Economic Dynamics Newsletter

Kjetil Storesletten on Inequality in Macroeconomics

Over the last decade or so, economists have made substantial effort departing from the representative agent framework and exploring the role of heterogeneity in macroeconomics. The central insight is that uninsurable risk and heterogeneity can have substantial impact on aggregate economic outcomes, the impact of government policies, and the mere choice of such policies. In this vein of research I have focused on three broad questions:

1. How important is risk on the household-level?
2. What are the implications of this risk for government policy and
3. How does this heterogeneity shape political conflict and policy outcomes?

Quantifying risk on the household-level

One of the most divisive and politically loaded questions in economics is whether cross-sectional dispersion and changes over time in income and labor earnings are driven by luck — shocks exogenous and unexpected to the household –, or by effort and innate ability — factors endogenous and known to the agents at birth. Individual data exhibit large dispersion in wages and earnings, and the within-cohort earnings-dispersion (measured as variance of logs) is increasing sharply with age. However, as econometricians know less than the agents in their data samples, data on earnings alone do not suffice to address this question. One way to bring theory to bear on this issue is to consider data on consumption. Deaton and Paxson (1994) document that within-cohort consumption dispersion is also linearly increasing over the life-cycle, albeit not as steeply as earnings dispersion. In Storesletten, Telmer and Yaron (2004a), we show that these facts are quantitatively consistent with a standard life-cycle model with incomplete markets, provided that a substantial fraction — roughly half — of the labor-market uncertainty people face must be realized throughout the working years, as opposed to early in life, before entering the labor market. Without shocks during working years, the theory can account for increasing inequality in income, but not consumption. Moreover, the joint behavior of income and consumption inequality implies that idiosyncratic shocks must be highly persistent. These results have strong implications for policies such as unemployment insurance and social security and for theories of savings and portfolio choice.One alternative explanation of this evidence on earnings and consumption dispersion, one consistent with complete markets, could be that agents’ preferences were not separable between consumption and leisure. The more productive agents would then work harder and be compensated with higher consumption. As wage dispersion increases with age, so would dispersion in both consumption and leisure. That implication is testable: Storesletten, Telmer, and Yaron (2001a) argues that empirical evidence on labor supply makes this story implausible, since the dispersion in labor supply is roughly constant over the life-cycle. This is inconsistent with a standard model of complete risk sharing — there are no “plausible” combinations of attitudes toward risk and substitutability between consumption and leisure simultaneously generating a non-increasing dispersion in hours worked and an increasing dispersion in consumption and labor earnings. I interpret this as further evidence of substantial uninsurable risk at the household level.

While the above studies focus on inequality over the life-cycle, one important reason for the recent awareness of inequality and heterogeneity in economics is the sharp increase in cross-sectional dispersion in wages and earnings over time — the trend in inequality over the 1970-2000 period (see Katz and Autor, 1999, for a survey). Concern for the surge in inequality is, arguably, driven by the presumption that these changes are associated with dire welfare consequences. However, dispersion of hours worked, consumption and wealth (excluding the top 1%) have remained roughly constant through time, while the wage-hour correlation has risen sharply. In Heathcote, Storesletten and Violante (2003), we decompose the rise in wage inequality over time into changes in the variance of permanent, persistent and transitory shocks. With the estimated changes in the wage process as the only primitive, we show that a standard calibrated life-cycle model with incomplete markets can successfully account for all these changes over time in cross-sectional U.S. data.

Now what about short-term fluctuations in cross-sectional inequality? In Storesletten, Telmer, and Yaron (2004b), we explore if household-level earnings risk vary over the business cycle and to what extent this risk is persistent. The answer influences our understanding of economic short-term fluctuations, something I return to below. The main statistical problem is that available panel data-sets have a very limited time dimension. For example, the Panel Study on Income Dynamics starts in 1968. As there are at most 5 business cycles during the available panel years 1968-1993, it is difficult to identify how cross-sectional variation interacts with business cycles. In this work, we overcome this by conditioning on household age and the macroeconomic history during which a household has worked. We combine the individual earnings data with business-cycle regimes identified using aggregate data. Thus, we can use aggregate data going back as far as 1930. The main empirical findings are that idiosyncratic risk is persistent and increases significantly in downturns.

