Recessions sometimes cause themselves
Economists generally put economic trouble down to unfortunate shocks, which can knock an economy temporarily out of equilibrium. A more plausible view is that economies often get into trouble all on their own.
Place a lit cigarette in an ashtray in a closed room where the air is perfectly still. As everyone knows, the smoke will rise, but not in a simple regular flow; the rising flow is unstable, begins to wobble, and then breaks out, as in the photo above, into a tangled mess — turbulence. You don’t need any outside cause or shock to the rising smoke to make it happen.
Economies do highly irregular things too, as a rule, going through repeated booms and busts, and yet economists seem quite hesitant to see such fluctuations as the result of similar natural instabilities. In recent decades, at least, they seem to have greatly preferred the idea that fluctuations around average growth must be caused by “shocks” to the economy of some kind, disturbances coming from outside, firm in their belief that an economy on its own should settle into a stable equilibrium. Noah Smith recently gave a nice summary of the Real Business Cycle theory of Kydland and Prescott, which Prescott and colleagues are still pushing today:
Here’s how recessions work. Sometimes, scientists and engineers invent less new stuff than normal. Fewer new inventions this year mean fewer new inventions next year, too. Anticipating this, companies invest less, and they also cut workers’ wages. When wages go down, workers decide to take a vacation instead of work. Voila — a recession!
Actually, I’m kidding. I don’t think this is how recessions work at all. But the theory I just described is a real macroeconomic theory. It came out in 1982, and its name is the Real Business Cycle model. In 2004, its creators, Edward Prescott and Finn Kydland, won a Nobel Prize for their work. The theory inspired a generation of researchers, and became the dominant theory in certain places, such as the University of Minnesota.
You might be forgiven for thinking that Real Business Cycle theory, or RBC for short, doesn’t deserve its moniker. Just as the Holy Roman Empire was none of the above, RBC theory doesn’t seem to have much to do with business or cycles, and for that matter doesn’t sound particularly real. Most people think that recessions are caused by asset-price crashes, by disturbances in the financial sector, or by Federal Reserve tightening of the money supply.
RBC says we’re all wrong about that. The financial sector, RBC adherents claim, isn’t important. Asset prices crash because people see a recession coming ahead of time and act accordingly. And the Fed, according to Prescott in a recent interview, has no more effect on the economy than a rain dance has on rain. In fact, RBC is really sort of a giant null hypothesis — a claim that the phenomenon known as the business cycle is just an illusion, and that recessions are the normal, smooth functioning of an efficient economy.
It’s true that some economists like a more subtle version of the shock theory. You might call it amplification theory. They suggest that interactions between different parts of an economy might make it possible for even tiny shocks to have big consequences, much as a spark in a parched forest can trigger a vast fire. A small downturn for an auto manufacturer might hurt its suppliers, undermining their ability to supply other auto makers and creating a growing cascade of distress. The cause is less the shock and more the links that amplify it.
But for most economists, that’s the end of the discussion: Recessions are either the result of big shocks, or of small shocks with amplification. They ignore a third possibility: that an economy might sometimes get seriously out of shape with no shock at all.
A while back, in Bloomberg, I wrote about some recent work that puts this shock perspective into a very new light. It suggests, in fact, that theories of the RBC class, if examined more closely, actually predict the existence of inherent instabilities in economies, not unlike (in qualitative terms) those affecting rising smoke. Specifically, the research — a collaboration between some physicists and economists—shows that if you relax even slightly some of the heroic assumptions usually employed in RBC type theories — regarding agents’ perfect rational foresight, or the ability of firms to adjust their output instantaneously to changing economic conditions — then these models become unstable, so that large recessions will occasionally happen even without any external shocks, simply because of coordination failures within the economy.
More people should know about this work, which suggests that the interactions of firms and individuals in an economy should naturally create an ongoing turbulence with sporadic recessions arising from a natural lack of coordination, without any shocks at all. The conclusion is pretty much the opposite of what the Real Business Cycle theory’s creators originally intended. They wanted to defend the notion that markets work perfectly, not to entertain the possibility that recessions might reflect an inability of markets to coordinate supply and demand. Their own model actually destroys that hope.
Lest anyone think this is not practical work, it’s extensions —in this very recent paper, for example— show that the instabilities which can stir up recessions may easily be triggered inadvertently by central banks through their efforts to steer an economy with monetary policy. Obviously, policy making based on theories which don’t even allow for instabilities—today’s standard macroeconomic theories—aren’t likely to offer good advice on how to avoid such problems.
Posted by Mark Buchanan at 11:18 AM
Email ThisBlogThis!Share to TwitterShare to FacebookShare to Pinterest
2 comments:
Robert VienneauSeptember 11, 2014 at 12:56 PM
May I suggest Agliari, Chiarella, & Gardini’s 2006 Journal of Economic Behavior and Organization article, A re-evaluation of adaptive expectations in light of global dynamic dynamic analysis? It has been known for some time that mainstream models, perhaps with slight twitches, can exhibit interesting bifurcations, chaotic behavior, and endogenous cycles. I think especially of overlapping generations models. It would be nice if this research has some general impact on economists.
Mark BuchananSeptember 12, 2014 at 11:36 AM
Hi Robert,
Thanks very much for suggesting the paper. It does look very interesting and hits on much the same topic. Did this paper get a lot of attention amongst macroeconomists? I’m guessing it was just ignored?
Links to this post
Subscribe to: Post Comments (Atom)
