Does Risk Shape Economies? Income Volatility and Structural Change

We investigate the role of risk in shaping the pattern of structural transformation of an economy. We first show a novel theoretical result: in a simple two-sector model, for any given level of GDP, higher microeconomic risk (e.g. volatility of TFP shocks) implies a smaller share of services in consumption. This occurs because higher income risk induces the representative household to increase precautionary savings, thus reducing consumption expenditure, whose level determines the structure of consumption due to non-homotheticity. The value added share of services also declines with higher risk, due to the increase in goods intensive investment relative to services intensive consumption. Time-series and cross-sectional U.S. data confirm a negative and statistically significant relationship between different measures of risk and the share of services, in both value added and consumption data. This relationship also holds in South-American and Asian countries experiencing premature de-industrialization. As these countries faced lower risk relative to the U.S. during their development, the proposed mechanism can account for part of their premature de-industrialization. Our estimates suggest that, had the U.S. experienced the same GDP volatility before WWII as it did after, its average services share would be 0.023 percentage points higher - explaining roughly 30% of the gap with premature de-industrializers at comparable income levels.