Economic implications of heterogeneity and risk

Now, given the above evidence of risk on the household-level, should we, as macro-economists, care? Below I argue risk and heterogeneity shapes our view on core macro issues such as fiscal policy, asset prices, portfolio choice, and the cost of aggregate short-term fluctuations.Starting with the latter, in Storesletten, Telmer and Yaron (2001b), we ask whether the welfare costs of business cycles depend on how aggregate shocks interact with idiosyncratic shocks. We find that if eliminating business cycles amounts to eliminating the negative correlation between the variability of idiosyncratic shocks and the overall level of economic activity (which we documented in our 2004b work), then the welfare costs of business cycles are much larger than previous work has suggested. These results support the popular view that distributional effects are an important aspect of understanding the welfare cost of business cycles.

What about asset prices and portfolio choices? While financial advisors often argue that young workers should hold stocks older workers should hold bonds, empirical evidence suggest that in reality people do exactly the opposite (Ameriks and Zeldes, 2001). Could individual earnings risk shed light on this apparent puzzle? A different, but related argument is due to Mankiw (1986) and Constantinides and Duffie (1996). They have suggested that individual labor-income risk could potentially resolve the “equity premium puzzle” — the statement that it is difficult to reconcile the historical return-premium of stocks over bonds with a standard calibrated representative-agent model with time-additive preferences. The key condition is, they argue, that this risk is counter-cyclical — large individual shocks when returns are low (i.e., in recessions) and small when returns are high (i.e., in booms). Such process is precisely what we recovered in our 2004b work I described above. In Storesletten, Telmer and Yaron (2002), we incorporate that individual earnings process into a standard life-cycle model and inquire about portfolio holdings over the life-cycle and its implications for the equity premium. Absent individual risks, our model suggests that young households should hold most of their financial wealth as stocks, whereas old ones should hold mostly bonds, consistent with Jagannathan and Kocherlakota (1996) and the standard financial advisor’s advice. Young households have far more human wealth than financial wealth, and since wages are far less variable than stock returns, human wealth is like a non-traded bond. Getting older means having less non-traded bonds and, therefore, maintaining an overall balanced portfolio requires increasing the bond share. This can be thought of as the intergenerational sharing of aggregate risk: aggregate risk is transferred from the old to the young via stock ownership. Idiosyncratic risk changes all this. It means that human wealth is risky and it deters those who have the most of it, the young, from holding stocks. The net effect is that idiosyncratic risk inhibits the intergenerational sharing of aggregate risk and, thus, drives up the reward to bearing aggregate risk: the equity premium. In this life-cycle model the wealthy middle aged are most suited to handle both aggregate and idiosyncratic shocks. Therefore, they end up holding more of their per-capita share of stocks, consistent with the empirical portfolio profile. Moreover, they demand a premium to these stocks, which drives up the equilibrium equity premium.

Given the above empirical evidence of substantial household-level risk, it is interesting to examine the scope of using government redistribution policies as an (ex-ante) vehicle of insurance. Such an exercise is of particular interest in light of the recent debate on reforming Social Security, the largest U.S. redistribution. Most proposals for reform involve less redistribution, moving from a benefit-defined system towards a contribution-defined system. In Storesletten, Telmer and Yaron (1999) we use a calibrated life-cycle model with incomplete markets to quantify the value of insurance, under the veil of ignorance, implicit in the current U.S. system. We find it to be worth 1.5% of lifetime income, given a risk aversion of 2. This is a large number, compared with other welfare assessments of risk in the quantitative macro literature (cf. Rios-Rull, 1994). However, when trading off the insurance value with the distortions of the pension system on aggregate savings, we find that privatization schemes contained in the proposals might still be welfare improving.

