Monday, October 11, 2004

Straight Thinking About Business Cycles

Economists and common folk have long thought that a recession -- a sustained drop in the total output of goods and services -- is caused by a failure of markets or government "to do the right thing." Now, the Nobel prize for economics has been awarded to Finn E. Kydland and Edward C. Prescott, a pair of economists who say otherwise. Here's the story, according to Alex Tabarrok at Marginal Revolution:
...Recessions have almost always been thought of as a failure of market economies. Different theories point to somewhat different failures, in Keynesian theories it's a failure of aggregate demand, in Austrian theories a mismatch between investment and consumption demand, in monetarist theories a misallocation of resource due to a confusion of real and nominal price signals. In some of these theories government actions may prompt the problem but the recession itself is still conceptualized as an error, a problem and a waste.

Kydland and Prescott show that a recession may be a purely optimal and in a sense desirable response to natural shocks. The idea is not so counter-intuitive as it may seem. Consider Robinson Crusoe on a desert island....Every day Crusoe ventures out onto the shoals of his island to fish. One day a terrible storm arises and he sits the day out in his hut - Crusoe is unemployed. Another day he wanders out onto the shoals and finds an especially large school of fish so he works especially long hours that day - Crusoe is enjoying a boom economy. Now add into Crusoe's economy some investment goods, nets for example, that take "time to build." A shock on day one will now exert an influence on the following days even if the shock itself goes away - Crusoe begins making the nets when it rains but in order to finish them he continues the next day when it shines. Thus, Crusoe's fish GDP falls for several days in a row - first because of the shock and then because of his choice to build nets, an optimal response to the shock.

An analogy is one thing but K[ydland] and P[rescott] showed that a model built from exactly the same microeconomic forces as in the Crusoe economy could duplicate many of the relevant statistics of the US economy over the past 50 years. This was a real shock to economists! There are no sticky prices in K & P's model, no systematic errors or confusions over nominal versus real prices and no unexploited profit opportunities. A perfectly competitive economy with no deviations from classical Arrow-Debreau assumptions could/would exhibit behaviour like the US economy.
That's what I've been trying to tell my wife (a Bush-hater), who likes to parrot the Democrats' line about "all those people who don't have jobs." My response: First, right now it's no worse than usual. The 5.4 percent unemployment rate for September was slightly lower than the average of 5.6 percent for 1948-2003 (computed from BLS data given here). Second, when the unemployment rate was worse it wasn't Bush's fault, nor was it Clinton's (even though the latest recession began on his watch). Recessions happen. They're inevitable and even desirable in a dynamic economy; they're fluctuations around an ever-rising trend, albeit a trend that has become less robust since the onset of the regulatory-welfare state about 100 years ago:

Data on real GDP for 1870-2003 are from Louis Johnston and Samuel H. Williamson, "The Annual Real and Nominal GDP for the United States, 1789 - Present." Economic History Services, March 2004, URL: Real GDP for 2004 estimated by deflating nominal 2004 GDP (source at footnote a) by increase in CPI between 2000 and 2004 (from Bureau of Labor Statistics).