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March 20, 2005
The Volatility Problem
After mining data from the Panel Study of Income and Dynamics, a database produced by the University of Michigan that tracks the incomes of the same families over a 40-year period, scholars have concluded that incomes are much less stable - i.e., much more volatile - today than they have been in the past. "There has unequivocally been general upward-trend income volatility since at least 1975," said Bruce A. Moffitt, the Krieger-Eisenhower professor of economics at Johns Hopkins University, who, with Professor Gottschalk, wrote one of the first papers on income volatility in the 1990's. "It accelerated in the 1980's, turned down in the early 1990's, and then accelerated into the end of the 1990's."
According to a measure of volatility constructed by Jacob S. Hacker, a Yale political scientist, which tracks the five-year moving average of family incomes, income volatility rose 88 percent between 1978 and 2000...
"The problem in the past few decades," Professor Moffitt said, "is that volatility has risen while real incomes haven't risen." What's more, income volatility has grown significantly for those who can afford it least. A series of articles last year in The Los Angeles Times, written by Peter G. Gosselin, who worked closely with Professor Moffitt and other scholars, reported that in the 1970's, income for middle-class Americans tended to fluctuate by 16 percent a year. But in the 1980's and 1990's, middle-class incomes fluctuated an average of 30 percent. For those whose earnings placed them in the bottom fifth, income volatility rose from 25 percent in the early 1970's to 50 percent in recent years.
Part of the solution? Maintain the existing defined-benefit social security system, of course.
As we learn more about income volatility in the information age, some scholars say, Social Security - an insurance program designed for the industrial age - may be even more essential...
"Social Security provides a vital kind of insurance," Professor Hacker said. "The real issue lurking behind this debate is whether we should have a program that provides the bedrock protection against economic risk."
I'm not going to dispute any of this, but it as at least worth pointing out that volatility is not the same thing as risk. That is obvious in the case where increased ups and downs in income are perfectly predictable, but that isn't really what I have in mind. What I have in mind is the perfectly straightforward observation that volatility of returns in financial assets can actually reduce the risk associated with fluctuating labor income by providing a means of diversifying total income.
It is true that an appeal to income diversification is not all that helpful to those of us who favor a private account option for social security reform. Steve Davis and Paul Willen have a very nice, and accessible, paper on the issue, and find that broad equity returns do not appear to be highly correlated with occupation-level income shocks. Furthermore, what benefits there might be would likely accrue to higher-income individuals.
Still, not a lot of research has been done on this issue, and I would ask this question: If muting the impact of labor-income volatility is a motivating factor for supporting the social security system, is a program intrinsically tied to both aggregate and individual labor-income fortunes the sensible way to go?
There is also this, from the Times article:
Because of other longstanding trends in the economy, strong income volatility can wreak greater havoc now than it did in the past...
Why? Many families already rely on two incomes. What's more, fixed commitments have risen as a percentage of total income.
Again, maybe so. But can't we be just a bit skeptical? Working more because we consume more is a choice. I make that choice all the time. So do you, I bet. What's the problem? (The same would go for endogenous income volatility associated with the choice to move in and out of the labor force, change employment circumstances as a life-style choice, and so on.)
Here's a simple smell test I can't help but employ. Any time a learned study seems to conclude that economic welfare has declined relative to the 1970s, it's time to start asking digging deeper. The facts may be right. What they mean is much trickier proposition.
A couple of other random points about the Times piece.
-- I meant to mention this before, but I was slightly amused that one of the poster-boys for the LA Times first article on the problem of income volatility was one Paul Fredo, a financial analyst, whose income fluctuated a lot, between $200,000 and $120,000. It looks to me that it is people in this income class that are likely to bear most of the burden of closing the social security financing gap. (Think removing the ceiling on income subject to payroll taxes, reducing benefit indexation for "high-income" folks, and so on.) So much for the helping hand of government in his case.
-- The "Bruce A. Moffitt" referenced in the NYT article is actually Robert A. Moffitt.
-- The NYT article leads with this sentence:
Judging by the polls, President Bush's plan to transform Social Security from an insurance program that guarantees a minimum income into something more closely resembling a 401(k) investment program isn't going very well.
That is a highly selective reading of the polls. More on that to follow.
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