Business cycle volatility: does the European-style safety net help?

Author:Ovaska, Tomi
  1. Introduction

    Volatility

    Synonyms: instability, unpredictability, precariousness, explosive nature Antonyms: stability, constancy, steadiness, firmness, solidity, permanence, immovability The great volatility in market outcomes has arguably been the biggest shortcoming in capitalism's successful run in the last few centuries. In fact, in his theory of historic materialism, Karl Marx argued that the capitalist system, while historically necessary in helping to increase nations' capacity to produce goods, will face crises of increasing severity over time. Its end will come when the masses of laborers will not put up with the crises and subsistence level wages anymore and they unite to force a change. Contrary to his prediction, capitalism has not collapsed, but survived and flourished. Marx was right, though, that economic volatility, the constant and at times erratic tendency of the economy to cycle from good times to bad times and back, seems to be one of the hallmark features of capitalist systems.

    That capitalism never died, as Marx predicted, has much to do with the reforms of the critical inner parts of the system in the last 130 years. The capitalist renewal process started in earnest in the 1870s with the Prussian welfare policies, partially enabled by the wealth generated through capitalist policies, and has been ongoing ever since. (1) A defining moment in this renewal process was the 1936 publication of John Maynard Keynes's The General Theory of Employment, Interest and Money. During the economic calamity of the Great Depression, when people were starting to doubt the long-term viability of capitalist economies, Keynes provided new answers to the critical question of the time: is there anything one can do to tame the extreme economic volatility in economic outcomes under capitalism? Keynes famously identified (but did not explicitly explain) the variability in aggregate demand as the culprit behind economic cycling, and then suggested that governments, through their spending and taxation (deficit) policies, should take an active role in smoothing the demand for goods and services.

    In the ensuing decades, governments accepted Keynes's policy prescription to varying degrees. In one side of this policy debate is a group of countries that has little or no trust in government-provided solutions, arguing that the Keynesian solution leads to (in this order) larger governments, higher taxes, and ultimately lower average incomes. This group is often characterized by its affinity for laissez-faire economic policies. On the other side of the continuum are the welfare states, which have not only embraced Keynesian demand management, but have also created highly elaborate social insurance systems aimed to shield their citizens as much as possible from market volatility.

    During the Great Recession of 2007-2009, a question arose whether economies with a strong government presence were coming out of the crisis faster and less damaged than economies with a lesser government presence. In this paper, we test empirically for the historical association between government size and type, and the severity of business cycles. Our sample of analysis includes twenty-one developed countries and comparable country-level data for 1970-2007. In particular, our tests measure whether the variability in income growth in high-income countries since 1970 is significantly related to the type of capitalism and the level of government intervention. Our specific interest is to compare countries at the opposite ends of the capitalist range (laissez faire vs. welfare states). Our contribution to the existing literature is threefold. First, we compare economic volatility in two specific country groups rather than analyzing volatility in just one single country or one larger group of countries. Second, our measures of volatility (CV, Baxter-King filtering) are more advanced than has been the norm in much of the previous literature. Finally, rather than following the standard of choosing between a cross-section and time series, our analysis covers twenty-one countries over thirty-nine years.

  2. Economic Cycles: A Historical Overview

    Classical economists maintained that supply will create its own demand. That is, the level of production will determine income, which in turn will very nearly ensure that there is adequate demand for the goods produced. Furthermore, as long as labor markets remained competitive, paying workers at rates significantly below their economic contribution would not happen. Capitalism was seen to have the potential to radically change the face of entire societies, helping the masses to escape the low incomes of agrarian societies.

    Not all classical economists agreed. While Marx and Engels (1848, p. 65) acknowledged that "the bourgeoisie, during its rule of scarcely one hundred years, has created more massive and more colossal productive forces than have all preceding generations together," they also maintained that the economic condition of the working class during the capitalist industrialization would become not better, but increasingly worse. While capitalism in their view did provide appropriate incentives for capital owners to invest their profits and constantly improve the means of production, Marx's "Law of the Tendency of the Rate of Profit to Fall" stated that the ever-worsening cycling in economic outcomes will ultimately be the undoing of the capitalist system (Marx and Engels 1867). In particular, Marx and Engels argued in their Communist Manifesto (p. 72) that "the growing competition among the bourgeoisie, and the resulting commercial crises, make the wages of workers ever more fluctuating," dragging an ever-larger portion of the middle class to the ranks of the proletariat. At that point, with its gigantic means of production and exchange, "[the bourgeois society] is like the sorcerer, who is no longer able to control the powers of the subterranean world which it has called up by his spells" (Marx and Engels 1848, pp. 66-67). The exploited working class would take control of all the productive assets with any means necessary and establish first, socialist, and then, communist societies. The notion that capitalism would die in the long term seemed inevitable to Marx.

    Marx was wrong about the inevitable demise of capitalism, but he was partially correct in his prediction that the degree of income inequality would be the critical factor in determining capitalism's long-term fate. Indeed, during the nineteenth century, the benefits and faults of capitalism became all too clear to the masses and rulers alike. The rise in societies' productive capacities was stunning--never had there been so much wealth--yet, the rising disparity in the living conditions of the haves and have-nots was also becoming ever-more apparent. The mass misery of workers during the industrial revolution is well-documented in the literary classics by Carlyle, Dickens, Fourier, Melville, Owen, Saint-Simon, Schiller, Wright, and others. For the new system of production to survive, it seemed some moderation needed to be incorporated into it. The problem was that economic cyclicality often hit the less-wealthy the hardest, eroding the popular support for capitalism.

    The capitalist transformation did start in earnest during the last decade of Marx's life, though, and has continued ever since. Every wealthy society of the twenty-first century has introduced elements to capitalism to moderate what are viewed as its built-in undesirable tendencies. The interpretation of what these undesirable tendencies are and what--if anything--needs to be done about them, though, has varied widely from country to country and over time.

    During the Great Depression, many people questioned openly the future of capitalism, with Soviet socialism presenting itself as a viable alternative. In fact, as Kornai (1992) notes, Soviet plans were created under the notion that if a plan covers the entire economy, much if not all of the uncertainty can by definition be planned away. It was in this context that Keynes proposed a way to get capitalism back on its feet. The Keynesian solutions were active demand management by...

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