Designing effective automatic stabilisers of the business cycle

Alisdair McKay, Ricardo Reis 14 July 2016

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As the prospects of a recession in the near term have risen on both sides of the Atlantic in the wake of the Brexit referendum, there is a strong concern that traditional aggregate demand policies will not be available. Monetary policy may be running out of stimulative tools, and the political mood is against the use of discretionary fiscal stimulus. A remaining available option is the use of automatic fiscal stabilisers.

The social insurance system stands at the centre of automatic stabilisers, yet we still know too little about how it affects the macroeconomy (Blanchard et al. 2010). There is a large literature on optimal social insurance systems, and how to balance the insurance value of insulating individuals from fluctuations in their market income against the incentive cost of reducing the return to work (Mirrlees 1971, Varian 1980, Baily 1978). But much less is known about how these policies stabilise the business cycle.

In a new paper, we investigate how the social insurance system affects the dynamics of the business cycle, and whether its stabilising effects call for a more or less generous social insurance system (McKay and Reis 2016a).  We focus on two key programmes: a progressive tax system, and unemployment insurance.  We find that unemployment insurance has a substantial stabilising effect on the business cycle, and as a result the optimal policy is to have a more generous unemployment benefit than would be optimal in a world without macroeconomic fluctuations.  On the other hand, the progressivity of the tax appears to have little effect on the business cycle.

Why does unemployment insurance stabilise the business cycle?

When households become unemployed, they reduce their consumption sharply (e.g. Browning and Crossley 2001). As a result, in a recession, the low consumption of unemployed individuals relative to the employed leads to a decline in aggregate consumption demand. By reducing the consumption impact of unemployment, a more generous unemployment insurance system mitigates this fall in aggregate demand. Unemployment insurance is a transfer from employed workers to unemployed workers and the marginal propensity to consume seems to be larger for individuals experiencing a period of low income such as unemployment (Parker et al. 2013). This transfer component of unemployment insurance is particularly important because households that  have been unemployed for more than a few months have often depleted many of their other resources to smooth their consumption in the face of unemployment, leaving them more likely to spend out of the transfer (Kekre 2016).

While this redistribution channel based on marginal propensities to consume is the classic explanation of how unemployment benefits function as an automatic stabiliser, we find that benefits have an even more important effect on the economy. Households face considerable uncertainty over employment and over the wages they earn when employed. The fear of losing their income because of an unemployment spell in the future leads workers to want to save, and so reduce their consumption.  That is, unemployment reduces aggregate consumption demand not just by reducing the current income of unemployed workers but also by inducing precautionary savings by all workers who fear the possibility of unemployment.  By making unemployment less painful, unemployment benefits reduce these concerns and give workers confidence to spend. 

Why is stabilising the business cycle valuable?

Economists have pointed out many welfare costs of business cycle fluctuations. First, recessions can result in inefficient levels of unemployment and hours worked, because different frictions and deviations from perfect competition do not allow the invisible hand to operate. Second, recessions are times of elevated risk for individual households (Guvenen et al. 2014, Davis and von Wachter 2011), which lead to increased income inequality. From a utilitarian perspective, for a given level of aggregate consumption, inequality reduces welfare as it creates differences in marginal utilities of consumption. Finally, with nominal rigidities, fluctuations in inflation lead to unwarranted dispersion in relative prices, which result in an inefficient allocation of demand across firms.

What is an automatic stabiliser?

Our analysis leads to a natural definition of the term ‘automatic stabiliser’. The unemployment insurance system is an automatic stabiliser because even with a fixed generosity of benefits, the system stimulates aggregate demand in a recession more than it does in an expansion. One way to put this is that there is a negative correlation between the output gap and the elasticity of output with respect to the level of benefits. This property is the hallmark of an automatic stabiliser.

Are these considerations quantitatively important?

When we quantify our model, we find that business cycle stabilisation considerations increase the optimal unemployment benefit replacement quite substantially.  We find that in the optimal unemployment insurance replacement rate is 49%, while it would be 36% in the absence of business cycles. This finding reflects two components of our analysis. First, the unemployment insurance system is very effective at stabilising the business cycle by dampening the cyclical swings in household precautionary savings motives. Second, recessions have large welfare costs due to the increase in uninsurable risks that households face.

While similar arguments can be put forward for the benefit of more progressive income taxes, both in terms of redistributing resources in a recession and by lowering precautionary savings, progressive income taxes have a stronger negative effect on average economic activity and a more limited effect on volatility, because of the comparatively small variation in income of those continuously employed during the business cycle. Therefore, we find that considering automatic stabilisation has a negligible effect on the desired level of progressivity.

Conclusion

Recent estimates suggest that existing automatic stabilisers provide little actual stabilisation, with the exception of small programmes like food stamps in US (McKay and Reis 2016b). In great part, this happens because of the way these programmes were designed, with optimal social insurance in mind, while business-cycle stabilisation was treated as a fortuitous side benefit. Fiscal policy in recessions has then ended up relying on large discretionary fiscal stimulus packages that are too often slow to be adopted, imprecisely targeted, time inconsistent, and as distortionary as they are potentially stimulative.

Designing better automatic stabilisers holds the promise of achieving a more efficient business cycle and reducing the use of ad hoc fiscal stimulus packages. The new research described here tries to understand how large redistributive programmes like unemployment insurance and progressivity of income taxes affect the business cycle, and how to trade off their macroeconomic stabilisation role with their social insurance role. While the policy conclusions from this work are still far from being definite, they already point to unemployment insurance or food stamps as programmes to focus on (as opposed to progressive income taxes), and to the main economic channels at play and variables to measure being those related to risk and precautionary savings (as opposed to marginal propensities to consume).

References

Baily, M N (1978), "Some aspects of optimal unemployment insurance", Journal of Public Economics, 10 (3), 379-402

Blanchard, O, G Dell’Ariccia, and P Mauro (2010), “Rethinking macroeconomic policy”, Journal of Money, Credit and Banking, 42 (s1), 199–215

Browning, M, and T F Crossley (2001), "Unemployment insurance benefit levels and consumption changes", Journal of Public Economics, 80 (1), 1-23

Davis, S J, and T von Wachter (2011), "Recessions and the Costs of Job Loss", Brookings Papers on Economic Activity, 2011-2, 1-72

Guvenen, F, S Ozkan, and J Song (2014), "The Nature of Countercyclical Income Risk", Journal of Political Economy, 122 (3), 621-660

Kekre, R (2016), “Unemployment Insurance in Macroeconomic Stabilization”, working paper

McKay, A, and R Reis (2016a), “Optimal Automatic Stabilizers”, CEPR Discussion Paper 11337

McKay, A, and R Reis (2016b), “The Role of Automatic Stabilizers in the U.S. Business Cycle”, Econometrica, 84 (1), 141-194

Mirrlees, J A (1971), "An exploration in the theory of optimum income taxation", The Review of Economic Studies, 38 (2),175-208

Parker, J A, N S Souleles, D S Johnson, and R McClelland (2013),"Consumer spending and the economic stimulus payments of 2008." The American Economic Review, 103 (6), 2530-2553

Varian, H R (1980), "Redistributive taxation as social insurance", Journal of Public Economics, 14 (1), 49-68

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Topics:  Macroeconomic policy

Tags:  Brexit, recession, business cycle, US, unemployment, fiscal stimulus, monetary policy, automatic stabilisers

Assistant Professor, Department of Economics, Boston University

A.W. Phillips Professor of Economics, LSE and CEPR Research Fellow

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