Volatile States: Institutions, Policy, and the Performance of American State Economies

3. Volatile States: Estimates of the Risk-Return Trade-Off

Chapter 3 Volatile States: Estimates of the Risk-Return Trade-Off Assessments of macroeconomic performance normally rely on indicators such as income per capita, output per capita, and employment levels or the growth rates of these indicators. The sorts of measures described and analyzed in chapter 1 are typical of the standards used to gauge state economic performance. From the standpoint of modern Anancial theory, however, such measures tell only part of the performance story. Suppose Portfolio A yields a 10 percent rate of return and Portfolio B yields a 5 percent rate of return. Would investors prefer Portfolio A or Portfolio B? The answer, of course, is uncertain. An assessment is not possible without information about the risk associated with Portfolio A and Portfolio B and without information about the risk preferences of individual investors. Modern Anancial theory relies on a two-dimensional criterion to evaluate and explain asset performance : the risk as well as the rate of return.1 This chapter examines the volatility of state economies and seeks to Besh out the two-dimensional approach to assessing macroeconomic performance. Comparing the economies of California and New York previews how this approach changes tradition assessments. In America’s two largest states, income per worker and income per capita were almost identical in 1970. By 1999, income per worker was 15 percent higher in New York than in California (a difference of nearly $8,000 per worker), and income per capita was 14 percent higher in New York than in California (about $4,200 per capita). Did the New York economy outperform the California economy over these three decades? By traditional measures, New York is the clear winner. By analogy to portfolio theory, the answer depends on the relative risk, or volatility, experienced in these two states.As the measures developed in this chapter indicate, the volatility of income per worker in New York exceeded volatility in California by 60 percent. The volatility of income per capita in New York exceeded volatility 31 in California by 25 percent. In essence, focusing on income levels alone reveals an incomplete and, in this case, a misleading picture. A high-income, high-volatility economy (New York) may or may not be preferable to another with lower income and lower volatility (California ). Returning to the portfolio perspective, the 15 percent income differential may reBect a risk premium for residing in New York instead of California. This chapter introduces the two-dimension perspective Arst by computing several indices to gauge state economic volatility. How the states fare with respect to these volatility indices is then described. Finally , the chapter analyzes both theoretically and empirically the relationship between levels of economic activity and the volatility of state economies. The Volatility of State Economies: Measures and Comparisons The usual statistical tool used to measure volatility is a standard deviation .At least three cross-national studies measure volatility as the standard deviation in a nation’s annual growth rates over time (Kormendi and McGuire 1985; Grier and Tullock 1989; Ramey and Ramey 1995). Ramey and Ramey (1995) raise potential drawbacks to this measure of economic volatility and propose two alternative approaches.The Arst relies on residuals from a core regression model that controls for other important factors that explain changes in macroeconomic conditions. One objection to this measure is that it includes both the predictable and the unpredictable income Buctuations . They propose an alternative that comes closer to capturing the unpredictable element in economic Buctuations; this measure uses variations in the residuals from a time-series forecasting equation. Both approaches to the measurement of state economic volatility are employed subsequently. The measurement and subsequent analysis of state economic volatility focus on the volatility in levels of economic activity, speciAcally Buctuations in income per capita and income per worker. This departs from the cross-country studies noted earlier that focus on the volatility in growth rates. Of course, this distinction is important. The decision to analyze levels rather than growth rates follows from the underlying theoretical framework. As discussed later in the chapter , a link between volatility and income levels is easier to establish on conceptual grounds than is a link between volatility and income growth rates.2 32 Volatile States The Arst measure of state economic volatility is computed in two steps, beginning by estimating the model speciAed in equation (3.1). ln (Income per Capitait) ⫽ ⌽⌾it ⫹ Constant ⫹ εit. (3.1) The data sample used...