David R. Henderson  

Scott Sumner on Real Causes of Business Cycles

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Scott Sumner has a first-rate post this morning and one of the most important ones you can read if you want a quick look at why real changes in the economy rarely cause large business cycles. Here are the first three paragraphs:

I've been thinking about how to teach monetary economics from the beginning. Perhaps before people start learning, they need to unlearn things they believe, that just ain't so. We market monetarists believe that monetary shocks (or "disequilibrium" if you prefer) [are] the primary cause of business cycles, indeed almost the only cause of big swings in unemployment.

Most people don't believe this; indeed it's not even clear that most economists believe this. Instead the average person thinks recessions are caused by big real shocks, or financial shocks, of one sort or another. Asset bubbles bursting, 9/11, stock market crashes, devastating natural disasters, etc.

It's surprisingly easy to dispose of these real theories. We know that 9/11 didn't cause the 2001 recession, because the recovery started just 2 months later. The biggest stock market crash in my life was 1987, which was almost identical to 1929, including the subsequent stock price rebound. The biggest natural disaster to hit a rich country in my lifetime was the 2011 Japanese earthquake/tsunami/nuclear meltdown, which killed tens of thousands of people, devastated a sizable area of Japan, and caused their entire nuclear industry (25% of total electrical output) to shutdown for more than a year (causing brownouts.)


Also, check out his graphs.

In an Executive MBA economics course I teach--the only econ course the students get--I spend most of the time on micro and only about the last 8 hours on macro. For that reason, I focus the macro on what we know: Inflation is always and everywhere a monetary phenomenon, to name one. This blog post by Scott will now be on the macro part of my syllabus.


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CATEGORIES: Macroeconomics



COMMENTS (16 to date)
Ken B writes:

Darth Vader uses the Death Star to destroy half of all crops, goods, buildings. He destroys no money, no people. I predict inflation. DV need not do this all at once. Give him 5 years, and I predict several years of inflation.

I hate to disagree with Milton Friedman, but my prediction is pretty convincing isn't it?

Likewise, won't longer lifespans, ceteris paribis , cause inflation?

David R. Henderson writes:

@Ken B,
Darth Vader uses the Death Star to destroy half of all crops, goods, buildings. He destroys no money, no people. I predict inflation. DV need not do this all at once. Give him 5 years, and I predict several years of inflation.
I would predict a year of inflation, but I take your point. So would Milton Friedman, were he alive. Milton was making an empirical point. He, like you, knew that MV = Py and so if y falls substantially and M and V are unchanged, P will increase.
But no, longer lifespans will not cause inflation. I'm not sure of the mechanism you have in mind here.

Ken B writes:

David,
Cet par longer life means more demand. So if the amount of goods is fixed, and the amount of money is fixed, won't prices rise? It's like Vader dropping more people who do not produce on the planet. Longer life at the same rate of productivity won't cause inflation I think, but that's an unlikely assumption.

I'm being perhaps persnickety but whenever I discuss this with people any lack of clarity usually causes confusion.

Always and everywhere sounds like logic not empirics I guess is my point.

Scott Sumner writes:

Thanks David!

genauer writes:

kinf of interesting.

I thought it was consensus, that the 2000 recession was caused by the bursting dot.com stock price bubble. Bubble as in a multi-year event. And 9/11 was 1.5 years later.

1987 was just the correction of a overvaluation blip, within a few months, caused by some silly "portfolio insurance", when people basically looked at it 2 days later, and said: looks reasonable.

1929, 2008 were the result of much more fundamental problems, therefore taking years to correct.

Vangel writes:

He, like you, knew that MV = Py and so if y falls substantially and M and V are unchanged, P will increase.

And here is the problem that most of the mainstream economists miss. As you well know David the whole equation is meaningless because V is not an independent variable that can be measured and there is no way to come up with a value for P that makes any sense. So what you have is an equation that pretends to be scientific being used for the purpose of providing narratives that are often used to justify transferring wealth from the consumers and saver to well connected groups.

