A case for volatility

A lot of conventional macroeconomics is wrong, according to new research.

For years, macroeconomists have assumed that economic stability is a good thing. For this reason many have supported inflation targets to stabilize inflation ("nominal stability") and/or counter-cyclical fiscal policy to stabilize real output.

However, a new paper by Marianne Sensier at the University of Manchester and colleagues casts doubt upon this assumption.

They estimate that. In the UK, nominal instability has actually been good for longer-term growth – because high inflation, such as in the 70s and recently, helps to cut real wages and so keep workers in jobs.

And, they find, in the G7 countries generally, "output volatility is good for growth." There are several reasons why this might be, not all of them necessarily mutually compatible. One is that in booms, firms learn how to become more efficient as they rush to get orders filled, and this knowledge stays with managers even in downturns. Another possibility – emphasized by Daniel Gross in Pop! - is that booms leave a legacy of investments and innovations (such as in railways in the mid-1800s or the internet in the late 90s) which help the economy in later years. A third, more contested, possibility is that recessions have a "cleansing" effect; they force inefficient firms out of business, freeing up capital and labour to be used more productively. A fourth possibility, proposed by the late Hyman Minsky, is that stability can do long-term damage because it encourages financiers to take on too much risk and the subsequent financial crisis depresses long-term growth by starving otherwise good investment projects of finance.

All this is controversial. If, however, it is right it has two implications for policy now. First, it weakens the case for inflation targeting, as it suggests a little extra inflation volatility is no bad thing; how far this is a criticism of policy depends upon how much you think the Bank of England has actually targeted inflation, which I doubt.

Secondly, it suggests that critics of the government's fiscal policy might be missing something. If output volatility is good for long-term growth, then counter-cyclical fiscal policy aimed at stabilizing output comes at the price of slower future growth. If you believe that high government spending also depresses long-term growth (which is a separate issue from the effect of volatility), then the case for austerity strengthens further.

However, I'm not sure how much this weakens the anti-austerians' case. For one thing, supporters of austerity have generally not taken the line that it will boost long-run growth by increasing volatility, so we can hardly blame austerity's critics for ignoring this possibility.

Secondly, in an economy where institutions for pooling economic risks are under-developed – macro markets don't exist and unemployment benefits are quite mean – counter-cyclical fiscal policy might be a second-best way of reducing risk. Maybe a combination of better risk-pooling and less stabilization through policy would be better than what we have. But this option is not available.

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