Macroeconomic priorities revisited: the behavioural foundations of stabilization policies

Macroeconomic priorities revisited: the behavioural foundations of stabilization policies Abstract The theoretical literature that neglects the benefits of stabilization policies (e.g., Lucas 1987, 2003) ultimately relies on the low impact of macroeconomic volatility on aggregate income and consumption. We argue that this conclusion is theoretically and empirically weak. Theoretically, the cost of volatility should be measured by including not only monetary magnitudes, but also those psychological costs whose relevance has been stressed by behavioural economics and that are correlated with the number of unemployment episodes. We refer here to implications for the experienced utility of loss aversion, the endowment effect and hedonic adaptation. Empirically, downturns more severely affect those who have less and who suffer greater well-being losses from each shock, magnifying the negative impact of recessions. It follows that the traditional analysis, which disregards the main causes of well-being losses determined by downturns, cannot represent a sound basis for dismissing policies aimed at preventing downturns (and/or their impact on the labour market). 1. Introduction In the last 30 years or so, in most OECD countries, policymakers’ propensity to regulate the economy and/or to implement measures against unemployment has become weaker and less incisive (D’Orlando and Ferrante, 2009; D’Orlando et al., 2011). In general terms, such a result appears to cohere with the diffusion of DSGE and new classical macroeconomic models, which have allowed, to some degree, the resurgence of pre-Keynesian economic principles. In more specific terms, the argument has been that macroeconomic volatility, caused by the reduction in public intervention, has merely a small impact on consumers’ well-being, such that people would give up only a tiny fraction of their consumption to avoid instability. This conclusion has been crucially influenced by two important contributions from Nobel laureate Robert Lucas (1987, 2003). A role has also been played by the idea that less activist public stabilization policies would permit a higher growth rate, thereby more than compensating, at least in the long run, the loss of well-being suffered by those subjects who pay the cost of macroeconomic volatility. A counterpart to the argument that it is rational to forgo the benefits of stabilization policy, due to its long-term costs, is the idea that a lack of redistribution, in very unequal societies, is rationally accepted by the median voter who would gain from redistribution because he/she expects to benefit from the higher probability of upward social mobility stemming from a lack of redistributive policies. This represents the ‘prospect of upward mobility’ (POUM) hypothesis (Benabou and Ok, 2001). Lucas’s 1987 and 2003 contributions deal with situations in which actual magnitudes deviate randomly from their long-period trend, realizing that trend only on average. In other words, they are concerned with a post–World War II and pre-subprime crisis world in which recessions have been defeated. Yet (at least implicitly) the same philosophy has been applied to the Great Recessions of 2007 and later, a situation clearly differing from that of random deviations of actual magnitudes from the trend. In such a world, the main driver of variations in well-being is assumed to be consumption volatility. In this article, we argue that the above-described approach is weak, both in theoretical and empirical terms, and regarding both temporary deviations from the trend and recessions. This is because Lucas (correctly) refers to well-being losses as the main indicator of macroeconomic performance, but he (incorrectly) neglects the main driver of people’s subjective well-being—their occupational status. By doing so, he understates the actual impact on individual well-being, and on specific social groups, of macroeconomic shocks generated not only by Great Recessions, but also by simple macroeconomic instability. Our argument is that, to correctly measure macroeconomic performance, one certainly must gauge well-being losses, but since well-being losses are crucially influenced by variations in people’s employment status, the analysis of macroeconomic performance should attribute a central role to unemployment, which is thus at the core of the present paper. Furthermore, since measuring well-being losses deriving from unemployment requires that one computes not only the monetary costs but also (and primarily) the psychological costs of unemployment, which are disregarded by traditional analyses, we conclude that well-being losses deriving from macroeconomic instability are far greater than in Lucas’s account. Our conclusions are based on a number of economic psychology and behavioural economics contributions on loss aversion, hedonic adaptation and the endowment effect,1 which are theoretically and empirically robust, but have nevertheless been almost entirely ignored in the debate on this theme. These contributions suggest that well-being losses caused by unemployment shocks are greater than believed not only by the majority of the traditional theoretical literature, but also by the critics of that literature. The policy implications of an approach that so greatly understates the actual magnitude of its main object of investigation can thus hardly be endorsed. Therefore, since almost all the literature based on Lucas’s contributions in fact ignores the great psychological costs of unemployment, the conclusion that the benefits of non-regulated markets would outweigh the costs of non-governed economic fluctuations is untenable. Stabilization policies, as well as micro regulation policies aimed at contrasting economic downturns and unemployment episodes, cannot be disregarded on the grounds of these weak theoretical bases. The traditional approach also appears weak from an empirical viewpoint. Downturns and recessions have increased inequality, having a greater effect on those who have less (in terms of skills, income and wealth), i.e. those for whom loss aversion is more severe. Therefore, even for the case in which monetary gains and losses from the business cycle balance out on average over time, the representative agent hypothesis used by Lucas does not cohere with reality and the sum of aggregate well-being gains and losses is not nil, but rather negative in sign and huge in absolute value. This is so for three reasons: i) the theoretical and empirical literature on loss aversion shows that losses (negatively) affect well-being more than do gains; ii) recessions and downturns are not randomly distributed within the working population since they affect individuals holding specific characteristics more than others and the probability of being hit at time t is positively correlated with the probability at time t-1 (Heckman and Borjas, 1980), so loss aversion is more severe for these subjects; and iii) as a result, recessions and downturns tend to primarily affect people for whom loss aversion and hence well-being losses are more severe. On these grounds, one can argue that labour market flexibility does not depend solely on the norms regulating the market itself, but also on behavioural factors that determine workers’ capabilities—in Sen’s perspective—to adapt to changes in their occupational status and the costs of doing so. According to this latter perspective, the impact of the non-pecuniary costs of unemployment episodes would be negatively related to the income and education levels of the individuals concerned. It follows that, in some circumstances and countries, loss aversion is more severe and, therefore, the cost of a lack of regulatory policies is particularly high and regressive. These results appear further strengthened if one considers several recent contributions, as we do in the present paper, that use insights from behavioural economics to draw conclusions valid for the aggregate. Such an approach has been referred to as behavioural macroeconomics (see, e.g., Akerlof, 2002). Some of these contributions suggest that endogenous waves of pessimism induced by ‘animal spirits’ can generate cyclical instability, render periods of negative macroeconomic performance longer and deeper (De Grauwe, 2008, 2012), justify more active public policies (De Grauwe and Ji, 2016) and strengthen the efficacy of fiscal policies (Gabaix, 2016). Whereas behavioural macroeconomics has the very ambitious scope of using behavioural economics to build a microfounded macroeconomic framework and to explain the causes of recessions, we have the far less ambitious scope of proposing a criterion for measuring the well-being impact of these recessions that differs from the standard approach. Nonetheless, as we shall see, behavioural insights represent a common feature and one approach can be used to reinforce the conclusions of another. In particular, our approach can furnish insights to explain why and under what circumstances waves of pessimism are higher (or lower). The above considerations undermine, on the one hand, the relevance of the arguments used to justify neglect of the need for policies to counteract downturns and, more broadly, to reduce the impact of economic fluctuations on the labour market. On the other hand, these considerations also undermine the relevance of the arguments used to dismiss labour market institutions on progressive grounds, based on so-called on the job protection, which can reduce the impact of labour market instability on workers’ well-being. On the same bases, one can also argue that limiting unemployment episodes—by stabilizing the business cycle through macroeconomic policies (specifically fiscal policies), by instituting microeconomic regulation policies and/or by avoiding the impact of economic shocks on the labour market—can generate better aggregate outcomes with respect to curing unemployment after it has appeared, by using subsidies or even by hiring the unemployed after they have become unemployed. This paper is organized as follows: Section 1 offers a review of the literature, originating from Lucas’s 1987 book, which discusses the idea that the benefits of flexibility—i.e. the absence of business cycle regulation—are greater than its costs. Section 2 focuses on the social costs of flexibility and shows that, if one includes psychological costs, these social costs are far greater than traditional economic approaches assume, particularly those approaches described in Section 1. Section 3 argues that downturns have a greater negative effect on those who have less wealth and education and, since those who have less suffer more from loss aversion, this reduces their well-being further and strengthens our conclusions. Section 4 draws out the main implications of our analysis, describing the policies that should be dismissed if Lucas’s analysis is sound and that, in our view, are again relevant once Lucas’s analysis proves unsound (particularly those policies necessary to reduce the costs of flexibility, as well as macro- and microeconomic regulations aimed at preventing recessions). Section 5 summarizes our results and offers conclusions. 2. Are stabilization policies unnecessary? Lucas’s 1987 book Models of Business Cycles gave rise to an important debate on the role of stabilization policies, a debate to which Lucas himself later contributed (Lucas, 2003). In line with neoclassical macroeconomic principles, Lucas considers stabilization policies, for the general case, unnecessary, useless and even dangerous. For the specific context here considered, he investigates the usefulness of policies aimed at reducing the macroeconomic volatility that the economy has in fact experienced over the past few decades. To put it another way, he discusses the utility of more aggressive stabilization policies with respect to ‘the general stabilization of spending that characterizes the last 50 years’ (Lucas, 2003, p. 11). He concludes that ‘there is little benefit from further stabilization’ (Barlevy, 2005, p. 32), since ‘[t]he potential gains from improved stabilization policies are on the order of hundredths of a percent of consumption, perhaps two orders of magnitude smaller than the potential benefits of available “supply-side” fiscal reforms’ (Lucas, 2003, p. 11). From what precedes, it is clear that Lucas’s contribution is not about recessions. He argues that macroeconomics and related stabilization policies have succeeded, since the ‘central problem of depression prevention has been solved’ (Lucas, 2003, p. 1). The problem is hence simply excess deviations of the economy from its long-run trend. According to Lucas, people suffer due to the uncertainty stemming from the unpredictable variability of their consumption path during the business cycle, which would be smoothed by further stabilization policies.2 However—and this is the central point—the extent of this well-being loss is very small, so small that the burden of the costs of further stabilization policies certainly exceeds their benefits. To reach such a result in a context in which consumption grows at a constant rate, Lucas calculates the utility loss deriving from the business cycle. He considers the following intertemporal utility function, in which utility depends upon a sequence through time of actual consumption expenditure, Ct, with t indicating the year: U=f(Ct, Ct+1,…) with Ct=(1+ε)C*t In these relations, C*t is the trend in consumption and ε is a random deviation of actual consumption from the trend. Aggregate consumption corresponds to the trend on average, but can be above or below it in a specific year. As we have said, recessions affecting the trend are out of the question. The loss in well-being that subjects suffer due to macroeconomic volatility can be measured by the difference between the utility of a path of consumption strictly corresponding to the consumption trend, U=f(C*t, C*t+1, ...), and the utility of a path of actual consumption deviating from the trend, U=f(Ct, Ct+1, ...). Lucas defines this loss as the amount of consumption that should be added to actual consumption to obtain the same utility that a consumer would have in a world in which consumption does not deviate from the trend (Lucas, 2003, p. 1). Formally, one obtains this result by singling out the value of the cost of volatility μ that realizes the following condition: U((1+µ)Ct, (1+µ)Ct+1,…)=U(C*t,C*t+1,…) According to Lucas, µ will increase with increasing consumption volatility and with increasing individual aversion to volatility. Hence, µ depends upon both the objective loss of consumption during the business cycle and the subjective aversion to risk of individuals. Since i) until 2007, consumption was not particularly volatile; and ii) Lucas assumes a relatively small risk aversion parameter, equal to one, he concludes that individuals would accept paying less than 0.1% of their lifetime consumption to avoid volatility. It follows that policies aimed at avoiding further deviation of consumption from this trend are almost useless. Lucas’s contribution has been the object of a number of critiques, most of which have primarily attempted to find different/greater values for the well-being loss. Some scholars (see, e.g., Guillén et al., 2014) criticize Lucas’s 1987 paper for considering a post–World War II world in which stabilization policies operate and not a pre–World War II world in which stabilization policies were almost absent. The point raised by Lucas would therefore refer to more active stabilization policies and not to stabilization policies per se, as these policies in fact prevented the greater welfare losses seen in pre–World War II times. Similar critiques refer to the fact that Lucas excludes from his analysis not only a world in which macroeconomic instability is significant due to the absence of stabilization policies, but also the cases of Great Recessions, in which the problem is not simply random deviations from the trend. In the case of a ‘crash state in consumption’ (see, e.g., Salyer, 2007), with a double-digit reduction in consumption, the