Didn't Scott miss the housing bubble, support QE2, and make ridiculous claims that Bernanke's tight money policies were responsible for the crash? I would have thought that you could do a lot better by referencing the Austrian School on the business cycle than by recycling failed monetarist ideas.

David R. Henderson writes:

@Ken B,
Cet par longer life means more demand. So if the amount of goods is fixed, and the amount of money is fixed, won't prices rise?
No. Not if V is constant.
Always and everywhere sounds like logic not empirics.
You're right. That was Milton being flashy when he was trying to get some people in India in the 1960s off their obsession with central planning and price controls.
@Scott Sumner,
You're welcome.
@Vangel,
So what you have is an equation that pretends to be scientific being used for the purpose of providing narratives that are often used to justify transferring wealth from the consumers and saver to well connected groups
Unlike you, I think it's very important to distinguish between motives and analysis. My guess is that you just cant' imagine that some ideas that some people use for bad purposes could be right. Can you?

Jim Rose writes:
The biggest natural disaster to hit a rich country in my lifetime was the 2011 Japanese earthquake/tsunami/nuclear meltdown, which killed tens of thousands of people, devastated a sizable area of Japan, and caused their entire nuclear industry (25% of total electrical output) to shutdown for more than a year (causing brownouts.)

Recoveries from disasters are rapid as Jack Hirshleifer pointed out in the papers he wrote for Rand in the 1960s on post-nuclear war civil defence.

As long as the basic market system is not suppressed, recoveries are rapid. war communism caused far more economic damage than the mass bombing of Axis cities in WW 2.

Recoveries from disasters are rapid because they are a case of unbalanced growth.

The war and disaster damage is random. Once these missing inputs are repaired ot restored, everything goes back to normal rapidly because the remaining capital is intact.

Jim Rose writes:

taxes,regulation and a failure to invest in higher education was good a enough to open up a 30% gap in income between the EU-6 and the USA. smaller fluctuations in tax, regulation and other costs should be able to cause recessions.

See also Fiscal Sentiment and the Weak Recovery from the Great Recession: A Quantitative Exploration by Finn E. Kydland and Carlos E. J. M. Zarazaga
• The U.S. economy isn’t recovering from the deep Great Recession of 2008-2009 with the anticipated strength. A widespread conjecture is that this weakness can be traced to perceptions of an imminent switch to a higher taxes regime.

• The main finding is that the fiscal sentiment hypothesis can account for a significant fraction of the decline in investment and labor input in the aftermath of the Great Recession, relative to their pre-recession trends.

• These results require a qualification: The perceived higher taxes must fall almost exclusively on capital income. This is not an unreasonable condition.

• People suspect that the tax structure that will be implemented to address large fiscal imbalances will be far from optimal

• As agents realize that their capital income will be taxed more heavily in the future, they reduce their holdings of the capital stock by not completely replenishing the part of it that depreciates every period and by changing the composition of output in favour of consumption.

Jim Rose writes:

Why should technology unfold at an even rate? who is the guiding hand to ensure such neatness?

Andofatto reminds that general purpose technologies are enough to ensure larger variations in technological progress, followed by slowdowns for learning about new techologies, and for intervening periods of less innovation.

Opponents of RBC default to an invisible explanation of productivity growth.

In Nozick's terms, where is the filter and where is the equilibrating mechanism to ensure growth is a smooth 2% but for monetary policy errors?

The filter of the market process is profits and losses and the equilibrating mechanism is relative prices. Losses eliminate undesirable behaviours and prices tell people what to do.

Vangel writes:

@David

Unlike you, I think it's very important to distinguish between motives and analysis. My guess is that you just cant' imagine that some ideas that some people use for bad purposes could be right. Can you?

You are missing my point. I am just a simple engineer who likes to see things as they are. In my equation the equation is useless because you can't measure any of the variables. Below I will state what I understand the equation and theory to be and explain why I think that the Austrians were right when they said that it was essentially nonsense.


Let us begin with the equation MV = PY


  • M is the Money Supply

  • P is the Price Level

  • V is the Velocity of Circulation

  • Y is the Real GDP

Let me begin by making it very clear that I agree with Benjamin Anderson that all the equation really tells us is that what is received is equal to what is paid. Now you may consider that to be a very important discovery but most people would say that is obvious and that we do not need economists to tell us the obvious.

