Disasters Everywhere: The Costs of Business Cycles Reconsidered

Abstract

Business cycles are costlier and stabilization policies could be more beneficial than widely thought.This paper introduces a new test to show that all business cycles are asymmetric and resemble "mini-disasters."By this we mean that growth is pervasively fat-tailed and non-Gaussian.Using long-run historical data, we show empirically that this is true for advanced economies since 1870.Focusing on peacetime eras, we develop a tractable local projection framework to estimate consumption growth paths for normal and financial-crisis recessions.Introducing random coefficient local projections (RCLP) we get an easy and transparent mapping from the estimates to a calibrated simulation model with disasters of variable severity.Simulations show that substantial welfare costs arise not just from the large rare disasters, but also from the smaller but more frequent mini-disasters in every cycle.On average, and in post-WW2 data, even with low risk aversion, households would sacrifice about 15 percent of consumption to avoid such cyclical fluctuations.

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