Arnold Kling  

Tyler's Tough Macro Test

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Tyler Cowen has some tough macroeconomics questions, including


Which aspect of the macroeconomy does real business cycle theory find most difficult to explain?

I would say that the apparent success of Keynesian stabilization policy in the United States since 1945 might be the most difficult aspect to explain. In my view, the pace of economic change has increased in recent years, and that should cause people to make more mistakes with their investments in human and physical capital, leading to more frequent and more serious recessions in the RBC world. In fact, however, postwar recessions have been relatively mild, and we've had some very long periods, notably 1991-2000, without a recession.

One possible explanation for this that might salvage RBC is that we have what I call an elastic economy. Otherwise, you have to give some credit to Keynesian stabilization policy. In fact, one could say that the most dramatic Keynesian intervention ever was the fiscal policy of the current President, which arguably kept the collapse of the Internet bubble from turning into a re-run of the 1930's.

Perhaps the topic of the macroeconomics of the Internet bubble and its aftermath would be my choice for Tyler's "write your own exam question" question. But I'm not sure how I would answer it.


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CATEGORIES: Macroeconomics



TRACKBACKS (3 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/376
The author at www.productivityshock.com in a related article titled Macroeconomics or meta-economics? writes:
    Professor Cowen today suggests that we be ready to write our own exam question and, if we want more than a C-minus, to answer it in full. [Tracked on October 7, 2005 9:19 PM]
COMMENTS (20 to date)
spencer writes:

Actually, since 1980 --some 25 years --we have only had two minor recessions. The old idea of a four year cycle is essentially dead.

Why? Your idea of an elastic economy is good, it an idea Greenspan keeps refering to. To me it looks like the internet and computers are moving the actual economy closer and closer to the economists perfectly competitive model, But it speeds business reaction times so we have many mini cycles rather then a few big or recessionary cycles. My view is that recessions occur when the business community makes a mistake. Now they react faster, and correct before the error gets too large. Second, the cyclical sectors of the economy, largely the goods sector, is not as important as it use to be and the noncyclical services sectors account for more of the economy.
So this is a second reason recessions are less frequent. Third, the inventory cycle now occurs more and more through trade. Use to be if retailers made a mistake and ended up with excess inventories they cut orders to manufacturing firms within the US. Now, they cut orders to Asian firms and it shows up in the national accounts as a drop in imports and that actually boost GDP. Besides your comments on Keynesian policies that are correct, monetary policy is much better. Under the classical gold based monetary system monetary policy was inheritently pro-cyclical. But even under the Fed system that allows monetary policy to be counter-cyclical the
federal reserve keeps learnings more and more about how to do its jobs. Under Greenspan monetary policy has been much more stable then it was from the Fed Accord to 1980.

Adam writes:

I think it would be best if we could avoid giving Keynes credit for, well, anything if possible.

But maybe I'm biased.

Bill Stepp writes:

I disagree that the second Bush Reich's fiscal policy prevented the internet bubble from becoming a rerun of the Great Depression. The earlier collapse was caused by the Fed's monetary policy and was abetted by protectionist policies and the cartellization of the American economy (see Rothbard, Hawley et al.) The resulting deflation caused real interest rates to be at historically high levels (for a good graphic, see Ken Fisher's _Wall Street Waltz_), contrary to our recent experience, which has been characterized by low and even negative real rates. In the 1930s the cost of capital was very high; the last decade its been much lower.
In addition, the move toward a (relatively more) deregulated economy since the late 1970s compared to the 1930s (with the move then toward more regulation), and the increasingly globalized economy enabled factors of production to move more easily to sectors where they were more highly valued. The current commodities bull market started in 1999 (the Rogers Raw Materials fund has outperformed the S&P 500 by a healthy margin since then); commodities-related investments have taken up much of what otherwise would have been a slacker world economy, and has been especially evident in the rise of China.
Productivity increases have continued to be strong the last decade as well, contrary to the 1930s.

