Yet another in my series of articles on economic theories, empirical hypotheses and policy programs that have been refuted, or undermined, by the Global Financial Crisis. This one, on Real Business Cycle Theory, is a bit econowonkish, but I’m putting it up here because
(a) I hope some econowonks among the readers might find errors and correct me
(b) Judging by some other recent commentary, RBC still has some interest.

* As indeed, they have. My suggestion of a link between calibration and the GMM has been roundly refuted both here and at Crooked Timber. I can only say, it seemed like a good idea at the time. Thanks for the very useful comments on this point, and on RBC more generally.

Real Business Cycle theory emerged in the early 1980s as a variant of New Classical Economics (of which more soon, I hope). The big papers were by Plosser & Long and Kydland & Prescott. The RBC literature introduced two big innovations, one theoretical and one technical.

In theoretical terms, relative to the standard New Classical story that the economy naturally more rapidly back towards full employment equilibrium in response to any shock, RBC advocates recognised the existence of fluctuations in aggregate and employment but argued that such fluctuations represent a socially optimal equilibrium response to exogenous shocks such as changes in productivity, the terms of trade, or workers’ preference for leisure.

In technical terms, RBC models were typically estimated using a calibration procedure in which the parameters of the model were adjusted to give the best possible approximation to the observed mean and variance of relevant economic variables and the correlations between them (sometimes referred to, in the jargon, as ‘stylised facts’). This procedure, closely associated with a set of statistical techniques referred to as the Generalized Method of Moments, differs from the standard approach pioneered by the Cowles Commission in which the parameters of a model are estimated on the basis of a criterion such as minimisation of the sum of squared errors (differences between predicted and observed values in a given data set.

There’s no necessary link between these two innovations and there gradually emerged two streams within the RBC literature. In one stream were those concerned to preserve the theoretical claim that the observed business cycle is an optimal outcome, even in the face of data that consistently suggested the opposite. In the other stream were those who adopted the modelling approach, but were willing to introduce non-classical tweaks to the model (imperfect information/competition and so on) to get a better fit to the stylised facts.

In a sense, the latter stream of RBC literature converged with New Keynesianism, which also uses non-classical tweaks to standard general equilibrium assumptions with the aim of fitting the macro data.

On the whole, though, the two groups tend to reflect their intellectual roots in one critical respect. Those in the RBC tradition tend to seek tweaks that are as modest as possible, and assume that any departures from the optimal business cycles described by the founders of the school are correspondingly modest. By contrast, the central point of New Keynesianism is that modest tweaks to the classical assumptions can produce aggregate outcomes that are far from optimal.

But as far as the global financial crisis is concerned, this difference is not all that material. As with the New Keynesians, RBC economists haven’t had much useful to offer, and this is, if anything more true of those who’ve tweaked the classical assumptions than of the smaller group who’ve stayed true to the original program.

Coming back to the original program, the big exception that was conceded by most RBC theorists at the outset was the Great Depression. The implied RBC analysis that the state of scientific knowledge had suddenly gone backwards by 30 per cent, or that workers throughout the world had suddenly succumbed to an epidemic of laziness was the subject of some well-deserved derision from Keynesians. A couple of quotes I’ve pinched from a survey by Luca Pensieroso

“the Great Depression [. . . ] remains a formidable barrier to a completely unbending application of the view that business cycles are all alike.” (Lucas (1980), pg. 273.) “If the Depression continues, in some respects, to defy explanation by existing economic analysis (as I believe it does),
perhaps it is gradually succumbing under the Law of Large Numbers.” (Lucas (1980), pg.284)

But towards the end of the 1990s, at a time when RBC theory had in any case lost the battle for general acceptance, some of the more hardline RBC advocates tried to tackle the Depression, albeit at the cost of ignoring its most salient features . First, they ignored the fact that the Depression was a global event, adopting a single-country focus on the US. Then, they downplayed the huge downturn in output between 1929 and 1933, focusing instead on the slowness of the subsequent recovery which they blamed (surprise, surprise) on FDR and the New Deal. The key paper here is by Cole and Ohanian (following a line of argument suggested by Prescott). Cole and Ohanian seem to be the main source for Amity Shlaes’ Forgotten Man (I haven’t read it, will try to get to this). As readers may recall, Cole and Ohanian (and Shlaes) reclassify WPA workers as unemployed to make the post-1933 period look worse. They put particular emphasis on the National Industrial Recovery Act.

There are plenty of difficulties with the critique of the New Deal, and these have been argued at length by Eric Rauchway among others. But the real problem, is that RBC can’t possibly explain the Depression as most economists understand it, that is, the crisis and collapse of the global economic system in the years after 1929. Instead, Cole and Ohanian want to change the subject. The whole exercise is rather like an account of the causes of WWII that starts at Yalta.

The failure of RBC is brought into sharp relief by the current global crisis. Not even the most ardent RBC supporter has been game to suggest that the crisis is caused by technological shocks or changes in tastes, and the suggestion that it was all the fault of a minor piece of anti-redlining law (the Community Reinvestment Act) has been abandoned as the speculative excesses and outright corruption of the central institutions of Wall Street has come to light.

Unlike New Keynesian macro, where some useful insights will be relevant to policy in future periods of relative stability, it’s hard to see anything being salvaged from the theoretical program of RBC. On the other hand, it has given us some potentially useful statistical techniques.

More importantly, it was a concern with the magnitudes of variances and correlations that led Prescott (along with Mehra) to observe the equity premium puzzle which, I think, will play a crucial role in the development of a more satisfactory macro theory.