welfare loss deriving from the absence of stabilization policies is far greater than in Lucas’s vision. These above-mentioned studies are the only ones capable of obtaining numeric results for the welfare loss that are considerably greater than those obtained by Lucas. The majority of the remaining contributions on this theme do not deviate much from Lucas’s quantitative results, even when they propose theoretically relevant (but numerically relatively insignificant) modifications to the logic of the argument. This is especially the case for those authors who argue that Lucas understates the cost of the business cycle, due to his misanalysis of the relevance of risk aversion (see, e.g., Epstein and Zin, 1991; Obstfeld, 1994; Pemberton, 1996; Dolmas, 1998; Tallarini, 2000). Other contributions (Krusell and Smith, 1998; Mukoyama and Sahin, 2006; Krebs, 2007; Krusell et al., 2009) criticize the representative agent hypothesis adopted by Lucas. They argue that, by using this hypothesis, Lucas greatly understates the huge impact of the business cycle on subgroups of subjects. In models with heterogeneous agents, specifically, the impact of the business cycle on weak subgroups, such as the poorest or the unemployed, would be particularly relevant. The present paper also aims to show the theoretical weaknesses of Lucas’s procedure, together with the far greater impact the business cycle has on well-being in the absence of stabilization policies. However, in doing so, we do not focus on ‘crash states’ in consumption, on pre– and post–World War II data, on Great Recessions, on an incorrect estimation of risk aversion or on the empirical invalidity of the representative agent hypothesis (even if, in our analysis, subjects are highly heterogeneous, inequality matters and hence that hypothesis cannot hold true). We instead base our argument on a number of robust theoretical and empirical results from recent contributions in economics and psychology. In particular, our conclusions are based on the concepts and models of loss aversion, status quo bias and hedonic adaptation. To the best of our knowledge, these models and principles have never been applied to Lucas’s analysis, even if intuitions in this direction may be found in De Neve et al. (2015, e.g., p. 19). On these bases, we find relevant well-being costs of downturns (and, in particular, of unemployment caused by downturns) and robust motivations for implementing stabilization policies. These results follow from the acknowledgement of ‘the non-pecuniary costs of unemployment (Clark and Oswald, 1994; Winkelmann and Winkelmann, 1998; Wolfers, 2003; Kassenboehmer and Haisken-DeNew, 2009), which typically increase during recessions’ (De Neve et al., 2015, p. 19). 3. The true costs of unemployment The unemployment costs resulting from the absence of macro and micro regulatory policies capable of avoiding severe economic downturns—and/or preventing workers from being fired during downturns—can be defined as the costs of flexibility (of the labour market). These costs can be classified as either pecuniary or non-pecuniary. Pecuniary costs can be computed in monetary terms and are the income and/or consumption losses deriving from unemployment, the costs of searching for a new job, the costs of geographical mobility, the possibility of finding a new job with a lower wage, etc. Non-pecuniary costs, on the contrary, are not linked with a loss of income and/or consumption, but include the psychological costs that subjects suffer due to changing status, habits and lifestyles, potential social stigma, loss of esteem and social networks, etc. These costs must be measured in terms of well-being rather than consumption (and/or income) and their relevance is confirmed by both empirical evidence and theoretical studies. A number of behavioural economics and economic psychology principles and models can be used to study the overall cost of the business cycle and of unemployment, in particular, loss aversion,3 the endowment effect,4 the status quo bias5 and hedonic adaptation.6 Let us start with loss aversion. According to Kahneman et al. (1991, p. 199): ‘[a] central conclusion of the study of risky choice has been that [...] changes that make things worse (losses) loom larger than improvement or gains’. This conclusion bears important implications for the calculation of the costs of downturns in general, and of unemployment in particular, since unemployment episodes are events that imply a very high psychological cost which is compensable only at a very high monetary cost. The idea that bad events carry more weight than good ones is confirmed by both the status quo bias and the endowment effect. These two concepts are strictly linked, and are also tied to the idea that people are more responsive to losses than to gains of equal size. The status quo bias was originally described by Samuelson and Zeckhauser (1988), who found a strong preference among individuals for the status quo (or what they believe to be the status quo) ‘because the disadvantages of leaving it loom larger than advantages’ (Kahneman et al., 1991, pp. 197–98). A similar behavioural principle is the endowment effect, which has been verified empirically, mainly by repeated experiments (see, e.g., Knetsch and Sinden, 1984; Knetsch, 1989; Kahneman et al., 1990). We can describe the endowment effect as ‘the fact that people often demand much more to give up an object than they would be willing to pay to acquire it’ (Kahneman et al., 1991, p. 194). When an object becomes part of the subject’s endowment (and here is the link with the status quo bias), the subject tends to overvalue it. The cumulative result of considering loss aversion, the status quo bias and the endowment effect together is that unemployment episodes reduce well-being more than hiring episodes increase it. Therefore, the fact that income and consumption do not change, on average, during the business cycle nonetheless implies aggregate well-being losses. The above principles and considerations are crucial for a full understanding of the importance of hedonic adaptation for the study of the psychological costs of business cycles. The key finding of the hedonic adaptation approach is that people adapt to life events: ‘[l]ife events such as marriage, loss of a job, and serious injury may deflect a person above or below [his/her] setpoint, but in time hedonic adaptation will return an individual to the initial setpoint’ (Easterlin, 2003, p. 1). Such a process is sometimes called ‘habituation’. After the seminal paper by Brickman et al. in 1978, empirical evidence on hedonic adaptation has been thoroughly discussed in psychological journals (see, e.g., Diener et al., 1999; Frederick and Loewenstein, 1999; Clark et al., 2004; Lucas et al., 2004; Oswald and Powdthavee, 2006; Diener et al., 2006; Lyubomirsky, 2011). However, it is still disputed whether adaptation is complete or incomplete, i.e. whether life shocks have a permanent effect on the long-term level of agents’ well-being,7 since in some cases ‘people do not completely adapt to conditions’ (Diener et al., 2006, p. 309). In particular, there seems to exist a rather asymmetric reaction to bad and good events in life:8 people adapt with more difficulty, over a longer period and less completely to negative rather than to positive events (Armenta et al., 2014, p. 64; Lyubomirsky, 2011, p. 204).9 Attempts have also been made to measure such an asymmetry and ‘[a]lthough it is premature to conclude that negative experiences are three times as bad as positive experiences, these findings at a minimum suggest that the “punch” of one bad emotion, utterance, or event can match or outdo that of three or more good ones’ (Lyubomirsky, 2011, p. 204). Furthermore, it is a generally accepted conclusion in literature (see, e.g., Lucas et al., 2004; Diener et al., 2006; Armenta et al., 2014) that reactions to unemployment episodes constitute a rather particular case of (the absence of) hedonic adaptation. Following the negative event represented by an unemployment episode, the habituation process starts as usual and people tend towards their baseline level of well-being, but the process is very slow and incomplete. As a result, people do not fully adapt to the unemployment episode and they never regain their baseline level of well-being. Some authors (see, e.g., Clark et al., 2008) maintain that unemployment is the only negative event that does not allow for complete adaptation in the long run. Furthermore, people do not regain their baseline level of well-being even if they are re-employed (Lucas et al., 2004). To put it another way, unemployment episodes leave an irreversible trace in people’s lives, permanently reducing their long-run levels of well-being. The idea, already discussed with reference to loss aversion, that bad events carry greater weight than good ones, is hence also confirmed within the hedonic adaptation framework. Hedonic adaptation is particularly suitable for developing a comprehensive approach capable of studying the true costs of unemployment episodes and, in particular, the non-pecuniary costs. In Figure 1, the evolution of a worker’s well-being in the presence of hedonic adaptation is illustrated. With the first unemployment episode, subjective well-being dramatically falls. Thereafter, thanks to hedonic adaptation, well-being increases again, but it never reaches the previous level, even if the unemployed person gets a new job at the same wage as the old one. We can suppose that this is a consequence of the loss of esteem, changing status, social stigma, etc. Only a wage higher than the original could compensate for and eliminate the loss deriving from unemployment episodes. Furthermore, irreversible losses tend to accumulate, unemployment episode after unemployment episode. Fig. 1. View largeDownload slide Hedonic adaptation and the true costs of unemployment. Fig. 1. View largeDownload slide Hedonic adaptation and the true costs of unemployment. In a hedonic adaptation framework, the negative impact on well-being of numerous unemployment episodes is hence greater (more severe) than the impact on well-being of fewer, even if longer, unemployment episodes. Both downturns and recessions generate an increase in the number of unemployment episodes. Furthermore, the financial transfer necessary to fully compensate individuals for the loss of their well-being caused by unemployment episodes would be extremely high, since an adequate unemployment benefit should be greater than the wage the fired workers lost. Even obtaining a new job after an unemployment episode could compensate the worker for the unemployment experience only if the new wage is higher than the old one. Therefore, again, even if, during the business cycle, income and consumption go up and down, remaining unchanged on average, the negative impact on well-being of unemployment episodes is greater than the positive impact of re-employment episodes. Even if income and consumption remain unchanged on average, well-being falls, and this is not due to the subjects’ aversion to volatility. It is exactly the same conclusion reached with reference to status quo bias, the endowment effect and loss aversion. Similar results have also been obtained by Wolfers (2003), according to whom unemployment volatility undermines well-being. It is not easy to quantify, even in rough terms, well-being losses deriving from the psychological costs of flexibility described above. Recent contributions, however, have demonstrated that the classic loss aversion effect operates in this domain such that an income loss decreases life satisfaction at least twice as strongly as an equivalent income gain increases it (Boyce et al., 2013, replicated at the macro level by De Neve et al., 2015). Survey data on life satisfaction have been used to quantify the adverse effect of unemployment on well-being (Winkelmann, 2014). The gap in life satisfaction between unemployed and employed workers in the 21 participating European countries in the European Social Survey for 2002–2009 ranges from 0.5 points to around 2.5 points (Wulfgramm, 2014). On a four-point life satisfaction scale, Helliwell and Huang (2014) find a gap in subjective well-being of 0.4 points among Americans. The latter difference in subjective well-being persists after controlling for income, suggesting that the main source of well-being loss due to unemployment is its pecuniary costs. Helliwell and Huang (2014) also show that the aggregate unemployment rate adversely affects subjective well-being, arguing that it does so by increasing job insecurity. All the above findings seem to fully justify a role for countercyclical policies as a means of reducing the number of unemployment episodes and hence well-being losses. 4. The impact on well-being of hitting the disadvantaged more By definition, during the business cycle, we have periods in which aggregate income and consumption are above the trend and periods in which they are below the trend, even if the average of actual magnitudes over time coincides with the trend. However, apart from the fact that Great Recessions meet these requisites only with difficulty, even if we assume that over time in the aggregate negative and positive effects cancel one another out, this does not happen for each individual. In fact, according to what we have experienced in the last 40 years or so, there exist categories of individuals who, in downturns, experience no decrease or even improve their economic position, at least in relative terms, as well as groups who always experience worsening economic positions, both in absolute and relative terms. If compensating mechanisms are absent, following an entire business cycle, some categories of people will have more than they had before the cycle and some less. According to Cingano (2014, p. 6): ‘[i]n most OECD countries, the gap between rich and poor is at its highest level since 30 years. Today, the richest 10 per cent of the population in the OECD area earn 9.5 times the income of the poorest 10 per cent; in the 1980s this ratio stood at 7:1 and has been rising continuously ever since. However, the rise in overall income inequality is not (only) about surging top income shares: often, incomes at the bottom grew much slower during the prosperous years and fell during downturns, putting relative […] income poverty on the radar of policy concerns’. Rising inequality is then also attributable to the fact that random shocks do not affect all people in the same way: downturns have a greater effect on those who have less in terms of skills, education and wealth. Furthermore, following a business cycle, these subjects may not regain the level of income and consumption they had before the cycle, such that even if the average effect over time is nil, some categories of people experience irreversible losses not only in psychological terms, but also in monetary terms (i.e. suffering income and consumption losses). The intuition behind the Great Gatsby curve and scarce upward social mobility, which, according to many scholars (Bukodi et al., 2015; Corak, 2013), characterizes the last few decades, contributes to the fact that shocks always affect the same (poor) people. Moreover, in the context of increasing downward social mobility, loss aversion implies that the welfare gains of those individuals enjoying upward social mobility are not sufficient to compensate the welfare loss of those individuals experiencing downward social mobility, unless the probability of the former is much larger—at least twice as large—as the probability of the latter.10 For instance, a study in the UK showed that, over the last 50 years or so, upward social mobility decreased and downward social mobility increased. As a result, the two probabilities converged, for men, on the same value of 35.8%; there was a similar trend for women (Bukodi et al., 2015). The above considerations bear important implications for the soundness of Lucas’s approach. We mentioned in Section 1 that a number of contributions (e.g. Krusell and Smith, 1998; Mukoyama and Sahin, 2006; Krebs, 2007; Krusell et al., 2009) critique Lucas’s approach