Those of you who think markets function efficiently, if only gubmint doesn’t get in the way, live in a dream world. //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 into a tangled mess -- turbulence. You dont 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 instability. 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. 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, isnt 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. In Bloomberg, Ive written about some new work that puts this RBC theory into a very new light. It suggests, in fact, that theories of this basic class, if examined more closely, actually predict the existence of inherent instabilities in economies. Specifically, if you relax even slightly some of the heroic assumptions usually employed in such 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 happen even without any external shocks, simply because of coordination failures within the economy.// physicsoffinance.blogspot/2014/09/economics-beyond-shocks.html
Posted on: Wed, 17 Sep 2014 00:39:33 +0000
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