The overall aim of introducing heterogeneity in macroeconomics is, in addition to further our understanding of how the economy works, to provide tools for actual policy analysis. The area where this agenda has had the most influence is, perhaps, the analysis of future fiscal policy in light of the aging of the baby-boom generation (cf. Auerbach and Kotlikoff, 1987). The main insight of this literature has been that most Western economies, including the U.S., should expect large future tax increases or substantial reductions in expenditures. However, this literature has usually abstracted from an important component of demographic change: immigration. Using a calibrated general equilibrium life-cycle model, which explicitly accounts for differences between immigrants and natives, I investigated whether an immigration policy reform alone could resolve the fiscal problems associated with the ageing of the baby boom generation (Storesletten, 2000). Such policies exist and are characterized by increased inflow of working-age high- and medium-skilled immigrants. One particular feasible policy involves admitting 1.6 million middle-aged high-skilled immigrants annually. Moreover, I find that high-skilled immigrants are a huge fiscal gain to the U.S. government, while low-skilled immigrants represent a net loss.

Political economy

So far I have described my research on the economic consequences of heterogeneity taking government policies are exogenous. For example, in Storesletten (2000), I derived the implications of different immigration policies. However, in recognizing the importance of heterogeneity across households, one opens up an important tension in economics: political conflict over government policies implies that the set of politically feasible policies is more restricted than the set of economically feasible ones. There is now a growing literature bringing politico-economic aspects into macroeconomics, describing government policies as endogenous outcomes collectively determined by rational self-interested individuals. While many important politico-economic issues are dynamic in nature, technical limitations have, however, so far prevented a thorough investigation of dynamic political choices in macroeconomics. Put bluntly, the main reason why the theoretical literature is scant on dynamics, is a lack of convenient analytical tools. The study of economic dynamics is perhaps hard, but there is a large body of work on the subject: for a given policy environment, it is textbook material how to analyze an economy’s behavior over time when the economic actors are fully rational. Similarly, pure political theory has worked on dynamic policy determination (although this literature is less well developed). The combination of politics and economics is what poses a difficulty; one needs to model strategic voting interactions, where political agents consider the consequences of their choice on future political outcomes, as well as appeal to dynamic (usually competitive) equilibrium theory to ensure that all economic agents consumers, firms and government maximize their respective objective functions under rational expectations, and resource constraints.Prior to Hassler, Rodriguez-Mora, Storesletten and Zilibotti (2003a), the only nontrivial dynamic models (that is, that are not repeated static frameworks or purely backward-looking setups) relied essentially on numerical solution (see, e.g., Krusell and Rios-Rull (1999) and the discussions therein). In this work, we provide a tractable framework where voters are influenced both by the state of the economy, the current income distribution and foresee effects of the current policy outcomes on both future income distributions and future voting outcomes, which they care about and therefore take into account when they vote. A key result is that the future constituency for redistributive policies depends positively on current redistribution, since this affects both private investments and the future distribution of voters. The model features multiple equilibria. In some equilibria, positive redistribution persists forever. In others, even a majority of beneficiaries of redistribution vote strategically so as to induce the end of the welfare state next period. Skill-biased technical change makes the survival of the welfare state less likely.

Can this line of research shed light on more applied politico-economic issues such as unemployment and the choice of unemployment benefits? There has emerged a consensus among economists that the high level of unemployment in Europe relative to the U.S. is caused by the generous unemployment benefits and, to a lesser extent, firing restrictions in Europe (cf. Ljungqvist and Sargent, 1998). But why then don’t European countries reform their welfare system in order to bring down unemployment? In Hassler, Rodriguez Mora, Storesletten and Zilibotti (2001), we argue that the cross-country empirical regularities in geographical mobility, unemployment and labor market institutions can be explained in a model with endogenous mobility and rational voting over unemployment insurance (UI). Agents with higher cost of moving, i.e., more attached to their current location, prefer more generous UI. The key assumption is that an agent’s attachment to a location increases the longer she has resided there. UI reduces the incentive for labor mobility and increases therefore the fraction of attached agents and the political support for UI. The main result is that this self-reinforcing mechanism can give rise to multiple steady-states: one “European” steady-state featuring high unemployment, low geographical mobility and high UI, and one “American” steady-state featuring low unemployment, high mobility and UI.

References