Considering that the Bush junta has opposed free trade (in practice, if not always rhetorically), and was not the progenitor of productivity gains or the deregulation that helped the globalization of the economy, I'd say it gets no credit for whatever economic gains have occured.
The Bush junta's spending has been a disaster, especially on the Warfare State. The one good thing its done is cut taxes, although not by nearly enough.

Lauren writes:

I loved Tyler's questions. My answer to this question would have been that real business cycle theory has not done a convincing job of explaining the amplitudes or durations of business cycles.

Arnold: I'm not sure what successes you have in mind. Keynesian stabilization policies in the U.S., both fiscal and monetary, failed miserably during the 1960s-70s--the first times they were ever deliberately put to the test. (Consider these three articles from the Concise Encyclopedia of Economics: Fiscal Policy, by David Weil, Keynesian Economics, by Alan Blinder, and Monetary Policy, by James Tobin. It is hard to think of any actual successes of Keynesian stabilization policies when it comes to business cycles!)

Real business cycle theory also has not done a good job of differentiating itself from other competing business cycle theories (e.g, do unexpected monetary shocks do an equally good job of explaining business cycles?). These problems are in part a matter of insufficient data and tests that are inherently not statistically powerful. There have been only a few business cycles since the 1930s, and data on real variables can often only be imputed with substantial measurement error and often only quarterly or annually. They nevertheless remain problematic.

spencer writes:

I would question the argument that productivity was weak in the 1930s. From the 1933 bottom until WW II real gdp growth was much stronger then employment growth, with the resultent strong productivity growth. But some people cite the poor employment record as evidence that the New Deal prolonged the recession. But it was not FDR, if was strong productivity. Interestingly, we are getting something of the same phenomenon now with strong productivity and weak employment.
If the a major cause of the depression was over investment this type of strong productivity after a crash is just what one would expect.

Bill Stepp writes:

I'm not sure there were productivity gains then, but to the extent there were, prolonging the depression as a result, they did so only because prices and markets were not allowed to adjust to underlying shifts in supply and demand.

The effects of Katrina aside, I wouldn't characterize the economy now as one of weak employment. The depression was not caused by over investment; manipulation of the money supply led to malinvestment, which is a very different thing.
Forget Keynes, get with the Austrians.

spencer writes:

OK -- What prevented markets from adjusting?

Arnold Kling writes:
Keynesian stabilization policies in the U.S., both fiscal and monetary, failed miserably during the 1960s-70s--the first times they were ever deliberately put to the test.

Wage and price controls certainly failed. Running a war on poverty and a war in Vietnam at the same time failed. But even with those and other policy errors, the severity of business cycles appears to have been much lower from 1965-2005 than from 1905-1945 or 1865-1905. I think that this basic fact necessarily puts real business cycle theory on the defensive.

eric writes:

I would ask what, if any, current macro models helped inform any great macro-economic success stories of the past 50 years (eg, growth of West Germany, Asian Tigers, Ireland's turnaround, decline in inflation from 1980-present). Later you can get to "explaining" things after the fact (clearly less impressive since hindsight's 20-20).

Failure is the norm (see third world, history of the world to 1750). Explain why incontrovertible successes happened.

Lauren writes:

Hi, Arnold.

Thanks for your quick response:

Wage and price controls certainly failed. Running a war on poverty and a war in Vietnam at the same time failed.

I think you are agreeing with me. There are no evident examples of successful Keynesian stabilization policies.

But even with those and other policy errors, the severity of business cycles appears to have been much lower from 1965-2005 than from 1905-1945 or 1865-1905. I think that this basic fact necessarily puts real business cycle theory on the defensive.

I quite agree with you that the amplitudes and durations of business cycles are not explained by real business cycle theory. But neither does anyone think that Keynesian stabilization policies were involved with the decline in business cycle duration observed since the Great Depression! The changes just seem to have happened, and no changes in government policies seem to have been behind them.