Given the fact that you are probably smarter than I am and are trained as an economist it is up to you and Scott to explain how you can use the equation for anything of value. Please explain how you measure the velocity of circulation. Or how you determine the price level. While we are at it, are you sure that you know the true value for the money supply? Or even of the Real GDP? If you look at this as a mathematician or scientist you will quickly have to conclude that there is no way to use the equation to reach a reasonable conclusion without looking at massive uncertainties and errors.

Now I do not mean to suggest that it is only the equation of exchange that has such problems. Looking at most of the reports that come from the BLS and other agencies, and looking at what passes for economics papers these days, I have to conclude that most of the mainstream field is guilty of pretending that it knows more than it does.

I look forward to a response that would set me straight.


Ken B writes:

"Not if V is fixed."

Ok, I see what I did. I confused real and nominal. More people who consume but not produce make us individually poorer in real terms, like when you raise a baby, but that can mean less stuff each, not higher prices. Like when you raise a baby.

genauer writes:

I am really looking for an answer to vangel,

because as an engineer/scientist (with a citation count > 1000 not pretending to be "simple") I have very similar doubts about the economists profession : - )

Vangel writes:

because as an engineer/scientist (with a citation count > 1000 not pretending to be "simple") I have very similar doubts about the economists profession : - )

I don't think that you will get an answer. Few economists ever bother to actually deal with the question because theirs is a position of faith. Ironically, they attack the Austrian School for not being mathematically and scientifically rigorous enough and for its reliance on logic and deductive reasoning. Yet, their answer is to make all kinds of simplifying assumptions so that they can use high level math to create mathematical models that have no predictive ability. And when we remind them that the Austrians had no trouble seeing the housing and tech bubbles that their models missed (as well as the current bond and fiat currency bubbles) they talk about broken clocks and make all kinds of excuses to hide their failures. There is nothing scientific about making assumptions that cannot really be justified just so that you can apply your simple tools to try and extract predictions about the real world that are wrong when it really matters.

David R. Henderson writes:

@genauer,
I tried to engage Vangel but he refused to address what I asked him.

But for your sake, I'll address some of his points. He's right, of course, that V cannot be measured. It can only be calculated. To calculate it, you must know P, y, and M. He claims that we can't know all these things. I say that we can certainly know them all within tolerable limits. Also, you might think that it's useless to introduce a variable that can't be measured. But if that were true, we would have to throw out much of economics. We can't really measure a demand curve, for example. All we really know is a point on the demand curve and then we make estimates of elasticity.

Also, I think that what Vangel is getting at is that MV = Py is a tautology: it has to be true. That's probably why he said that it's obvious. It IS obvious, but that's a virtue. It says that anything you say in macro has to be consistent with it.
I'll give an important historical example. When the Reagan administration came out with its projections for the economy in early 1981, the late James Tobin pointed out that given their projections for M, y, and P, V would have to change by x%. I've forgotten what x was and whether it was positive or negative. He then explained how incredibly implausible this change was.

Vangel writes:

But for your sake, I'll address some of his points. He's right, of course, that V cannot be measured. It can only be calculated. To calculate it, you must know P, y, and M.

But that is my point. How do you know the value of P when most prices are in flux as is the weighting of the importance of the goods in the economy? To make any attempt at using the equation you have to assume a general equilibrium in a chaotic world where local conditions are always changing and value is subjective. See the problem?

Now we have two variables that cannot be measured but must be calculated. What about y? I suggest that y is also not really known as the BLS has demonstrated perfectly. Note that it has been using the post-Boskin methodology to calculate the inflation rate, which is used to determine real GDP. But if the same methodology were applied to the 1970s we would see GDP in the 1970s much stronger and there would have been little inflation. If we use the pre-Boskin methodology today we would see that GDP is negative as the inflation rate would come out to around 9% or so. Now I am not saying that one method is better than the other here although I am very certain that pre-Boskin is much closer to the truth. What I am pointing out is that the people who put out the report spliced the outputs together instead of restate the numbers using one method or another. This shows political goals rather than any desire to find some truth.

