Recessions and Hunks of Junk

The so-called Real Business Cycle theory has numerous problems, since it seems to be neither real now have much to do with business. 
The founding father of RBC.                                                        

Here's how recessions work. Sometimes, scientists and engineers invent less new stuff than normal. Fewer new inventions this year mean fewer new inventions next year, too. Anticipating this, companies invest less, and they also cut workers' wages. When wages go down, workers decide to take a vacation instead of work. Voila -- a recession!

Actually, I'm kidding. I don't think this is how recessions work at all. But the theory I just described is a real macroeconomic theory. It came out in 1982, and its name is the Real Business Cycle model. In 2004, its creators, Edward Prescott and Finn Kydland, won a Nobel Prize for their work. The theory inspired a generation of researchers, and became the dominant theory in certain places, such as the University of Minnesota.

You might be forgiven for thinking that Real Business Cycle theory, or RBC for short, doesn't deserve its moniker. Just as the Holy Roman Empire was none of the above, RBC theory doesn't seem to have much to do with business or cycles, and for that matter doesn't sound particularly real. Most people think that recessions are caused by asset-price crashes, by disturbances in the financial sector, or by Federal Reserve tightening of the money supply.

RBC says we're all wrong about that. The financial sector, RBC adherents claim, isn't important. Asset prices crash because people see a recession coming ahead of time and act accordingly. And the Fed, according to Prescott in a recent interview, has no more effect on the economy than a rain dance has on rain. In fact, RBC is really sort of a giant null hypothesis -- a claim that the phenomenon known as the business cycle is just an illusion, and that recessions are the normal, smooth functioning of an efficient economy.

After RBC came out, it was immediately attacked. Harvard economist Larry Summers led the charge, pointing out that the numbers in the model didn't make much sense, and that the model predicted inflation where none actually occurred. A generation of macroeconomists spent untold hours picking over the model, and found no end of issues. An especially serious problem with the RBC story was that in order to cause a recession as big as the ones in 2009, 1930, or the early 1980s, technological progress would actually have to go in reverse -- humanity would have to forget things that we knew how to do!

In response, Team RBC battled back. "Technology," they claimed, was really just a catch-all word for an economy's productivity. So an increase in government regulation or taxes could cause a recession. In fact, according to this explanation, the 2009 recession was caused by the abrupt realization that the administration of Barack Obama would eventually increase government intervention in the economy!

Meanwhile, RBC theorists worked to fix the technical kinks in the model. They proposed a clever model in which news about future technological or government policy changes causes recessions. That took care of the inflation issue (though other researchers claimed that this theory, too, doesn't fit the facts). More recently, Prescott and a co-author argued that the RBC theory had never really failed at all, and that all other theories (i.e., the mainstream theories used by most central banks) are "untested" and should be ignored.

To non-macroeconomists, the claims of the RBC theorists can seem infuriating. Isn't it obvious that recessions are caused by financial panics, asset-price crashes and hikes in interest rates? But the problem with macroeconomics is that the data isn't very informative, so it's very hard to definitively reject RBC theory as a whole -- if you exert the Herculean effort required to kill one version of it, two new variants will spring up like hydra heads.

Even though RBC can't be killed, frustration has built among the macroeconomic mainstream, which has mostly turned to other explanations of recessions. Central banks tend to use so-called New Keynesian models, in which monetary policy reigns supreme. Meanwhile, academic macroeconomists are building models in which malfunctioning financial institutions cause collapses in the economy. Private-sector economists are staying out of the debate entirely.

So RBC's star is on the wane. Mention the name "RBC" at a macroeconomics convention, and eyes immediately roll. The debate can even turn rancorous, as when two top RBC theorists were fired from the Federal Reserve Bank of Minneapolis last year. But the theory, and similar ideas, remain the loyal opposition of the macroeconomics world, reminding us that all our elaborate models may simply be hunks of junk.

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