Why is unclear. The amplitudes and durations of business cycles have apparently decreased during the last 100 years, compared to the preceding 200 years. The decreases are not explained by Keynesian, monetary, real business cycle, or any other theories I know, nor by any reliable policy actions, ad hoc or proposed by theory. It's one of the biggest outstanding questions in economics today.

Keynesian theory originally predicted that business depressions can persist permanently, with no way to get out of them unless, say, a benevolent government undertakes a "stabilizing" action that is successful. Certainly after experiencing a depression in England from the 1920s onwards, that may have been a compelling feature to build into a model for Lord Keynes in 1936. That built-in persistence has since been coincidentally appealing to many who find faith in government.

But, since the end of the Great Depression, and with the mitigation of recessions since, modelling long-term persistence in business declines, much less government's ability to rescue the economy in such instances, has turned out to be unproductive. No model has completely explained the problem, and no model has proposed any viable government solutions.

(For interested readers: A stabilization policy is a government policy that is intended to counteract a nationwide decline in business activity or overall income or output, as might be associated with a business recession. Keynesian policies suggested for stabilization included increases in government expenditure or the money supply. A policy would be deemed successful if the business decline was mitigated.)

I don't see that real business cycle theory is any more on the defensive in trying to explain this recalicrant problem--the duration of business cycles--than Keynesian theory is. No current theory does too well on these matters. If anything, real business cycle theory has done a little better than Keynesian theory by leading toward a potentially endogenous solution.

OK -- What prevented markets from adjusting?

New Deal policies according to Cole and Ohanian: http://minneapolisfed.org/research/qr/qr2311.pdf

Chris Bolts writes:

What about Greenspan's "conundrum" of increasing interest rates and low long-term interest rates? Perhaps Greenspan's tightening policy as well as Bush Co's. loose fiscal policy has presented us with a new puzzle to play with. This might fit under Kling's term of an "elastic economy" in that our economy has been able to withstand the tightening of monetary policy with an influx of liquidity coming from international capital markets as well as a drowning of deficit spending which would normally force firms and people to save more in preparation for higher taxation in the coming years.

I would have to agree with spencer in that although employment has been average (I wouldn't classify what we are experiencing with employment as weak, but not too strong, as Katrina has shown us), but we have gotten great productivity from the existing workforce. It's surprising that with terrorist attacks, an unpopular war, high gas prices, two huge hurricanes which has disrupted our energy supplies, and the growing profligacy of the politicians in Washington the US economy has been chugging along as if it is impervious to internal and external shocks. I wonder the RBC theory could have predicted this?

spencer writes:

Be sure and read the article in the Saturday times on Fedex. It is great support for my thesis that the modern ability to manage information is making the economy more elastic. One of the big difference is business reaction times that correct mistakes before they become severe.

In a way that is why we had the 1990 recession, the psychology of "it is different this time" allowed the investment boom to go too far and create to much excess capacity, so that the eventual reaction was substantial.


http://www.nytimes.com/2005/10/08/business/08fedex.html

spencer writes:

I do the stock market.

From 1970 to 1945 the stock market was in a bear market almost 50% of the time, and the frequency did not change significantly over that era.

From 1945 to the 1980s this declined to about 25%.

In the 20 years before the 2000 bear market stocks were in a bear market only 12% of the time.

I define a bear market as a double digit drop that carries the market below it level of a year ago.

Barkley Rosser writes:

spencer,

On your first comment, I note that there have been three recessions since 1980, with the one in 1982 being the deepest since the Great Depression, unless you want to get technical and say that we did not have a recession in 2001.

Not sure if you count what has been going on since 2000 or not as a bear market. Are you?

Chris Bolts,

Although not your regular event, rising short term interest rates coinciding with falling long term rates is not unheard of, just as the opposite is also not unheard of. Rational expectations types can argue that the market sees the Fed engaging in anti-inflationary policy with the short term tightening, which rationally reduces their inflation expectations, thereby pushing down long term rates, and vice versa.

