On the Welfare Gains of Eliminating a Small Likelihood of Economic Crises: a Case for Stabilization Policies?

In this paper we estimate the potential benefit of policies that eliminate a small likelihood of economic crises. We define an economic crisis as a Depression-style collapse of economic activity. For the U.S., based on the observed frequency of Depression-like events, we estimate the likelihood of encountering a depression to be about once every 83 years. Even for this small probability of moving into a Depression-like state, the welfare gain from setting it to zero can range between 1 and 7 percent of annual consumption, in perpetuity. These estimates are large in comparison to welfare costs typically found for microeconomic distortions and suggest that there may be a net benefit to policies directed toward preventing economic instability.