Asset Bubbles and the Cost of Economic Fluctuations

Lucas (1987, 2003) estimates that the cost of ‡uctuations is less than 0.1% of consumption. In other words, a social planner would pay no more than 0.1% of (permanent) consumption to eliminate all future business cycle ‡uctuations. The current paper extends Lucas’calculations by studying the costs of ‡uctuations arising from asset bubbles. We estimate two classes of costs: consumption volatility due only to asset price volatility, and consumption volatility due to asset trading interacted with price volatility. We show that the magnitude of these welfare costs is driven by heterogeneous household portfolios. If assets are held proportionately across the population, the welfare costs fall by an order of magnitude. Our benchmark calibration, which assumes a coe¢ cient of relative risk aversion of 3, implies that the asset bubbles of the last decade generated a social welfare cost equal to a permanent 3 percent reduction in the level of national consumption. Our calculations are sensitive to the details of the calibration, including the degree of balance sheet and trading heterogeneity, the coe¢ cient of relative risk aversion, and the magnitude of the asset bubble. Our speci…cations with reasonable parameter values generate welfare costs ranging from 1 to 10 percent of (permanent) national consumption. Harvard University. The authors gratefully acknowledge helpful comments from Alberto Alesina, Robert Barro, John Campbell, Richard Cooper, Vince Crawford, Ben Friedman, John Leahy, Greg Mankiw, Klaus Schmidt, Andrei Shleifer, and seminar participants at Harvard, Gerzensee, UC Berkeley, and UCSD. Prepared for a conference at Gerzensee Switzerland on the integration of macroeconomic and microeconomic perspectives. Laibson acknowledges …nancial support from the NSF (0527516) and the NIA (R01-AG-021650, R01-AG-1665, P30-AG-012810). Corresponding author: Johanna Mollerstrom. 1