We have seemed to have figured out growth (well, at least the U.S. has,
I can't say as much for Niger or Zimbabwe). As Ed Leamer points out, the U.S. has pretty much been
growing at a constant rate of 3% for the last 35 years- what we need to
do is to figure out how to "iron out" the cycle. Our theories of the
business cycle are terrible.
There are three main theories of business cycles. I'll present them in more or less the order they were originated:
1) Keynesian Business Cycle Theory: Keynesians argue that a drop in aggregate demand causes business cycles. Consumer confidence falls for one reason or another, and this decrease in spending is multiplied as it filters through the economy (people buy less so firms produced less so households get less income and buy even less...). While lacking good micro-foundations, this theory gives liberal economists a great reason for the government to be active (and, conveniently, employ economists)- fiscal and monetary authorities can really help fix things by stimulating aggregate spending.
2) Austrian Business Cycle Theory: Named after the Austrian School of Economics, this theory basically says that business cycles are caused by the Federal Reserve. Business cycles are claimed to be caused by low interest rates, which aren't sustainable. When the Fed keeps interest rates below the "natural rate" consumers and businesses are extended too much credit. When the Fed then raises rates, many projects undertaken during the low rate regime are no longer profitable and so are stopped, causing a bust. There is not a good reason given as to why businessmen act like such fools when they see the artificially low rates. The upshot of ABC is that Austrians (most of whom are very libertarian) have a reason to blame the business cycle on the actions of the government.
3) Real Business Cycle Theory: This work is mostly credited to Ed Prescott and Finn Kydland who won the 2004 Nobel Prize for there work on the topic. It is the model that many mainstream economists now use to explain business cycles and is an extension of the neoclassical growth model. In this model, business cycles are caused by a "negative shock" to technology. That is, we have down-turns because capital and labor aren't as productive as "normal" (or at least productivity didn't increase as much as normal). Given the bad shock to technology, people are acting optimally by employing less labor and capital in production. The idea that a shock to technology is the cause of business cycles is either wrong or too vague to be of much use. Even Prescott says we need more of an idea as to what technology is.
I was talking with a buddy recently and he brought up a great way to think about business cycles (he also came close to really depressing me with his macroeconomic forecast- which hurt all the more because he has great intuition for these things). As I understand it, his idea rests upon coordination games. In this view, busts happen when coordination falls apart. During booms, there is usually an asset bubble. Think of the last boom due to increasing home values or the previous one to due to the bubble in the value of tech companies. Smart money chases bubbles and it builds on itself. As long as people believe the economy is strong, people lend money and the economy keeps growing. But this is unstable. If people lose confidence, then the bubble quickly unwinds and we find ourselves in a bust.
In some sense, this theory is like the Austrian theory, but with a foundation for the building up of investment when credit is cheap, without relying on the non-optimal behavior of businessmen. In the coordination game, its rational to borrow the cheap money as long as everyone thinks the economy is growing. Also important is that this theory predicts the contraction of credit that we see in busts.
I'll need to think about how such a theory fits other stylized facts of business cycles, but this struck me as an intuitive, consistent, and at least superficially accurate description of business cycles. I'm also not sure just how much more of a contribution this is beyond the collateral models of Kiyotaki and Moore (JPE, 1997) and recently of Mendoza.
1) Keynesian Business Cycle Theory: Keynesians argue that a drop in aggregate demand causes business cycles. Consumer confidence falls for one reason or another, and this decrease in spending is multiplied as it filters through the economy (people buy less so firms produced less so households get less income and buy even less...). While lacking good micro-foundations, this theory gives liberal economists a great reason for the government to be active (and, conveniently, employ economists)- fiscal and monetary authorities can really help fix things by stimulating aggregate spending.
2) Austrian Business Cycle Theory: Named after the Austrian School of Economics, this theory basically says that business cycles are caused by the Federal Reserve. Business cycles are claimed to be caused by low interest rates, which aren't sustainable. When the Fed keeps interest rates below the "natural rate" consumers and businesses are extended too much credit. When the Fed then raises rates, many projects undertaken during the low rate regime are no longer profitable and so are stopped, causing a bust. There is not a good reason given as to why businessmen act like such fools when they see the artificially low rates. The upshot of ABC is that Austrians (most of whom are very libertarian) have a reason to blame the business cycle on the actions of the government.
3) Real Business Cycle Theory: This work is mostly credited to Ed Prescott and Finn Kydland who won the 2004 Nobel Prize for there work on the topic. It is the model that many mainstream economists now use to explain business cycles and is an extension of the neoclassical growth model. In this model, business cycles are caused by a "negative shock" to technology. That is, we have down-turns because capital and labor aren't as productive as "normal" (or at least productivity didn't increase as much as normal). Given the bad shock to technology, people are acting optimally by employing less labor and capital in production. The idea that a shock to technology is the cause of business cycles is either wrong or too vague to be of much use. Even Prescott says we need more of an idea as to what technology is.
I was talking with a buddy recently and he brought up a great way to think about business cycles (he also came close to really depressing me with his macroeconomic forecast- which hurt all the more because he has great intuition for these things). As I understand it, his idea rests upon coordination games. In this view, busts happen when coordination falls apart. During booms, there is usually an asset bubble. Think of the last boom due to increasing home values or the previous one to due to the bubble in the value of tech companies. Smart money chases bubbles and it builds on itself. As long as people believe the economy is strong, people lend money and the economy keeps growing. But this is unstable. If people lose confidence, then the bubble quickly unwinds and we find ourselves in a bust.
In some sense, this theory is like the Austrian theory, but with a foundation for the building up of investment when credit is cheap, without relying on the non-optimal behavior of businessmen. In the coordination game, its rational to borrow the cheap money as long as everyone thinks the economy is growing. Also important is that this theory predicts the contraction of credit that we see in busts.
I'll need to think about how such a theory fits other stylized facts of business cycles, but this struck me as an intuitive, consistent, and at least superficially accurate description of business cycles. I'm also not sure just how much more of a contribution this is beyond the collateral models of Kiyotaki and Moore (JPE, 1997) and recently of Mendoza.