for being founded on a hypothesis (the representative agent hypothesis) which inevitably understates actual well-being losses. According to these contributions, upon removing the representative agent hypothesis economic shocks show stronger negative well-being effects for subcategories of subjects.11 This is so because ‘the gains from eliminating the business cycles exhibit a “U”-shaped pattern. Borrowing constrained agents have a larger gain, reflecting the fact that they cannot self-insure their risk by their own assets. […] The “middle class” tends to have small or negative gains. […] Very rich agents realize welfare gains since their income is largely coming from capital income’ (Mukoyama and Sahin, 2003, p. 18). The implications of our contribution go further in this direction. If downturns have a greater effect on those who have less (in terms of skills and education), and the analysis we have proposed in the previous section is correct, one must also consider that those who have less are those who disproportionately suffer from loss aversion. Having a higher level of loss aversion, in turn, implies unemployment shocks and status shocks imposing greater negative effects on well-being. In other words, economic downturns and recessions generate larger shocks for people for whom shocks reduce well-being to a greater extent; and since losses carry a greater weight than gains, the resulting aggregate well-being variations may be large and negative. Furthermore, these subjects are not compensated by future adequate income increases, since they exit downturns worse off than when they entered. As a result, there is a further reduction in aggregate (and average) well-being that is not compensated by future expansions. The problem is particularly relevant for unskilled workers, who face a greater probability of being fired. According to Mukoyama and Sahin (2003, pp. 19–20), ‘[u]nskilled agents face more cyclical unemployment risk and they have less opportunity to self-insure. As a result, the cost of business cycles is much larger for a typical unskilled agent compared to a typical skilled agent’.12 It follows that our contribution further strengthens the critiques addressed to Lucas regarding the use of the representative agent hypothesis. We have shown that, upon removing this hypothesis, not only does theoretical analysis demonstrate a negative impact of the business cycle on average well-being, but also that this impact is far greater than that imagined by these critics. If, as we have sketched above, one introduces into the model the realistic assumption that subjects are highly heterogeneous (since different endowments of skill and/or education and/or wealth imply different psychological consequences of downturns and expansions), and if their well-being is influenced in a highly differentiated and asymmetric way by downturns and expansions, such that inequality matters, the results reached by modelling the behaviour of a representative single agent as valid for the aggregate are very different from the results reached by modelling the behaviour of heterogeneous agents. Indeed, in the real world, subjects are heterogeneous. As a result, the representative agent hypothesis cannot be defended even on the grounds of ‘small deviations’ or an ‘as if’ argument. Lucas’s analysis is flawed and the significant impact of the business cycle on well-being leaves space for justified stabilization policies. Our conclusion—that the traditional arguments used to claim the uselessness of countercyclical policies are theoretically weak—is hence strengthened by empirical considerations regarding how the absence of further business cycle stabilization actually influences distributive magnitudes and well-being and, in fact, strengthens the critiques of Lucas’s use of the representative agent hypothesis. 5. Why stabilization and micro regulation policies cannot be considered unnecessary Both the pecuniary and non-pecuniary costs of unemployment and downturns have differing impacts on workers’ well-being depending on whether labour market institutions are based on protection on the market or protection on the job. In the first case, firms’ firing costs are low so that firms can easily vary the composition of their workforce, but the unemployed get generous unemployment compensation. By contrast, in the case of protection on the job, firing costs are high (and can be so high as to prevent firms from firing workers) but the unemployed do not receive compensation benefits, or these benefits are extremely low. Empirical evidence (Bertola, 1990; Bertola and Rogerson, 1997) shows that there are differences between these two contexts in terms of flows entering and exiting unemployment and the lengths of unemployment periods. In the case of protection on the market, small firing costs result in not only easier firing, but also easier hiring of workers, since firms know that they will be able to fire workers with relatively low cost when they become unnecessary. As a result, flows entering and exiting unemployment are high and workers can expect many unemployment episodes during their working life, though these episodes will be of short length. Moreover, young people entering the labour market for the first time find it easy to gain employment. By contrast, in the case of protection on the job, high firing costs force firms to be extremely cautious in hiring workers, as they know they will not be able to easily fire them. Flows entering and exiting unemployment are thus low and workers can expect few unemployment episodes during their working life, but these episodes will be long-lasting. In this case, young people entering the labour market for the first time experience greater difficulty in being hired, so they must expect a longer unemployment period. All of the above implies that the choice between the types of employment protection legislation to be implemented is not neutral with respect to workers’ interests. Indeed, on the job protection reduces the probability of being fired for less skilled workers, but increases unemployment lengths for all workers, particularly the most skilled, who face a lower probability of losing their jobs, as well as people entering the labour market for the first time. By contrast, on the market protection increases the probability of being fired for less skilled workers, but reduces unemployment lengths for all workers, particularly the most qualified, and makes it easier for people entering the labour market for the first time to find a job. Hence, on the job protection improves the relative position of less qualified workers and worsens the relative position of young and more qualified workers, while on the market protection creates the opposite effect. On the job and on the market protections differ not only in the frequency and duration of unemployment episodes and hence the categories of workers who find their relative position improved or worsened. They differ also in the kind of unemployment costs that they succeed in compensating for. Unemployment benefits used in on the market protection compensate (at least partially) for monetary losses deriving from unemployment, but are not projected as instruments for compensating non-pecuniary costs and, in particular, psychological costs. On the contrary, both on the job protection (which protects workers from being fired during the business cycle) and countercyclical macro stabilization policies (which resist recessive shocks and hence reduce their impact on the labour market) can be used as instruments for minimizing non-pecuniary costs by reducing the number of unemployment episodes in workers’ lifetimes. In the specific context depicted in Sections 2 and 3, with huge negative effects of the business cycle on aggregate well-being due to the high psychological costs it generates, no sound theoretical or empirical argument can maintain that the costs of these policies exceed their benefits. However, the situation might vary across countries and Lucas’s conclusions might cohere with reality to a greater or lesser extent depending on the country in question. This is the case because loss aversion, the endowment effect and hedonic adaptation are sound and important concepts, but they depend upon factors such as workers’ skills, education, culture, religion, etc., such that their actual relevance varies from country to country (Ferrante, 2004; D’Orlando et al., 2011). It follows that workers from different countries will suffer varying degrees of psychological distress due to the business cycle and will hence require more or less incisive stabilization policies and different employment protection rules. In addition, a crucial role in determining the policies required by individuals, given these other conditions, is played by their level of training and education. More educated and/or better trained workers will need, and will hence demand, less protection against the business cycle and/or less on the job protection than less educated and/or less well-trained workers. It is therefore not surprising that countries with less educated and less well-trained workforces—typically those of the Global South—face more problems in their attempts to reduce labour market protection and countercyclical policies than countries in which the labour force is better trained and better educated—typically those of the Global North. We believe that the above considerations may play a role within the behavioural macroeconomics approach,13 particularly (but not exclusively) within those models that study the impact of ‘animal spirits’ on the business cycle (see, e.g., De Grauwe, 2008). Behavioural macroeconomists aim at grounding macroeconomics in more empirically robust bases, substituting some insights from behavioural economics for the standard rational expectations-maximizing assumptions regarding subjects’ behaviours. In this way, they find a rationale for fluctuations alternative to the standard DSGE explanation, i.e. alternative to ‘exogenous shocks in preferences, endowments and technologies that are slowly transmitted into the economy’ due to wage and price rigidities in a context in which subjects have rational expectations (De Grauwe, 2008, p. 2). Specifically, according to ‘animal spirits’ models, if agents experience cognitive limitations and use simple rules (‘heuristics’) to forecast the future, ‘endogenous and self-fulfilling waves of optimism and pessimism […] gripping investors and consumers’ (De Grauwe, 2008, pp. 1–2) can spread through the economy, generating endogenous dynamics (and hence the business cycle). Furthermore, fluctuations are more severe in these models than in the standard approach (Gabaix, 2016, p. 4). While sharing many theoretical and psychologically based tools with behavioural macroeconomics, our contribution does not have the aim of proposing more empirically robust foundations for macroeconomics or for the business cycle. It instead has the more modest goal of proposing an empirically sound way of measuring the well-being losses stemming from macroeconomic instability. In other words, behavioural macroeconomics aims at explaining the causes of recessions, while we simply aim at measuring their effects. Nonetheless, our approach and that of behavioural macroeconomics can reinforce one another. This is because animal spirits are a main source of macro- and microeconomic instability. As such, they deserve to be mentioned in the analysis of unemployment costs and the potential benefits of macro and micro regulation policies. Psychological factors responsible for the animal spirits dynamics are composed of both common and idiosyncratic components. The first component originates in the general climate of macroeconomic uncertainty affecting all agents, and especially investors, in the same ways. The second component originates in the climate of technological and organizational turbulence affecting specific industries or groups of firms sharing similar characteristics and structural problems at certain epochs (e.g. firms’ small size, their access to finance, etc.). The severity of the downturn characterizing macroeconomic instability will affect such idiosyncratic components, thereby amplifying the severity of the downturn and the general climate of uncertainty. This is often due to the effects of the downturn on the financial positions of industries or firms that are experiencing specific real turbulences. Now, we have shown that due to psychological costs downturns have a higher negative impact on well-being than predicted by the standard analysis. This magnified effect appears understated in animal spirits models, which usually limit themselves to forecasting pessimistic effects when pessimistic outcomes outperform their optimistic counterparts (De Grauwe 2008, pp. 7 ff.). Yet it is easy to link the spread of pessimism to the amplitude of the impact of recessions on well-being: greater negative psychological effects of downturns generate more intense waves of pessimism and hence greater turbulence. In other words, our analysis offers additional causes for the spread of pessimism, or at least furnishes important insights for measuring the amplitude of pessimistic waves, and calls for micro regulation policies to deal with idiosyncratic turbulences. It is worth noticing that, if our conclusions hold, waves of pessimism will be greater than waves of optimism due to asymmetry in the well-being impact of downturns and expansions. Furthermore, we have shown above that loss aversion, the endowment effect and hedonic adaptation depend upon elements such as workers’ skills, education, culture, religion, etc., so their actual relevance varies from country to country: countries with more educated and/or better trained workers will suffer less negative well-being effects due to downturns than countries with less educated and/or worse trained workers. This implies that waves of pessimism, and hence the (negative) effects of animal spirits on the depth of downturns, will be greater in less educated countries while waves of optimism will be weaker, thereby generating more severe recessions and less expansionary effects in these countries. The differing institutional and educational frameworks of different countries also contribute to an explanation of why the strength of opposition to labour market flexibility has been so geographically differentiated. These differences have emerged when countercyclical policies have been invoked both for further stabilization of the business cycle and for coping with the 2007 Great Recession. The first case lies within the Lucas framework, according to which, over time, aggregate average income and consumption coincide with the trend. The second case, however, falls outside the Lucas framework, since the question is whether flexibility permits the system to quickly return to full employment. In both cases, our approach shows that the costs of instability and/or recessions are higher than those assumed by the traditional approach, and that stabilization policies and/or on the job protections preventing downturns and/or recessions from affecting the labour market can be justified on sound theoretical bases. Additionally, on these points, our conclusions appear to cohere with those of behavioural macroeconomics, which invokes more active monetary policies and demonstrates that ‘[f]iscal policy is more powerful because Ricardian equivalence partly fails, [t]he Lucas critique has less, or zero, bite [and] GDP fluctuations are amplified and more persistent’ (Gabaix, 2016, p. 4). The above-proposed distinction between the common and idiosyncratic components of animal spirits implies that both macro and micro regulation policies will be required to deal with the common and the idiosyncratic components, respectively. As far as fiscal and monetary stabilization policies are concerned, there is not much to add to the existing contributions apart from the fact that their net benefits are much larger than is usually assumed. Micro regulation policies should be targeted to deal with the specific causes of turbulence and, as such, they may require a wide set of policy tools: industrial