Note that we now have three out of four variables that can't be measured directly but must be calculated. The equation of exchange is not looking all that good at this point. But not to worry; it will get even worse.

He claims that we can't know all these things. I say that we can certainly know them all within tolerable limits.

I disagree. When you are reporting 2% inflation by one methodology and 9% by the previous one there is nothing tolerable about the certainty. How do we calculate a general price level when local conditions are different and changing and our unit of measurement is not stable? (When a dollar consists of "twenty-five and eight-tenths grains (1.67 g) of gold nine-tenths fine," the unit of measure is stable and constant. When a dollar is just a piece of paper that only refers to itself there is no constant unit of measure.)

Also, you might think that it's useless to introduce a variable that can't be measured. But if that were true, we would have to throw out much of economics. We can't really measure a demand curve, for example. All we really know is a point on the demand curve and then we make estimates of elasticity.

Yes we do have to throw out most of economics. But note everything. When we throw out the inappropriate and incorrect what we keep is much more useful because it actually makes pretty good predictions. The Austrians use logic, not complex mathematical formulas, to predict the tech and housing bubbles. They predicted that Milton Friedman was wrong when he stated that gold would fall in price when its link to the USD was cut to a level that would reflect its use as a dental material. They argued that it was the USD that was propped up by its link to gold, not the other way around. They predicted the Great Depression when Irwin Fisher, whose research on the quantity theory of money set the foundation for the monetarist school, was writing about a permanent plateau of prosperity. The Austrians predicted the improvement of the economy when government spending went down after WWII when Keynesians were worried about a collapse into another depression.

I am not saying to throw out all of economics. I am saying that you need to throw out the nonsensical part of economics that pretends to be rigorous mathematics and a hard science. Any mindful observer has figured out that the assumption that the economy is in a stable equilibrium is false and that Arrow and Debreu seem to have done even more damage to rational economic thinking than Marx. It is the reliance of most modern economists on such nonsense that have created such a huge gap between prediction and reality.

Let me get back to the last variable, M. You may argue that this is the simplest of all measures but I would argue the opposite. The twentieth century has been the century of fake money where a currency note, which isn't really a note in the formal legal term, became self-referential and its production has distorted reality. The constant money printing has robbed savers of their purchasing power and destroyed traditional society by undermining the old who depended on fixed incomes for their living. It has transferred wealth to the state and the protected financial system that creates purchasing power out of thin air by expanding balance sheets.

Let me see. I may not be all that bright but we just found that all four variables are not easy to measure and are calculated by referencing other variables that are often not measurable. So much for the scientific nature of the equation of exchange.

Also, I think that what Vangel is getting at is that MV = Py is a tautology: it has to be true. That's probably why he said that it's obvious. It IS obvious, but that's a virtue. It says that anything you say in macro has to be consistent with it.

What it says is the price paid is the price received. That does not tell us anything new or useful to us. And it certainly does not justify the narratives that demand that some lever be pulled or button be pushed by policy makers to 'fix the economy.'

I'll give an important historical example. When the Reagan administration came out with its projections for the economy in early 1981, the late James Tobin pointed out that given their projections for M, y, and P, V would have to change by x%. I've forgotten what x was and whether it was positive or negative. He then explained how incredibly implausible this change was.

My bigger problem is that the variables are not independent and are not easy to measure. The use of an equation that has little meaning to drive policy is not science; it is narrative designed to strengthen a faith based positions. Fisher and the monetarists are barking up the wrong tree David. They use simplifying assumptions that we all know are not true to make it possible to use mathematical tools that are inadequate to shed much light on the complex, non-linear system that is a modern economy. This is why we are on the brink of a global financial meltdown and are drowning in an orgy of money printing and credit expansion.

I think that you are clearly knowledgeable and smart enough to see where the logic is leading you. Isn't it time to abandon failed theories pretending to be science and embrace methodology and theory that works and has predictive value?

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