Myself, I think that long term rates are low because of the Chinese wanting to keep the dollar up and their unemployment down, plus we are having a collapse of consumer confidence. Althought there will be a fiscal stimulus (ultra Keynesian I suppose) coming out of the post Katrina spending splurge, consumer confidence will really take a hit when the super high heating bills arrive. Few people realize yet just how high natural gas prices have gone (and will stay for some time).

Regarding Keynes himself I would only note that it is not accurate to identify him with an advocacy of massive or out-of-control deficit spending. When he wrote the UK traditionally ran budget surpluses. The fiscal stimuli he advocated for depression periods involved reductions of those surpluses. In his _How to Pay for the War_ he advocated tax increases to "pay for the war," and was clearly concerned about any appearance of excessive deficits. Heck, we ran bigger deficits in the US in WW II than did the Brits.

Barkley Rosser writes:

A further comment.

Tyler Cowen raises serious issues about the standard ISLM model, although it is no longer taught much at grad levels, even as it continues to haunt the consciousness of policymakers and many other observers. However, what should replace it is very unclear.

I remember a cartoon I saw quite some time ago. An unemployed economist was sitting on a bench saying to someone, "Once I was a Keynesian, then I became a monetarist, then I became a supply sider, and now I don't know what I am."

RBC may be the new substitute, reflecting last year's Nobel prize winners, but the models that come out of RBC are all over the place. Reportedly both the Fed and the World Bank have RBC-based Dynamic Stochastic General Equilibrium (DSGE) models in their basement computers. Despite many overlaps, they come to very different conclusions/forecasts about some very basic issues. Thus, supposedly the Sigma model in the Fed basement says that the response of the current account deficit to an increase in the US budget deficit is 20%, whereas the World Bank's basement model says that it is 50%. These are large differences with large policy implications, given the massive international debt problem the US is accumulating and its threat to global financial stability.

Ray writes:

Recessions have been mild because of the "flexibility" (as Greenspan noted today) in the US economy, not because of Keynesian policies. That flexibility would not have come about without the supply-side revolution initiated by Reagan.

Keynsian policies that manipulated demand made the economy inflexible prior to the Reagan Administration. The supply-side revolution only restored the classical model; it made policies that influenced supply equal to Keynes's beloved demand policies.

What was the Keynesian solution to recessions prior to 1980 given the stifling tax rates, wage-price controls, and ridiculous government spending as a percentage of GDP? It was higher taxes and spending and more regulation and price controls. We would still be living in Carter's "malaise" if Keynes had any influence after 1980.

Barkley Rosser writes:

Ray,

Keynes did advocate increased government spending as a method of fighting recessions (and that World War II spending put an end to the lingering Great Depression once and for all). He also argued rather vaguely for some sort of state control or influence over private capital investment. But I would challenge you to find anywhere in Keynes' writings that he suggested that higher taxes, wage and price controls, or increased regulation were solutions to recessions.

Arguably more recent "Keynesians" have advocated some of these things, but I don't think you can find any of them either who have ever advocated tax increases as ways of combating recessions. Name one, I dare you.

Ray writes:

Barkley,
I did not say that Keynes called for higher taxes as a cure for recessions, but the politicians who were influenced by Keynes, namely Democrats, did raise taxes to ridiculous levels to support their Keynesian spending prior to 1980. Keynesian policies in practice might be different from what Keynes wrote in the General Theory, but no politician of any stripe would survive with deficits equal to 15% or more of GDP. The Democrats had to pay for their Keynesian spending by raising taxes.
Ray

Ray writes:

Barkley,
To further my point, I paste a quote of yours that I just read for the first time:

Regarding Keynes himself I would only note that it is not accurate to identify him with an advocacy of massive or out-of-control deficit spending. When he wrote the UK traditionally ran budget surpluses. The fiscal stimuli he advocated for depression periods involved reductions of those surpluses. In his _How to Pay for the War_ he advocated tax increases to "pay for the war," and was clearly concerned about any appearance of excessive deficits. Heck, we ran bigger deficits in the US in WW II than did the Brits.
(Emphasis mine) Ray
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