policies to deal with crises affecting specific industries, firms or groups of firms being required to implement structural transformations (incentives to network or to merge, access to finance, workers’ training, early retirement programmes for the elderly, etc.). The aim of all these measures is to turn the decision to break the employment relationship into a last resort, a solution to be taken only if no other long-term sustainable solution can be devised. The benefits of macroeconomic stabilization policies should be seen as a counterpart to the costs of on the job protection policies that would be imposed on the economy to minimize the costs of unemployment in the absence of macroeconomic stabilization policies. Additionally, dual labour market policies may be legitimate if insiders are older, less skilled and thus requiring of more protection than younger and more skilled outsiders, who are capable of dealing with risks, changes and more flexible contracts. In other words, skill and educational differences can justify different labour market institutions (i.e. on the job or on the market protections) not only between different countries, but also between different social groups within the same country. Groups who suffer more well-being losses due to downturns should be protected against unemployment to a greater extent than groups who suffer less. As we have noted, according to some estimates (Boyce et al., 2013; De Neve et al., 2015), the non-pecuniary costs of unemployment are dominant (75% of total cost). This implies that policies preventing unemployment should be preferred with respect to income support measures and that active labour market policies, while important, can contribute marginally to alleviating this cost by streamlining the search process. Nonetheless, the history of economic policies has followed a different path. Building on the traditional approach, countercyclical policies have been progressively and indiscriminately implemented with less frequency and intensity, and in some countries (and groups of countries) public expenditure on social welfare and on the job labour market protection has been reduced (D’Orlando and Ferrante, 2009). This is the case, for example, in the European Union. These policies have been implemented despite the fact that the losses associated with labour market flexibility, for some countries and/or individuals, outweigh the gains, with the consequence of thereby generating strong social and political opposition. This opposition cannot be explained by the traditional approach, but can by the approach here proposed. This confirms that both on the job protection and countercyclical policies are necessary in some countries in which low-skilled and -educated workers are a large percentage of the workforce.14 It is also necessary to give preference, when possible, to countercyclical measures over on the job protection schemes, since the latter may impose greater costs on society by blocking beneficial workers’ reallocation across sectors. For the same reasons, microeconomic regulation policies (e.g. industrial policies) may also play a role in governing the process of creative destruction, such that their impact on displaced workers is minimized—even if, in the long run, the most effective means of reducing the costs of workers’ reallocation across sectors and territories is to increase their behavioural flexibility through appropriate education and life-long training policies (Ferrante, 2004). With regards to the European Union, in which countercyclical policies are now particularly unpopular among many influential governments, our approach implies that fiscal policies and a different statute for the European Central Bank can be theoretically justified. In particular, fiscal policy should be targeted to public investment, as in the USA, whereas monetary policy should deal with not only inflation, but also unemployment, with the aim of reducing the frequency of unemployment episodes. 6. Conclusions The waves of deregulation experienced by the world economy over the past 30 years or so, accompanied by a less activist approach to micro- and macroeconomic regulation policies, have been inspired by the view that markets work well and that labour market flexibility is just a matter of setting the right norms. The underlying idea is that labour market flexibility depends solely on the norms it is regulated by and not also on behavioural factors that determine people’s capacity to adapt to changing life circumstances. According to this view, the long-run benefits of soft regulation and flexibility outweigh their short-term costs. Lucas’s 1987 and 2003 contributions are fully coherent with this view, suggesting that the welfare costs deriving from market volatility are almost nil and hence further stabilization policies are unnecessary. While contemporary economic reality, characterized by ‘Great Recessions’ and ‘secular stagnations’, is far from the world of random deviations of actual magnitudes from a long-term trend described by Lucas, simply rejecting his approach on the ground of realism does not seem sufficient. In many countries (e.g. those of the European Union), the philosophy used to fight the Great Recessions appears inspired by ideas very similar to those of Lucas. It is thus crucial to demonstrate that his conclusions regarding the uselessness of stabilization policies are untenable not only in the case of Great Recessions, but also in the more favourable case of cyclical instability. This is because sound theoretical contributions and robust empirical and experimental evidence suggest that the psychological costs of adaptation to unemployment episodes can be very large, particularly for less educated/skilled workers, during the business cycle as well as during recessions. However, we do not simply criticize the traditional approach and propose alternative criteria for measuring the aggregate true costs of the business cycle and unemployment. Further building upon the literature regarding the disproportionate impact of downturns on subgroups of agents (Krusell and Smith, 1998; Mukoyama and Sahin, 2006; Krebs, 2007; Krusell et al., 2009), our argument is that the traditional approach, and specifically Lucas’s analysis, also understates the fact that these costs are disproportionally borne by less educated/skilled workers. Hence, for a given level of income/consumption loss (i.e. a given deviation of income/consumption from its trend), the impact of business cycle volatility on well-being greatly varies i) with the number of unemployment episodes (and hence in the presence of different countercyclical policies and different labour market institutions); and ii) with workers’ educational and skills endowments. This is confirmed by contemporary economic theory, according to which well-being is a function of the number of unemployment episodes a worker experiences, on which countercyclical policies and labour market institutions crucially impact, and of workers’ capabilities endowments. As a result, not only should these variables somehow be included in the utility function, greatly increasing the cost of volatility, but, furthermore, we cannot even measure the cost of the absence of stabilization policies if we do not consider the different institutional frameworks of the labour market. Specifically, the same business cycle can produce worse effects on well-being in the presence of on the market employment protection legislation and better effects in the presence of on the job protection, the latter of which mitigates the impact of business cycle volatility on the labour market. Both of these institutional frameworks can produce different aggregate welfare effects, depending on workers’ skills/educational endowments. Furthermore, since hedonic adaptation confirms that well-being losses deriving from unemployment episodes can be compensated only by a new wage or unemployment benefit exceeding the preceding wage, it follows that preventing unemployment episodes before they happen is more efficient than curing them after they have happened. We can hence conclude that, for some groups of workers and for some countries, the traditional view according to which countercyclical policies and/or on the job protection may generate worse aggregate results than flexibility and/or on the market protection is incorrect. This result especially applies to countries with a low-skilled and relatively low-educated workforce. It is worth noting that our conclusions focus on the impact that unemployment episodes have on well-being within Lucas’s framework, in a context different from that which primarily focuses on the role of loss aversion in determining the impact of growth reduction on well-being, as carried out by De Neve et al. (2015).15 However, our analysis can be used to offer greater support to the idea that a ‘policy designed to engineer economic “booms”, but that risks even relatively short “busts” is unlikely to improve societal well-being in the long run. Steady positive growth that minimizes the risk of economic contraction seems the most likely route to an improvement in general well-being’ (De Neve et al., 2015, p. 22). We agree also with the conclusion that ‘[s]tandard analyses of the income-happiness relationship could arguably be interpreted as “growth is good”. However, in light of the asymmetric experience of positive and negative growth, an empirically more accurate interpretation of the income-happiness relationship would be that “recession is bad”’ (De Neve et al., 2015, p. 23). The deregulation and liberalization of trade and capital markets have also resulted in an inefficient redistribution of the costs of uncertainty within societies. Unskilled workers are now less protected from unemployment risks, whereas entrepreneurs and top managers can more easily reduce the financial and real risks of economic activity by exploiting diversification opportunities stemming from financial liberalization and the international delocalization of production. The risk of economic activity now carries more weight for less educated and weaker social groups than it did 40 years ago. In such a context, the main problem is not (or is not only) income and consumption, but well-being. Yet increasing income inequality is just one side of the coin, since less skilled/educated people bear larger psychological costs also due to their experience of a larger number of episodes of involuntary unemployment. Hence, in the long run, lack of both macro- and microeconomic regulation will also bring about an even larger increase in inequality of experienced utility (De Neve et al., 2015). In the past, much emphasis has been placed on the importance of upward social mobility to explain the lack of redistributive institutions in the USA and, more generally, in Anglo-Saxon countries. The recorded trend in income inequality and social mobility across the OECD countries (Cingano, 2014; Corak, 2013; Bukodi et al., 2015) would suggest that the probability of downward social mobility has been underrated by most people, or that democratic institutions have not worked well in responding to preferences for redistribution and, more generally, socially inclusive economic institutions.16 Finally, the main link between rising income inequality and rising social immobility is education (Bukodi et al., 2015). People at the bottom of the income distribution are confronted with poorer educational opportunities and a lack of incentives to invest in human capital. This leads to a double adverse effect: it spurs future income inequality through the labour market and it maintains high costs of macroeconomic volatility for less skilled social groups. Bibliography Akerlof , G . 2002 . 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(2014). 2 ‘I ask what the effect on welfare would be if all consumption variability could be eliminated’ (Lucas, 2003, p. 3). 3 See e.g. Tversky and Kahneman (1991), Kahneman et al. (1991), D’Orlando and Ferrante (2009), D’Orlando et al. (2011). 4 See e.g. Knetsch and Sinden (1984), Knetsch (1989), Kahneman et al. (1990, 1991). 5 See e.g. Samuelson and Zeckhauser (1988), Kahneman et al. (1991). 6 See e.g. Brickman et al. (1978), Clark and Oswald (1994), Clark (1999), Diener et al. (1999), Frederick and Loewenstein (1999), Frey and Stutzer (2002), Di Tella et al. (2003), Clark et al. (2004), Stutzer (2004), Layard (2005), Diener et al. (2006), Oswald and Powdthavee (2006), D’Orlando and Ferrante (2008, 2009), Lyubomirsky (2011), D’Orlando et al. (2011), Armenta et al. (2014). 7 For a discussion on the theme of complete or incomplete adaptation and the setpoint hypothesis, see Easterlin (2003) and Lucas et al. (2004). 8 ‘Numerous investigations offer evidence for an asymmetry in positive and negative emotions’ (Lyubomirsky, 2010, p. 203). 9 ‘Whether individuals have experienced disability, unemployment, widowhood, or divorce (all extremely negative experiences in the domains of health, work, and interpersonal relationship), their levels of well-being took a “hit” from the event and, on average, never fully recover’ (Lyubomirsky, 2010, p. 202). 10 ‘We find that relative income mobility is a significant predictor of life satisfaction and mental health. We also find that its effects are consistent with the loss aversion hypothesis—going down matters more. This is reflected in the fact that the coefficients attached to downward mobility are always larger than those for upward mobility’ (Dolan and Lordan, 2013, p. 16). For instance, according to Dolan and Lordan’s estimations, the negative impact on life satisfaction of downward social mobility is 1.98 times the positive impact of upward social mobility. 11 According to Krusell et al. (2009, pp. 394, 404 and passim), in the presence of stabilization policies, precautionary saving in the economy falls, so that the interest rate raises and the very richest, who own a great amount of wealth, ultimately benefit. 12 According to the data reported by Mukoyama and Sahin (2003, pp. 4–5), unskilled workers (‘high school diploma or lower’) have historically experienced an unemployment rate on average more than double that of skilled workers (‘some college or above’). Furthermore, unskilled workers experience a higher risk of becoming unemployed during recessions and their unemployment rate is also more volatile (Mukoyama and Sahin, 2003, p. 5 and note 1). 13 George Akerlof referred to his research programme as ‘behavioral macroeconomics’ in the lecture he delivered in Stockholm on December 2001 when he received the Nobel Memorial Prize in Economic Sciences. This lecture later became a published paper (Akerlof, 2002). Among the other most relevant contributions on behavioural macroeconomics and animal spirits are Woodford (1991), De Grauwe (2008, 2012), Dow and Dow (2011), De Grauwe and Ji (2016) and Gabaix (2016). 14 We do not want to suggest that rigidity in employment contracts is a good thing per se. An excess of protection can generate opportunistic behaviours, and the moving of workers from shrinking traditional sectors to expanding innovative ones is a positive phenomenon. However, it is necessary to build mechanisms capable of governing these processes, by minimizing the associated well-being losses, particularly for the weakest individuals and categories of workers who obtain fewer advantages through flexibility. 15 According to De Neve et al. (2015, pp. 9–10): ‘some 2 to 6 percent of economic growth would be required to offset just 1 percent of economic contraction’. 16 Or that, perhaps due to the prevailing cultural climate spurred by mainstream economics, the electoral body suffered from cognitive distortions in assessing the true probability of upward social mobility. © The Author(s) 2017. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Cambridge Journal of Economics Oxford University Press

Macroeconomic priorities revisited: the behavioural foundations of stabilization policies

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Oxford University Press
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© The Author(s) 2017. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved.
