Do economic booms cause economic busts?
To a lot of people, this seems like a silly question to even ask. Of course booms cause busts, they say. Excessive greed or optimism or easy credit leads to overinvestment, soaring asset prices and unsustainable borrowing binges. What goes up must come down, and the surest sign of a bust tomorrow is a boom today.
So many people instinctively believe this that it would astonish most people to learn that for the last half-century, this hasn’t been the way macroeconomists – the type working as university professors, anyway – think about the business cycle.
For the past half-century, the academic macro story has gone something like this: There is a general trend of rising growth and prosperity in the U.S. economy, caused by steady improvements in technology. But this steady course is disturbed by unpredictable events – “shocks” – that temporarily slow growth or speed it up. The shocks might last for a while, but a positive shock today doesn’t mean a negative shock tomorrow. Recessions and booms are like rainy days and sunny days – when you look back on them, it looks like they alternate, but really they’re just random.
Why did macroeconomists arrive at this conclusion? First of all, the most simple theory of booms and busts – that the economy is like a wave, peaking and plunging at regular intervals – doesn’t hold up. The occurrence of booms and busts is highly irregular. Some people tried to compensate by making the models very complex and chaotic, but the math got too hard, and in the end, chaotic systems usually just end up looking random anyway.
At this point macroeconomists turned to the “trend-plus-shocks” model that they still mostly use today. But since the grand debacle of 2008 and 2009, there has been a lot of pressure on macroeconomic theorists, from both within academia and without (but mostly from without), to discard old ideas and try new ones.
So a small handful of macroeconomists are turning back to the old idea that booms cause busts, and vice versa. “About time,” you might say. But academic research paradigms are very difficult ships to turn around, and researchers are often less like captains and more like prisoners chained below decks. Publish some pathbreaking theoretical idea, and you might become a hero, but it’s even more likely that you will just get your paper rejected, especially if there isn’t some extremely convincing empirical support. For the most part, only the most famous and well-established researchers can get radical ideas taken seriously.
Paul Beaudry and Franck Portier are two such researchers. They are famous for a 2006 theory saying that news about future changes in productivity could be what cause recessions and booms. That model never really caught on – it always had some issues with the data, and it definitely didn’t seem to be able to explain the Great Recession. But it inspired further research, and it was an interesting and novel idea.
Now, Beaudry and Portier, along with co-author Dana Galizia, are going after bigger fish. They want to resurrect the idea that booms cause recessions.
In a new paper called “Reviving the Limit Cycle View of Macroeconomic Fluctuations,” Beaudry and Portier try to think of reasons why booms might cause busts. The mechanism they come up with is pretty simple. You have a whole bunch of people – basically, companies – who invest in their businesses. The amount other people invest affects the amount I want to invest, but I can only adjust my investment slowly. When you have feedback effects like this, you’re going to get instability in your model economy, and that’s exactly what the authors find – the economy experiences booms and busts in a chaotic, unstable way. To reproduce the randomness found in the real economy, the authors simply add in some random “shocks” to productivity.
Now, this exercise will be infuriating to some “heterodox” macroeconomists, who have been conducting similar exercises in obscurity for decades, largely ignored by the mainstream of the profession. But it’s an interesting exercise nonetheless, for two main reasons.
The first thing it shows is that academic macroeconomists are starting to question their most basic, fundamental assumptions about how the economy works. Maybe the old macroeconomics, which critics had long said needed to be tossed out, really was smashed by the crisis. If this paper is any indication, it means macroeconomists are casting around for big new ideas, which in turn means that they have realized that they don’t know what’s going on.
The second thing it shows is that if you add even a little bit of the right kind of feedback into an economic system, it becomes unstable. Heterodox macroeconomists have long been yelling that this is the case, but now some heavy hitters in the mainstream are finally starting to catch on to the idea as well. Unfortunately, the fact that a little bit of feedback can totally send models off the rails doesn’t bode well for our ability to understand recessions. It looks like macroeconomists are going to continue to scratch their heads for years to come.
