, it is in fact very doubtful whether stability is so important.

Certainly, it's a trivial mathematical fact that a rise in macroeconomic stability can happen at the same time as every individual suffers increased uncertainty. This would happen if correlations between individual incomes falls as their standard deviation rises. There's strong evidence (pdf) that this has happened for companies since the 1960s - so it's probably happened for individuals too.
What's more, Robert Lucas established in 1987 that the welfare gains to be gotten from stabilization were "trivially small" for the average person - equivalent to one-twentieth of 1 per cent of annual consumption. (He discusses this estimate, and reactions to it, in this pdf.)
In itself, then, macroeconomic stability is unimportant. Of course, individual security is valuable. But this can be pursued independently of macroeconomic policies, for example by encouraging the greater use of insurance markets, as proposed by Robert Shiller.
Instead, stability is a virtue insofar as it might increase long-run growth (of course, it's doubtful whether this is a good thing - in which case Gordon Brown's implicit argument disappears - but let's assume it is.)
But does stability really increase long-run growth? In this pdf, Gadi Barlevy shows how it can. And in this paper, Keith Blackburn shows how it might not.
The truth is, there are countless mechanisms pointing in either direction. Do recessions weed out lame ducks and free up resources for better uses, as Joseph Schumpeter suggested? Do they encourage firms to divert resources into increasing efficiency rather than just meeting orders? Or do they merely destroy experience and on-the-job learning by throwing people out of work? Does the threat of recession cut investment and R&D more than the hope of a boom raises them?
Theory is ambiguous. Much depends on convexities and non-linearities that might or might not exist and which might change over time.
But what about the facts? Strong evidence that stability raises growth came in this early paper by Garey and Valerie Ramey. Countries with volatile output, they found, had lower growth.
However, time series  evidence suggests a different story. In the 50s and 60s, the UK economy was stable by international standards. And growth was relatively  sluggish. Relative growth improved after the early 80s, as the economy became relatively more volatile.
Nor even is it clear that the UK's recent stability is encouraging growth. The likeliest mechanism through which it might do so - though not the only one - is an increase in business investment. And here, the data is wonderfully inconclusive. Measured in volume terms, the share of investment in GDP is near a record high. But in current prices, it's far below its 40-year average.
So, it's unclear whether macreconomic stability is a good thing or not. What's more, even those economists who think it is a good thing don't trust governments to pursue it. Mr Barlevey's paper concludes:

While the arguments presented here suggest the business cycles might be quite costly, it bears repeating that it does not immediately follow from this that stabilization policy is inherently desirable or could avoid these underlying costs. This conclusion hinges on the precise nature and source of aggregate fluctuations, and the degree to which government policy can truly eliminate them.

All this raises the question: why, then, does Mr Brown think stability is so important? My suspicion is that he's trying to fool us. He wants us to think that stability is the result of his masterful control of the economy, and that it is somehow worth having. Both claims are dubious.

Comments

[dearieme]

Yup, I suppose that the US economy might have been pretty stable in 1930-1938, with the blessings of Hoover's and FDR's hamfistedness upon them? Or was the Fed to blame? Whatever: until weapons orders from the UK and France perked them up, they were pretty stable at a low level of activity, weren't they?

[spencer]

Actually, economic output was extremely volatile in the 1930s-- the depression consisted of two very distinct recessions with a major recovery between them.

But, if you read the history the original reason for creating the Fed was to create economic stability. There was not a word about inflation in the original legislation or debate. The monetary system before the fed tended to be very pro-cyclical and the fed did not really learn how to implement a counter cyclical monetary policy until after the 1930s.

[rjw]

very interesting post, and I buy your conclusion about GB. Couple of points strike me though :

- the average costs of a macroeconomic dip are small maybe, but the fact is they are concentrated and can have profound effects on individuals. And this means that we have to look at the adequacy of social insurance... both income replacement and help in finding work again. there are plenty of reasons to believe markets in social insurance fail; so policy matters, both macroeconomic and microeconomic

- if a dip is big enough it can have political effects .... the rise of the nazis in germany was on the back not only of the war defeat, but also the lousy economy. and the nazis early grip on power was cemented by the economic recovery that took place when they were in power. So the economy and society are inter-twined, and the effects of a recession are not necessarily always linear.

[Monjo]

I would like stable economic growth of 5pc a year, and stable decreases of taxation as a per cent of national GDP.
Maybe rjw nails it: stable economies can mean a stable populace and a stable government, whereas even a small blip in the economy can bring a political change (as we all expected in 1992, but prolly Labourites were so confident of the win, those unemployed spongers forgot to go to the Polling stations before spending their days boozing and celebrating the "victory" - much like Bart's campaign in The Simpsons, which Martin then won by a single vote, as only one vote was cast.)
So this stability Brown talks about does two things:
1 - highlights the greater instability under the Conservatives (but perhaps hiding better overall longterm growth)
2 - cements Labour's position in government

[Franco]

The risk reduction achievable through insurance is limited by the riskiness of the economy as a whole. So, if we have efficient insurance markets that people use, macro-economic stability would be the proper goal as any individual instability could be insured against.

Imagine 10 people on an island fishing. If they all fish in the same place then they all catch the same number of fish, but the number each day could vary a lot. There would be no opportunity to insure. Alternatively, they could all fish in different places and catch wildly different numbers of fish, but the average number of fish caught would be more stable. Without insurance, this would be a less volatile economy with the same individual volatility (**). They could also rationally agree to pool all their catches and divide them equally, now they have lower individual vol than before.

(**) further complication could lead to an economy with lower overall vol, higher individual vol, higher average value, and lower individual vol after insurance.

[insurance]

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