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0309-166X
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1464-3545
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10.1093/cje/bex076
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Abstract

Abstract The theoretical literature that neglects the benefits of stabilization policies (e.g., Lucas 1987, 2003) ultimately relies on the low impact of macroeconomic volatility on aggregate income and consumption. We argue that this conclusion is theoretically and empirically weak. Theoretically, the cost of volatility should be measured by including not only monetary magnitudes, but also those psychological costs whose relevance has been stressed by behavioural economics and that are correlated with the number of unemployment episodes. We refer here to implications for the experienced utility of loss aversion, the endowment effect and hedonic adaptation. Empirically, downturns more severely affect those who have less and who suffer greater well-being losses from each shock, magnifying the negative impact of recessions. It follows that the traditional analysis, which disregards the main causes of well-being losses determined by downturns, cannot represent a sound basis for dismissing policies aimed at preventing downturns (and/or their impact on the labour market). 1. Introduction In the last 30 years or so, in most OECD countries, policymakers’ propensity to regulate the economy and/or to implement measures against unemployment has become weaker and less incisive (D’Orlando and Ferrante, 2009; D’Orlando et al., 2011). In general terms, such a result appears to cohere with the diffusion of DSGE and new classical macroeconomic models, which have allowed, to some degree, the resurgence of pre-Keynesian economic principles. In more specific terms, the argument has been that macroeconomic volatility, caused by the reduction in public intervention, has merely a small impact on consumers’ well-being, such that people would give up only a tiny fraction of their consumption to avoid instability. This conclusion has been crucially influenced by two important contributions from Nobel laureate Robert Lucas (1987, 2003). A role has also been played by the idea that less activist public stabilization policies would permit a higher growth rate, thereby more than compensating, at least in the long run, the loss of well-being suffered by those subjects who pay the cost of macroeconomic volatility. A counterpart to the argument that it is rational to forgo the benefits of stabilization policy, due to its long-term costs, is the idea that a lack of redistribution, in very unequal societies, is rationally accepted by the median voter who would gain from redistribution because he/she expects to benefit from the higher probability of upward social mobility stemming from a lack of redistributive policies. This represents the ‘prospect of upward mobility’ (POUM) hypothesis (Benabou and Ok, 2001). Lucas’s 1987 and 2003 contributions deal with situations in which actual magnitudes deviate randomly from their long-period trend, realizing that trend only on average. In other words, they are concerned with a post–World War II and pre-subprime crisis world in which recessions have been defeated. Yet (at least implicitly) the same philosophy has been applied to the Great Recessions of 2007 and later, a situation clearly differing from that of random deviations of actual magnitudes from the trend. In such a world, the main driver of variations in well-being is assumed to be consumption volatility. In this article, we argue that the above-described approach is weak, both in theoretical and empirical terms, and regarding both temporary deviations from the trend and recessions. This is because Lucas (correctly) refers to well-being losses as the main indicator of macroeconomic performance, but he (incorrectly) neglects the main driver of people’s subjective well-being—their occupational status. By doing so, he understates the actual impact on individual well-being, and on specific social groups, of macroeconomic shocks generated not only by Great Recessions, but also by simple macroeconomic instability. Our argument is that, to correctly measure macroeconomic performance, one certainly must gauge well-being losses, but since well-being losses are crucially influenced by variations in people’s employment status, the analysis of macroeconomic performance should attribute a central role to unemployment, which is thus at the core of the present paper. Furthermore, since measuring well-being losses deriving from unemployment requires that one computes not only the monetary costs but also (and primarily) the psychological costs of unemployment, which are disregarded by traditional analyses, we conclude that well-being losses deriving from macroeconomic instability are far greater than in Lucas’s account. Our conclusions are based on a number of economic psychology and behavioural economics contributions on loss aversion, hedonic adaptation and the endowment effect,1 which are theoretically and empirically robust, but have nevertheless been almost entirely ignored in the debate on this theme. These contributions suggest that well-being losses caused by unemployment shocks are greater than believed not only by the majority of the traditional theoretical literature, but also by the critics of that literature. The policy implications of an approach that so greatly understates the actual magnitude of its main object of investigation can thus hardly be endorsed. Therefore, since almost all the literature based on Lucas’s contributions in fact ignores the great psychological costs of unemployment, the conclusion that the benefits of non-regulated markets would outweigh the costs of non-governed economic fluctuations is untenable. Stabilization policies, as well as micro regulation policies aimed at contrasting economic downturns and unemployment episodes, cannot be disregarded on the grounds of these weak theoretical bases. The traditional approach also appears weak from an empirical viewpoint. Downturns and recessions have increased inequality, having a greater effect on those who have less (in terms of skills, income and wealth), i.e. those for whom loss aversion is more severe. Therefore, even for the case in which monetary gains and losses from the business cycle balance out on average over time, the representative agent hypothesis used by Lucas does not cohere with reality and the sum of aggregate well-being gains and losses is not nil, but rather negative in sign and huge in absolute value. This is so for three reasons: i) the theoretical and empirical literature on loss aversion shows that losses (negatively) affect well-being more than do gains; ii) recessions and downturns are not randomly distributed within the working population since they affect individuals holding specific characteristics more than others and the probability of being hit at time t is positively correlated with the probability at time t-1 (Heckman and Borjas, 1980), so loss aversion is more severe for these subjects; and iii) as a result, recessions and downturns tend to primarily affect people for whom loss aversion and hence well-being losses are more severe. On these grounds, one can argue that labour market flexibility does not depend solely on the norms regulating the market itself, but also on behavioural factors that determine workers’ capabilities—in Sen’s perspective—to adapt to changes in their occupational status and the costs of doing so. According to this latter perspective, the impact of the non-pecuniary costs of unemployment episodes would be negatively related to the income and education levels of the individuals concerned. It follows that, in some circumstances and countries, loss aversion is more severe and, therefore, the cost of a lack of regulatory policies is particularly high and regressive. These results appear further strengthened if one considers several recent contributions, as we do in the present paper, that use insights from behavioural economics to draw conclusions valid for the aggregate. Such an approach has been referred to as behavioural macroeconomics (see, e.g., Akerlof, 2002). Some of these contributions suggest that endogenous waves of pessimism induced by ‘animal spirits’ can generate cyclical instability, render periods of negative macroeconomic performance longer and deeper (De Grauwe, 2008, 2012), justify more active public policies (De Grauwe and Ji, 2016) and strengthen the efficacy of fiscal policies (Gabaix, 2016). Whereas behavioural macroeconomics has the very ambitious scope of using behavioural economics to build a microfounded macroeconomic framework and to explain the causes of recessions, we have the far less ambitious scope of proposing a criterion for measuring the well-being impact of these recessions that differs from the standard approach. Nonetheless, as we shall see, behavioural insights represent a common feature and one approach can be used to reinforce the conclusions of another. In particular, our approach can furnish insights to explain why and under what circumstances waves of pessimism are higher (or lower). The above considerations undermine, on the one hand, the relevance of the arguments used to justify neglect of the need for policies to counteract downturns and, more broadly, to reduce the impact of economic fluctuations on the labour market. On the other hand, these considerations also undermine the relevance of the arguments used to dismiss labour market institutions on progressive grounds, based on so-called on the job protection, which can reduce the impact of labour market instability on workers’ well-being. On the same bases, one can also argue that limiting unemployment episodes—by stabilizing the business cycle through macroeconomic policies (specifically fiscal policies), by instituting microeconomic regulation policies and/or by avoiding the impact of economic shocks on the labour market—can generate better aggregate outcomes with respect to curing unemployment after it has appeared, by using subsidies or even by hiring the unemployed after they have become unemployed. This paper is organized as follows: Section 1 offers a review of the literature, originating from Lucas’s 1987 book, which discusses the idea that the benefits of flexibility—i.e. the absence of business cycle regulation—are greater than its costs. Section 2 focuses on the social costs of flexibility and shows that, if one includes psychological costs, these social costs are far greater than traditional economic approaches assume, particularly those approaches described in Section 1. Section 3 argues that downturns have a greater negative effect on those who have less wealth and education and, since those who have less suffer more from loss aversion, this reduces their well-being further and strengthens our conclusions. Section 4 draws out the main implications of our analysis, describing the policies that should be dismissed if Lucas’s analysis is sound and that, in our view, are again relevant once Lucas’s analysis proves unsound (particularly those policies necessary to reduce the costs of flexibility, as well as macro- and microeconomic regulations aimed at preventing recessions). Section 5 summarizes our results and offers conclusions. 2. Are stabilization policies unnecessary? Lucas’s 1987 book Models of Business Cycles gave rise to an important debate on the role of stabilization policies, a debate to which Lucas himself later contributed (Lucas, 2003). In line with neoclassical macroeconomic principles, Lucas considers stabilization policies, for the general case, unnecessary, useless and even dangerous. For the specific context here considered, he investigates the usefulness of policies aimed at reducing the macroeconomic volatility that the economy has in fact experienced over the past few decades. To put it another way, he discusses the utility of more aggressive stabilization policies with respect to ‘the general stabilization of spending that characterizes the last 50 years’ (Lucas, 2003, p. 11). He concludes that ‘there is little benefit from further stabilization’ (Barlevy, 2005, p. 32), since ‘[t]he potential gains from improved stabilization policies are on the order of hundredths of a percent of consumption, perhaps two orders of magnitude smaller than the potential benefits of available “supply-side” fiscal reforms’ (Lucas, 2003, p. 11). From what precedes, it is clear that Lucas’s contribution is not about recessions. He argues that macroeconomics and related stabilization policies have succeeded, since the ‘central problem of depression prevention has been solved’ (Lucas, 2003, p. 1). The problem is hence simply excess deviations of the economy from its long-run trend. According to Lucas, people suffer due to the uncertainty stemming from the unpredictable variability of their consumption path during the business cycle, which would be smoothed by further stabilization policies.2 However—and this is the central point—the extent of this well-being loss is very small, so small that the burden of the costs of further stabilization policies certainly exceeds their benefits. To reach such a result in a context in which consumption grows at a constant rate, Lucas calculates the utility loss deriving from the business cycle. He considers the following intertemporal utility function, in which utility depends upon a sequence through time of actual consumption expenditure, Ct, with t indicating the year: U=f(Ct, Ct+1,…) with Ct=(1+ε)C*t In these relations, C*t is the trend in consumption and ε is a random deviation of actual consumption from the trend. Aggregate consumption corresponds to the trend on average, but can be above or below it in a specific year. As we have said, recessions affecting the trend are out of the question. The loss in well-being that subjects suffer due to macroeconomic volatility can be measured by the difference between the utility of a path of consumption strictly corresponding to the consumption trend, U=f(C*t, C*t+1, ...), and the utility of a path of actual consumption deviating from the trend, U=f(Ct, Ct+1, ...). Lucas defines this loss as the amount of consumption that should be added to actual consumption to obtain the same utility that a consumer would have in a world in which consumption does not deviate from the trend (Lucas, 2003, p. 1). Formally, one obtains this result by singling out the value of the cost of volatility μ that realizes the following condition: U((1+µ)Ct, (1+µ)Ct+1,…)=U(C*t,C*t+1,…) According to Lucas, µ will increase with increasing consumption volatility and with increasing individual aversion to volatility. Hence, µ depends upon both the objective loss of consumption during the business cycle and the subjective aversion to risk of individuals. Since i) until 2007, consumption was not particularly volatile; and ii) Lucas assumes a relatively small risk aversion parameter, equal to one, he concludes that individuals would accept paying less than 0.1% of their lifetime consumption to avoid volatility. It follows that policies aimed at avoiding further deviation of consumption from this trend are almost useless. Lucas’s contribution has been the object of a number of critiques, most of which have primarily attempted to find different/greater values for the well-being loss. Some scholars (see, e.g., Guillén et al., 2014) criticize Lucas’s 1987 paper for considering a post–World War II world in which stabilization policies operate and not a pre–World War II world in which stabilization policies were almost absent. The point raised by Lucas would therefore refer to more active stabilization policies and not to stabilization policies per se, as these policies in fact prevented the greater welfare losses seen in pre–World War II times. Similar critiques refer to the fact that Lucas excludes from his analysis not only a world in which macroeconomic instability is significant due to the absence of stabilization policies, but also the cases of Great Recessions, in which the problem is not simply random deviations from the trend. In the case of a ‘crash state in consumption’ (see, e.g., Salyer, 2007), with a double-digit reduction in consumption, the welfare loss deriving from the absence of stabilization policies is far greater than in Lucas’s vision. These above-mentioned studies are the only ones capable of obtaining numeric results for the welfare loss that are considerably greater than those obtained by Lucas. The majority of the remaining contributions on this theme do not deviate much from Lucas’s quantitative results, even when they propose theoretically relevant (but numerically relatively insignificant) modifications to the logic of the argument. This is especially the case for those authors who argue that Lucas understates the cost of the business cycle, due to his misanalysis of the relevance of risk aversion (see, e.g., Epstein and Zin, 1991; Obstfeld, 1994; Pemberton, 1996; Dolmas, 1998; Tallarini, 2000). Other contributions (Krusell and Smith, 1998; Mukoyama and Sahin, 2006; Krebs, 2007; Krusell et al., 2009) criticize the representative agent hypothesis adopted by Lucas. They argue that, by using this hypothesis, Lucas greatly understates the huge impact of the business cycle on subgroups of subjects. In models with heterogeneous agents, specifically, the impact of the business cycle on weak subgroups, such as the poorest or the unemployed, would be particularly relevant. The present paper also aims to show the theoretical weaknesses of Lucas’s procedure, together with the far greater impact the business cycle has on well-being in the absence of stabilization policies. However, in doing so, we do not focus on ‘crash states’ in consumption, on pre– and post–World War II data, on Great Recessions, on an incorrect estimation of risk aversion or on the empirical invalidity of the representative agent hypothesis (even if, in our analysis, subjects are highly heterogeneous, inequality matters and hence that hypothesis cannot hold true). We instead base our argument on a number of robust theoretical and empirical results from recent contributions in economics and psychology. In particular, our conclusions are based on the concepts and models of loss aversion, status quo bias and hedonic adaptation. To the best of our knowledge, these models and principles have never been applied to Lucas’s analysis, even if intuitions in this direction may be found in De Neve et al. (2015, e.g., p. 19). On these bases, we find relevant well-being costs of downturns (and, in particular, of unemployment caused by downturns) and robust motivations for implementing stabilization policies. These results follow from the acknowledgement of ‘the non-pecuniary costs of unemployment (Clark and Oswald, 1994; Winkelmann and Winkelmann, 1998; Wolfers, 2003; Kassenboehmer and Haisken-DeNew, 2009), which typically increase during recessions’ (De Neve et al., 2015, p. 19). 3. The true costs of unemployment The unemployment costs resulting from the absence of macro and micro regulatory policies capable of avoiding severe economic downturns—and/or preventing workers from being fired during downturns—can be defined as the costs of flexibility (of the labour market). These costs can be classified as either pecuniary or non-pecuniary. Pecuniary costs can be computed in monetary terms and are the income and/or consumption losses deriving from unemployment, the costs of searching for a new job, the costs of geographical mobility, the possibility of finding a new job with a lower wage, etc. Non-pecuniary costs, on the contrary, are not linked with a loss of income and/or consumption, but include the psychological costs that subjects suffer due to changing status, habits and lifestyles, potential social stigma, loss of esteem and social networks, etc. These costs must be measured in terms of well-being rather than consumption (and/or income) and their relevance is confirmed by both empirical evidence and theoretical studies. A number of behavioural economics and economic psychology principles and models can be used to study the overall cost of the business cycle and of unemployment, in particular, loss aversion,3 the endowment effect,4 the status quo bias5 and hedonic adaptation.6 Let us start with loss aversion. According to Kahneman et al. (1991, p. 199): ‘[a] central conclusion of the study of risky choice has been that [...] changes that make things worse (losses) loom larger than improvement or gains’. This conclusion bears important implications for the calculation of the costs of downturns in general, and of unemployment in particular, since unemployment episodes are events that imply a very high psychological cost which is compensable only at a very high monetary cost. The idea that bad events carry more weight than good ones is confirmed by both the status quo bias and the endowment effect. These two concepts are strictly linked, and are also tied to the idea that people are more responsive to losses than to gains of equal size. The status quo bias was originally described by Samuelson and Zeckhauser (1988), who found a strong preference among individuals for the status quo (or what they believe to be the status quo) ‘because the disadvantages of leaving it loom larger than advantages’ (Kahneman et al., 1991, pp. 197–98). A similar behavioural principle is the endowment effect, which has been verified empirically, mainly by repeated experiments (see, e.g., Knetsch and Sinden, 1984; Knetsch, 1989; Kahneman et al., 1990). We can describe the endowment effect as ‘the fact that people often demand much more to give up an object than they would be willing to pay to acquire it’ (Kahneman et al., 1991, p. 194). When an object becomes part of the subject’s endowment (and here is the link with the status quo bias), the subject tends to overvalue it. The cumulative result of considering loss aversion, the status quo bias and the endowment effect together is that unemployment episodes reduce well-being more than hiring episodes increase it. Therefore, the fact that income and consumption do not change, on average, during the business cycle nonetheless implies aggregate well-being losses. The above principles and considerations are crucial for a full understanding of the importance of hedonic adaptation for the study of the psychological costs of business cycles. The key finding of the hedonic adaptation approach is that people adapt to life events: ‘[l]ife events such as marriage, loss of a job, and serious injury may deflect a person above or below [his/her] setpoint, but in time hedonic adaptation will return an individual to the initial setpoint’ (Easterlin, 2003, p. 1). Such a process is sometimes called ‘habituation’. After the seminal paper by Brickman et al. in 1978, empirical evidence on hedonic adaptation has been thoroughly discussed in psychological journals (see, e.g., Diener et al., 1999; Frederick and Loewenstein, 1999; Clark et al., 2004; Lucas et al., 2004; Oswald and Powdthavee, 2006; Diener et al., 2006; Lyubomirsky, 2011). However, it is still disputed whether adaptation is complete or incomplete, i.e. whether life shocks have a permanent effect on the long-term level of agents’ well-being,7 since in some cases ‘people do not completely adapt to conditions’ (Diener et al., 2006, p. 309). In particular, there seems to exist a rather asymmetric reaction to bad and good events in life:8 people adapt with more difficulty, over a longer period and less completely to negative rather than to positive events (Armenta et al., 2014, p. 64; Lyubomirsky, 2011, p. 204).9 Attempts have also been made to measure such an asymmetry and ‘[a]lthough it is premature to conclude that negative experiences are three times as bad as positive experiences, these findings at a minimum suggest that the “punch” of one bad emotion, utterance, or event can match or outdo that of three or more good ones’ (Lyubomirsky, 2011, p. 204). Furthermore, it is a generally accepted conclusion in literature (see, e.g., Lucas et al., 2004; Diener et al., 2006; Armenta et al., 2014) that reactions to unemployment episodes constitute a rather particular case of (the absence of) hedonic adaptation. Following the negative event represented by an unemployment episode, the habituation process starts as usual and people tend towards their baseline level of well-being, but the process is very slow and incomplete. As a result, people do not fully adapt to the unemployment episode and they never regain their baseline level of well-being. Some authors (see, e.g., Clark et al., 2008) maintain that unemployment is the only negative event that does not allow for complete adaptation in the long run. Furthermore, people do not regain their baseline level of well-being even if they are re-employed (Lucas et al., 2004). To put it another way, unemployment episodes leave an irreversible trace in people’s lives, permanently reducing their long-run levels of well-being. The idea, already discussed with reference to loss aversion, that bad events carry greater weight than good ones, is hence also confirmed within the hedonic adaptation framework. Hedonic adaptation is particularly suitable for developing a comprehensive approach capable of studying the true costs of unemployment episodes and, in particular, the non-pecuniary costs. In Figure 1, the evolution of a worker’s well-being in the presence of hedonic adaptation is illustrated. With the first unemployment episode, subjective well-being dramatically falls. Thereafter, thanks to hedonic adaptation, well-being increases again, but it never reaches the previous level, even if the unemployed person gets a new job at the same wage as the old one. We can suppose that this is a consequence of the loss of esteem, changing status, social stigma, etc. Only a wage higher than the original could compensate for and eliminate the loss deriving from unemployment episodes. Furthermore, irreversible losses tend to accumulate, unemployment episode after unemployment episode. Fig. 1. View largeDownload slide Hedonic adaptation and the true costs of unemployment. Fig. 1. View largeDownload slide Hedonic adaptation and the true costs of unemployment. In a hedonic adaptation framework, the negative impact on well-being of numerous unemployment episodes is hence greater (more severe) than the impact on well-being of fewer, even if longer, unemployment episodes. Both downturns and recessions generate an increase in the number of unemployment episodes. Furthermore, the financial transfer necessary to fully compensate individuals for the loss of their well-being caused by unemployment episodes would be extremely high, since an adequate unemployment benefit should be greater than the wage the fired workers lost. Even obtaining a new job after an unemployment episode could compensate the worker for the unemployment experience only if the new wage is higher than the old one. Therefore, again, even if, during the business cycle, income and consumption go up and down, remaining unchanged on average, the negative impact on well-being of unemployment episodes is greater than the positive impact of re-employment episodes. Even if income and consumption remain unchanged on average, well-being falls, and this is not due to the subjects’ aversion to volatility. It is exactly the same conclusion reached with reference to status quo bias, the endowment effect and loss aversion. Similar results have also been obtained by Wolfers (2003), according to whom unemployment volatility undermines well-being. It is not easy to quantify, even in rough terms, well-being losses deriving from the psychological costs of flexibility described above. Recent contributions, however, have demonstrated that the classic loss aversion effect operates in this domain such that an income loss decreases life satisfaction at least twice as strongly as an equivalent income gain increases it (Boyce et al., 2013, replicated at the macro level by De Neve et al., 2015). Survey data on life satisfaction have been used to quantify the adverse effect of unemployment on well-being (Winkelmann, 2014). The gap in life satisfaction between unemployed and employed workers in the 21 participating European countries in the European Social Survey for 2002–2009 ranges from 0.5 points to around 2.5 points (Wulfgramm, 2014). On a four-point life satisfaction scale, Helliwell and Huang (2014) find a gap in subjective well-being of 0.4 points among Americans. The latter difference in subjective well-being persists after controlling for income, suggesting that the main source of well-being loss due to unemployment is its pecuniary costs. Helliwell and Huang (2014) also show that the aggregate unemployment rate adversely affects subjective well-being, arguing that it does so by increasing job insecurity. All the above findings seem to fully justify a role for countercyclical policies as a means of reducing the number of unemployment episodes and hence well-being losses. 4. The impact on well-being of hitting the disadvantaged more By definition, during the business cycle, we have periods in which aggregate income and consumption are above the trend and periods in which they are below the trend, even if the average of actual magnitudes over time coincides with the trend. However, apart from the fact that Great Recessions meet these requisites only with difficulty, even if we assume that over time in the aggregate negative and positive effects cancel one another out, this does not happen for each individual. In fact, according to what we have experienced in the last 40 years or so, there exist categories of individuals who, in downturns, experience no decrease or even improve their economic position, at least in relative terms, as well as groups who always experience worsening economic positions, both in absolute and relative terms. If compensating mechanisms are absent, following an entire business cycle, some categories of people will have more than they had before the cycle and some less. According to Cingano (2014, p. 6): ‘[i]n most OECD countries, the gap between rich and poor is at its highest level since 30 years. Today, the richest 10 per cent of the population in the OECD area earn 9.5 times the income of the poorest 10 per cent; in the 1980s this ratio stood at 7:1 and has been rising continuously ever since. However, the rise in overall income inequality is not (only) about surging top income shares: often, incomes at the bottom grew much slower during the prosperous years and fell during downturns, putting relative […] income poverty on the radar of policy concerns’. Rising inequality is then also attributable to the fact that random shocks do not affect all people in the same way: downturns have a greater effect on those who have less in terms of skills, education and wealth. Furthermore, following a business cycle, these subjects may not regain the level of income and consumption they had before the cycle, such that even if the average effect over time is nil, some categories of people experience irreversible losses not only in psychological terms, but also in monetary terms (i.e. suffering income and consumption losses). The intuition behind the Great Gatsby curve and scarce upward social mobility, which, according to many scholars (Bukodi et al., 2015; Corak, 2013), characterizes the last few decades, contributes to the fact that shocks always affect the same (poor) people. Moreover, in the context of increasing downward social mobility, loss aversion implies that the welfare gains of those individuals enjoying upward social mobility are not sufficient to compensate the welfare loss of those individuals experiencing downward social mobility, unless the probability of the former is much larger—at least twice as large—as the probability of the latter.10 For instance, a study in the UK showed that, over the last 50 years or so, upward social mobility decreased and downward social mobility increased. As a result, the two probabilities converged, for men, on the same value of 35.8%; there was a similar trend for women (Bukodi et al., 2015). The above considerations bear important implications for the soundness of Lucas’s approach. We mentioned in Section 1 that a number of contributions (e.g. Krusell and Smith, 1998; Mukoyama and Sahin, 2006; Krebs, 2007; Krusell et al., 2009) critique Lucas’s approach for being founded on a hypothesis (the representative agent hypothesis) which inevitably understates actual well-being losses. According to these contributions, upon removing the representative agent hypothesis economic shocks show stronger negative well-being effects for subcategories of subjects.11 This is so because ‘the gains from eliminating the business cycles exhibit a “U”-shaped pattern. Borrowing constrained agents have a larger gain, reflecting the fact that they cannot self-insure their risk by their own assets. […] The “middle class” tends to have small or negative gains. […] Very rich agents realize welfare gains since their income is largely coming from capital income’ (Mukoyama and Sahin, 2003, p. 18). The implications of our contribution go further in this direction. If downturns have a greater effect on those who have less (in terms of skills and education), and the analysis we have proposed in the previous section is correct, one must also consider that those who have less are those who disproportionately suffer from loss aversion. Having a higher level of loss aversion, in turn, implies unemployment shocks and status shocks imposing greater negative effects on well-being. In other words, economic downturns and recessions generate larger shocks for people for whom shocks reduce well-being to a greater extent; and since losses carry a greater weight than gains, the resulting aggregate well-being variations may be large and negative. Furthermore, these subjects are not compensated by future adequate income increases, since they exit downturns worse off than when they entered. As a result, there is a further reduction in aggregate (and average) well-being that is not compensated by future expansions. The problem is particularly relevant for unskilled workers, who face a greater probability of being fired. According to Mukoyama and Sahin (2003, pp. 19–20), ‘[u]nskilled agents face more cyclical unemployment risk and they have less opportunity to self-insure. As a result, the cost of business cycles is much larger for a typical unskilled agent compared to a typical skilled agent’.12 It follows that our contribution further strengthens the critiques addressed to Lucas regarding the use of the representative agent hypothesis. We have shown that, upon removing this hypothesis, not only does theoretical analysis demonstrate a negative impact of the business cycle on average well-being, but also that this impact is far greater than that imagined by these critics. If, as we have sketched above, one introduces into the model the realistic assumption that subjects are highly heterogeneous (since different endowments of skill and/or education and/or wealth imply different psychological consequences of downturns and expansions), and if their well-being is influenced in a highly differentiated and asymmetric way by downturns and expansions, such that inequality matters, the results reached by modelling the behaviour of a representative single agent as valid for the aggregate are very different from the results reached by modelling the behaviour of heterogeneous agents. Indeed, in the real world, subjects are heterogeneous. As a result, the representative agent hypothesis cannot be defended even on the grounds of ‘small deviations’ or an ‘as if’ argument. Lucas’s analysis is flawed and the significant impact of the business cycle on well-being leaves space for justified stabilization policies. Our conclusion—that the traditional arguments used to claim the uselessness of countercyclical policies are theoretically weak—is hence strengthened by empirical considerations regarding how the absence of further business cycle stabilization actually influences distributive magnitudes and well-being and, in fact, strengthens the critiques of Lucas’s use of the representative agent hypothesis. 5. Why stabilization and micro regulation policies cannot be considered unnecessary Both the pecuniary and non-pecuniary costs of unemployment and downturns have differing impacts on workers’ well-being depending on whether labour market institutions are based on protection on the market or protection on the job. In the first case, firms’ firing costs are low so that firms can easily vary the composition of their workforce, but the unemployed get generous unemployment compensation. By contrast, in the case of protection on the job, firing costs are high (and can be so high as to prevent firms from firing workers) but the unemployed do not receive compensation benefits, or these benefits are extremely low. Empirical evidence (Bertola, 1990; Bertola and Rogerson, 1997) shows that there are differences between these two contexts in terms of flows entering and exiting unemployment and the lengths of unemployment periods. In the case of protection on the market, small firing costs result in not only easier firing, but also easier hiring of workers, since firms know that they will be able to fire workers with relatively low cost when they become unnecessary. As a result, flows entering and exiting unemployment are high and workers can expect many unemployment episodes during their working life, though these episodes will be of short length. Moreover, young people entering the labour market for the first time find it easy to gain employment. By contrast, in the case of protection on the job, high firing costs force firms to be extremely cautious in hiring workers, as they know they will not be able to easily fire them. Flows entering and exiting unemployment are thus low and workers can expect few unemployment episodes during their working life, but these episodes will be long-lasting. In this case, young people entering the labour market for the first time experience greater difficulty in being hired, so they must expect a longer unemployment period. All of the above implies that the choice between the types of employment protection legislation to be implemented is not neutral with respect to workers’ interests. Indeed, on the job protection reduces the probability of being fired for less skilled workers, but increases unemployment lengths for all workers, particularly the most skilled, who face a lower probability of losing their jobs, as well as people entering the labour market for the first time. By contrast, on the market protection increases the probability of being fired for less skilled workers, but reduces unemployment lengths for all workers, particularly the most qualified, and makes it easier for people entering the labour market for the first time to find a job. Hence, on the job protection improves the relative position of less qualified workers and worsens the relative position of young and more qualified workers, while on the market protection creates the opposite effect. On the job and on the market protections differ not only in the frequency and duration of unemployment episodes and hence the categories of workers who find their relative position improved or worsened. They differ also in the kind of unemployment costs that they succeed in compensating for. Unemployment benefits used in on the market protection compensate (at least partially) for monetary losses deriving from unemployment, but are not projected as instruments for compensating non-pecuniary costs and, in particular, psychological costs. On the contrary, both on the job protection (which protects workers from being fired during the business cycle) and countercyclical macro stabilization policies (which resist recessive shocks and hence reduce their impact on the labour market) can be used as instruments for minimizing non-pecuniary costs by reducing the number of unemployment episodes in workers’ lifetimes. In the specific context depicted in Sections 2 and 3, with huge negative effects of the business cycle on aggregate well-being due to the high psychological costs it generates, no sound theoretical or empirical argument can maintain that the costs of these policies exceed their benefits. However, the situation might vary across countries and Lucas’s conclusions might cohere with reality to a greater or lesser extent depending on the country in question. This is the case because loss aversion, the endowment effect and hedonic adaptation are sound and important concepts, but they depend upon factors such as workers’ skills, education, culture, religion, etc., such that their actual relevance varies from country to country (Ferrante, 2004; D’Orlando et al., 2011). It follows that workers from different countries will suffer varying degrees of psychological distress due to the business cycle and will hence require more or less incisive stabilization policies and different employment protection rules. In addition, a crucial role in determining the policies required by individuals, given these other conditions, is played by their level of training and education. More educated and/or better trained workers will need, and will hence demand, less protection against the business cycle and/or less on the job protection than less educated and/or less well-trained workers. It is therefore not surprising that countries with less educated and less well-trained workforces—typically those of the Global South—face more problems in their attempts to reduce labour market protection and countercyclical policies than countries in which the labour force is better trained and better educated—typically those of the Global North. We believe that the above considerations may play a role within the behavioural macroeconomics approach,13 particularly (but not exclusively) within those models that study the impact of ‘animal spirits’ on the business cycle (see, e.g., De Grauwe, 2008). Behavioural macroeconomists aim at grounding macroeconomics in more empirically robust bases, substituting some insights from behavioural economics for the standard rational expectations-maximizing assumptions regarding subjects’ behaviours. In this way, they find a rationale for fluctuations alternative to the standard DSGE explanation, i.e. alternative to ‘exogenous shocks in preferences, endowments and technologies that are slowly transmitted into the economy’ due to wage and price rigidities in a context in which subjects have rational expectations (De Grauwe, 2008, p. 2). Specifically, according to ‘animal spirits’ models, if agents experience cognitive limitations and use simple rules (‘heuristics’) to forecast the future, ‘endogenous and self-fulfilling waves of optimism and pessimism […] gripping investors and consumers’ (De Grauwe, 2008, pp. 1–2) can spread through the economy, generating endogenous dynamics (and hence the business cycle). Furthermore, fluctuations are more severe in these models than in the standard approach (Gabaix, 2016, p. 4). While sharing many theoretical and psychologically based tools with behavioural macroeconomics, our contribution does not have the aim of proposing more empirically robust foundations for macroeconomics or for the business cycle. It instead has the more modest goal of proposing an empirically sound way of measuring the well-being losses stemming from macroeconomic instability. In other words, behavioural macroeconomics aims at explaining the causes of recessions, while we simply aim at measuring their effects. Nonetheless, our approach and that of behavioural macroeconomics can reinforce one another. This is because animal spirits are a main source of macro- and microeconomic instability. As such, they deserve to be mentioned in the analysis of unemployment costs and the potential benefits of macro and micro regulation policies. Psychological factors responsible for the animal spirits dynamics are composed of both common and idiosyncratic components. The first component originates in the general climate of macroeconomic uncertainty affecting all agents, and especially investors, in the same ways. The second component originates in the climate of technological and organizational turbulence affecting specific industries or groups of firms sharing similar characteristics and structural problems at certain epochs (e.g. firms’ small size, their access to finance, etc.). The severity of the downturn characterizing macroeconomic instability will affect such idiosyncratic components, thereby amplifying the severity of the downturn and the general climate of uncertainty. This is often due to the effects of the downturn on the financial positions of industries or firms that are experiencing specific real turbulences. Now, we have shown that due to psychological costs downturns have a higher negative impact on well-being than predicted by the standard analysis. This magnified effect appears understated in animal spirits models, which usually limit themselves to forecasting pessimistic effects when pessimistic outcomes outperform their optimistic counterparts (De Grauwe 2008, pp. 7 ff.). Yet it is easy to link the spread of pessimism to the amplitude of the impact of recessions on well-being: greater negative psychological effects of downturns generate more intense waves of pessimism and hence greater turbulence. In other words, our analysis offers additional causes for the spread of pessimism, or at least furnishes important insights for measuring the amplitude of pessimistic waves, and calls for micro regulation policies to deal with idiosyncratic turbulences. It is worth noticing that, if our conclusions hold, waves of pessimism will be greater than waves of optimism due to asymmetry in the well-being impact of downturns and expansions. Furthermore, we have shown above that loss aversion, the endowment effect and hedonic adaptation depend upon elements such as workers’ skills, education, culture, religion, etc., so their actual relevance varies from country to country: countries with more educated and/or better trained workers will suffer less negative well-being effects due to downturns than countries with less educated and/or worse trained workers. This implies that waves of pessimism, and hence the (negative) effects of animal spirits on the depth of downturns, will be greater in less educated countries while waves of optimism will be weaker, thereby generating more severe recessions and less expansionary effects in these countries. The differing institutional and educational frameworks of different countries also contribute to an explanation of why the strength of opposition to labour market flexibility has been so geographically differentiated. These differences have emerged when countercyclical policies have been invoked both for further stabilization of the business cycle and for coping with the 2007 Great Recession. The first case lies within the Lucas framework, according to which, over time, aggregate average income and consumption coincide with the trend. The second case, however, falls outside the Lucas framework, since the question is whether flexibility permits the system to quickly return to full employment. In both cases, our approach shows that the costs of instability and/or recessions are higher than those assumed by the traditional approach, and that stabilization policies and/or on the job protections preventing downturns and/or recessions from affecting the labour market can be justified on sound theoretical bases. Additionally, on these points, our conclusions appear to cohere with those of behavioural macroeconomics, which invokes more active monetary policies and demonstrates that ‘[f]iscal policy is more powerful because Ricardian equivalence partly fails, [t]he Lucas critique has less, or zero, bite [and] GDP fluctuations are amplified and more persistent’ (Gabaix, 2016, p. 4). The above-proposed distinction between the common and idiosyncratic components of animal spirits implies that both macro and micro regulation policies will be required to deal with the common and the idiosyncratic components, respectively. As far as fiscal and monetary stabilization policies are concerned, there is not much to add to the existing contributions apart from the fact that their net benefits are much larger than is usually assumed. Micro regulation