The End of the Traditional Business Cycle and an Apologyby
First, the apology. I’m sorry for the lack of posts—I was pounded by a bad upper respiratory infection at the end of September, and it has taken me a full month to get back to (more or less) normal.
I’m going to attempt to maintain a regular posting schedule from here on out….once I figure out what it is.
Now, on to the business cycle. Over the past month I’ve written two pieces for the magazine (“The Economy’s Safety Valve” and “The Even-Keel Economy”) where I argued that the pain from the subprime housing crisis was going to be deep but narrow.
The broader point is that business cycles in the traditional sense may no longer exist. The National Bureau of Economic Research defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months”.
The key words are “spread across the economy.” Now, business cycles and recessions have always posed a problem for economists. It’s easy to construct a model of the economy which only predicts a recession in response to a very very big negative shock. That is, different sectors of the economy are only weakly linked, so that the impact of a negative shock is dissipated over time. (Most of the big macro models have this property).
It’s also easy to construct a model of the economy where recessions happen all the time. Just assume that economic actors adjust very quickly to a fall in their expectations about the future, so everyone cuts back simultaneously when there is a negative shock. A big rise in the price of oil, for example, would immediately propagate across the entire economy, causing a fall in production, a cut in employment, and so forth. The flip side is that the economy would jump quickly in the case of a positive shock. Bounce, bounce—but the bounces are smaller.
However, it turns out to be very difficult to construct a model of the economy which reproduces the historic frequency of recessions. Instead, what you get is either too many or too few recessions, relative to what we have actually seen.
As a result, virtually all useful models of the economy have incorporated some types of rigidities. That is, it is assumed that some combination of prices, quantities, and expectations adjust slowly to negative shocks, rather than immediately. With the proper calibrated assumptions, you get something that generates roughly the right frequency of downturns.
Now, I think what is happening is that many of these rigidities, especially in the financial markets, have been disappearing over time. As a result, the links between different sectors of the economy have been attenuating.
Instead, we now may be in a world of mini-recessions—sharp falls in one or two sectors which do not pull down the whole economy. Think about the different parts of the economy as being connected by springs (or slinkys, if you want). A sharp drop in one sector—say, housing—may pull down a couple of adjacent sectors, such as furniture. But the rest of the economy steams on, and maybe even accelerates, as resources are transferred from the weak sectors to the strong sectors.
This picture of the world actually fits very well with neoclassical economics. We may get a couple of quarters of negative GDP growth, but deep economy-wide recessions may be an anomaly rather than the norm.
Of course, a big enough shock could lead to a full scale downturn. Massive terrorist attacks, a major financial crisis in China, nuclear war in the Mideast all could cause a global recession. But those disasters aside, the old world of the synchronized rise and fall of different sectors may be over.