policies should be targeted to deal with the specific causes of turbulence and, as such, they may require a wide set of policy tools: industrial policies to deal with crises affecting specific industries, firms or groups of firms being required to implement structural transformations (incentives to network or to merge, access to finance, workers’ training, early retirement programmes for the elderly, etc.). The aim of all these measures is to turn the decision to break the employment relationship into a last resort, a solution to be taken only if no other long-term sustainable solution can be devised. The benefits of macroeconomic stabilization policies should be seen as a counterpart to the costs of on the job protection policies that would be imposed on the economy to minimize the costs of unemployment in the absence of macroeconomic stabilization policies. Additionally, dual labour market policies may be legitimate if insiders are older, less skilled and thus requiring of more protection than younger and more skilled outsiders, who are capable of dealing with risks, changes and more flexible contracts. In other words, skill and educational differences can justify different labour market institutions (i.e. on the job or on the market protections) not only between different countries, but also between different social groups within the same country. Groups who suffer more well-being losses due to downturns should be protected against unemployment to a greater extent than groups who suffer less. As we have noted, according to some estimates (Boyce et al., 2013; De Neve et al., 2015), the non-pecuniary costs of unemployment are dominant (75% of total cost). This implies that policies preventing unemployment should be preferred with respect to income support measures and that active labour market policies, while important, can contribute marginally to alleviating this cost by streamlining the search process. Nonetheless, the history of economic policies has followed a different path. Building on the traditional approach, countercyclical policies have been progressively and indiscriminately implemented with less frequency and intensity, and in some countries (and groups of countries) public expenditure on social welfare and on the job labour market protection has been reduced (D’Orlando and Ferrante, 2009). This is the case, for example, in the European Union. These policies have been implemented despite the fact that the losses associated with labour market flexibility, for some countries and/or individuals, outweigh the gains, with the consequence of thereby generating strong social and political opposition. This opposition cannot be explained by the traditional approach, but can by the approach here proposed. This confirms that both on the job protection and countercyclical policies are necessary in some countries in which low-skilled and -educated workers are a large percentage of the workforce.14 It is also necessary to give preference, when possible, to countercyclical measures over on the job protection schemes, since the latter may impose greater costs on society by blocking beneficial workers’ reallocation across sectors. For the same reasons, microeconomic regulation policies (e.g. industrial policies) may also play a role in governing the process of creative destruction, such that their impact on displaced workers is minimized—even if, in the long run, the most effective means of reducing the costs of workers’ reallocation across sectors and territories is to increase their behavioural flexibility through appropriate education and life-long training policies (Ferrante, 2004). With regards to the European Union, in which countercyclical policies are now particularly unpopular among many influential governments, our approach implies that fiscal policies and a different statute for the European Central Bank can be theoretically justified. In particular, fiscal policy should be targeted to public investment, as in the USA, whereas monetary policy should deal with not only inflation, but also unemployment, with the aim of reducing the frequency of unemployment episodes. 6. Conclusions The waves of deregulation experienced by the world economy over the past 30 years or so, accompanied by a less activist approach to micro- and macroeconomic regulation policies, have been inspired by the view that markets work well and that labour market flexibility is just a matter of setting the right norms. The underlying idea is that labour market flexibility depends solely on the norms it is regulated by and not also on behavioural factors that determine people’s capacity to adapt to changing life circumstances. According to this view, the long-run benefits of soft regulation and flexibility outweigh their short-term costs. Lucas’s 1987 and 2003 contributions are fully coherent with this view, suggesting that the welfare costs deriving from market volatility are almost nil and hence further stabilization policies are unnecessary. While contemporary economic reality, characterized by ‘Great Recessions’ and ‘secular stagnations’, is far from the world of random deviations of actual magnitudes from a long-term trend described by Lucas, simply rejecting his approach on the ground of realism does not seem sufficient. In many countries (e.g. those of the European Union), the philosophy used to fight the Great Recessions appears inspired by ideas very similar to those of Lucas. It is thus crucial to demonstrate that his conclusions regarding the uselessness of stabilization policies are untenable not only in the case of Great Recessions, but also in the more favourable case of cyclical instability. This is because sound theoretical contributions and robust empirical and experimental evidence suggest that the psychological costs of adaptation to unemployment episodes can be very large, particularly for less educated/skilled workers, during the business cycle as well as during recessions. However, we do not simply criticize the traditional approach and propose alternative criteria for measuring the aggregate true costs of the business cycle and unemployment. Further building upon the literature regarding the disproportionate impact of downturns on subgroups of agents (Krusell and Smith, 1998; Mukoyama and Sahin, 2006; Krebs, 2007; Krusell et al., 2009), our argument is that the traditional approach, and specifically Lucas’s analysis, also understates the fact that these costs are disproportionally borne by less educated/skilled workers. Hence, for a given level of income/consumption loss (i.e. a given deviation of income/consumption from its trend), the impact of business cycle volatility on well-being greatly varies i) with the number of unemployment episodes (and hence in the presence of different countercyclical policies and different labour market institutions); and ii) with workers’ educational and skills endowments. This is confirmed by contemporary economic theory, according to which well-being is a function of the number of unemployment episodes a worker experiences, on which countercyclical policies and labour market institutions crucially impact, and of workers’ capabilities endowments. As a result, not only should these variables somehow be included in the utility function, greatly increasing the cost of volatility, but, furthermore, we cannot even measure the cost of the absence of stabilization policies if we do not consider the different institutional frameworks of the labour market. Specifically, the same business cycle can produce worse effects on well-being in the presence of on the market employment protection legislation and better effects in the presence of on the job protection, the latter of which mitigates the impact of business cycle volatility on the labour market. Both of these institutional frameworks can produce different aggregate welfare effects, depending on workers’ skills/educational endowments. Furthermore, since hedonic adaptation confirms that well-being losses deriving from unemployment episodes can be compensated only by a new wage or unemployment benefit exceeding the preceding wage, it follows that preventing unemployment episodes before they happen is more efficient than curing them after they have happened. We can hence conclude that, for some groups of workers and for some countries, the traditional view according to which countercyclical policies and/or on the job protection may generate worse aggregate results than flexibility and/or on the market protection is incorrect. This result especially applies to countries with a low-skilled and relatively low-educated workforce. It is worth noting that our conclusions focus on the impact that unemployment episodes have on well-being within Lucas’s framework, in a context different from that which primarily focuses on the role of loss aversion in determining the impact of growth reduction on well-being, as carried out by De Neve et al. (2015).15 However, our analysis can be used to offer greater support to the idea that a ‘policy designed to engineer economic “booms”, but that risks even relatively short “busts” is unlikely to improve societal well-being in the long run. Steady positive growth that minimizes the risk of economic contraction seems the most likely route to an improvement in general well-being’ (De Neve et al., 2015, p. 22). We agree also with the conclusion that ‘[s]tandard analyses of the income-happiness relationship could arguably be interpreted as “growth is good”. However, in light of the asymmetric experience of positive and negative growth, an empirically more accurate interpretation of the income-happiness relationship would be that “recession is bad”’ (De Neve et al., 2015, p. 23). The deregulation and liberalization of trade and capital markets have also resulted in an inefficient redistribution of the costs of uncertainty within societies. Unskilled workers are now less protected from unemployment risks, whereas entrepreneurs and top managers can more easily reduce the financial and real risks of economic activity by exploiting diversification opportunities stemming from financial liberalization and the international delocalization of production. The risk of economic activity now carries more weight for less educated and weaker social groups than it did 40 years ago. In such a context, the main problem is not (or is not only) income and consumption, but well-being. Yet increasing income inequality is just one side of the coin, since less skilled/educated people bear larger psychological costs also due to their experience of a larger number of episodes of involuntary unemployment. Hence, in the long run, lack of both macro- and microeconomic regulation will also bring about an even larger increase in inequality of experienced utility (De Neve et al., 2015). In the past, much emphasis has been placed on the importance of upward social mobility to explain the lack of redistributive institutions in the USA and, more generally, in Anglo-Saxon countries. The recorded trend in income inequality and social mobility across the OECD countries (Cingano, 2014; Corak, 2013; Bukodi et al., 2015) would suggest that the probability of downward social mobility has been underrated by most people, or that democratic institutions have not worked well in responding to preferences for redistribution and, more generally, socially inclusive economic institutions.16 Finally, the main link between rising income inequality and rising social immobility is education (Bukodi et al., 2015). People at the bottom of the income distribution are confronted with poorer educational opportunities and a lack of incentives to invest in human capital. This leads to a double adverse effect: it spurs future income inequality through the labour market and it maintains high costs of macroeconomic volatility for less skilled social groups. Bibliography Akerlof , G . 2002 . 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(2014). 2 ‘I ask what the effect on welfare would be if all consumption variability could be eliminated’ (Lucas, 2003, p. 3). 3 See e.g. Tversky and Kahneman (1991), Kahneman et al. (1991), D’Orlando and Ferrante (2009), D’Orlando et al. (2011). 4 See e.g. Knetsch and Sinden (1984), Knetsch (1989), Kahneman et al. (1990, 1991). 5 See e.g. Samuelson and Zeckhauser (1988), Kahneman et al. (1991). 6 See e.g. Brickman et al. (1978), Clark and Oswald (1994), Clark (1999), Diener et al. (1999), Frederick and Loewenstein (1999), Frey and Stutzer (2002), Di Tella et al. (2003), Clark et al. (2004), Stutzer (2004), Layard (2005), Diener et al. (2006), Oswald and Powdthavee (2006), D’Orlando and Ferrante (2008, 2009), Lyubomirsky (2011), D’Orlando et al. (2011), Armenta et al. (2014). 7 For a discussion on the theme of complete or incomplete adaptation and the setpoint hypothesis, see Easterlin (2003) and Lucas et al. (2004). 8 ‘Numerous investigations offer evidence for an asymmetry in positive and negative emotions’ (Lyubomirsky, 2010, p. 203). 9 ‘Whether individuals have experienced disability, unemployment, widowhood, or divorce (all extremely negative experiences in the domains of health, work, and interpersonal relationship), their levels of well-being took a “hit” from the event and, on average, never fully recover’ (Lyubomirsky, 2010, p. 202). 10 ‘We find that relative income mobility is a significant predictor of life satisfaction and mental health. We also find that its effects are consistent with the loss aversion hypothesis—going down matters more. This is reflected in the fact that the coefficients attached to downward mobility are always larger than those for upward mobility’ (Dolan and Lordan, 2013, p. 16). For instance, according to Dolan and Lordan’s estimations, the negative impact on life satisfaction of downward social mobility is 1.98 times the positive impact of upward social mobility. 11 According to Krusell et al. (2009, pp. 394, 404 and passim), in the presence of stabilization policies, precautionary saving in the economy falls, so that the interest rate raises and the very richest, who own a great amount of wealth, ultimately benefit. 12 According to the data reported by Mukoyama and Sahin (2003, pp. 4–5), unskilled workers (‘high school diploma or lower’) have historically experienced an unemployment rate on average more than double that of skilled workers (‘some college or above’). Furthermore, unskilled workers experience a higher risk of becoming unemployed during recessions and their unemployment rate is also more volatile (Mukoyama and Sahin, 2003, p. 5 and note 1). 13 George Akerlof referred to his research programme as ‘behavioral macroeconomics’ in the lecture he delivered in Stockholm on December 2001 when he received the Nobel Memorial Prize in Economic Sciences. This lecture later became a published paper (Akerlof, 2002). Among the other most relevant contributions on behavioural macroeconomics and animal spirits are Woodford (1991), De Grauwe (2008, 2012), Dow and Dow (2011), De Grauwe and Ji (2016) and Gabaix (2016). 14 We do not want to suggest that rigidity in employment contracts is a good thing per se. An excess of protection can generate opportunistic behaviours, and the moving of workers from shrinking traditional sectors to expanding innovative ones is a positive phenomenon. However, it is necessary to build mechanisms capable of governing these processes, by minimizing the associated well-being losses, particularly for the weakest individuals and categories of workers who obtain fewer advantages through flexibility. 15 According to De Neve et al. (2015, pp. 9–10): ‘some 2 to 6 percent of economic growth would be required to offset just 1 percent of economic contraction’. 16 Or that, perhaps due to the prevailing cultural climate spurred by mainstream economics, the electoral body suffered from cognitive distortions in assessing the true probability of upward social mobility. © The Author(s) 2017. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved.

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Cambridge Journal of EconomicsOxford University Press

Published: Dec 25, 2017

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