Recessions and the Big Shock Theory
Economists still don't know what makes it happen. An economy thrives for years, and then suddenly, without warning, falls into a hole. Unemployment soars until somehow, sooner or later, growth resumes. Every economy on the planet has experienced these painful, mysterious and apparently unavoidable slumps.
Among academics, the most popular theory is the Big Shock, which has many variations. In this view, you get a recession when some big thing like an oil crisis whacks the economy, causing a corresponding reaction. Conservative economists assume individuals and businesses will react in the best and most rational possible way, creating an optimal economic response, so the government shouldn't get involved. Others take the less extreme view that governments and central banks, acting wisely, can intervene to help an economy recover.
A few economists instead prefer what you might call the amplification theory. They suggest that interactions between different parts of an economy might make it possible for even tiny shocks to have big consequences, much as a spark in a parched forest can trigger a vast fire. A small downturn for an auto manufacturer might hurt its suppliers, undermining their ability to supply other auto makers and creating a growing cascade of distress. The cause is less the shock and more the links that amplify it.
For most economists, that's the end of the discussion: Recessions are either the result of big shocks, or of small shocks with amplification. They ignore a third possibility: that an economy might sometimes get seriously out of shape with no shock at all. The omission is odd, because this way of thinking was quite common in economics some 50 years ago.
Fortunately, a group of economists and physicists is reviving the old "no shocks" idea. Interestingly, they start with a mathematical model of the economy built by Big Shock theorists -- specifically, the so-called Real Business Cycle model, which still garners lots of attention from economists. Like many mainstream economic models, it assumes that individuals and businesses make perfectly rational, optimal decisions, which lead the economy to a stable economic equilibrium. The new research then makes some adjustments to this picture: It assumes that individuals, rather than having perfect foresight when predicting future prices, sometimes make small errors. The result is radically different. The interactions of firms and individuals now create an ongoing turbulence with sporadic recessions arising from a natural lack of coordination, without any shocks at all.
The researchers go on to show that if you make the model more realistic along any of a number of dimensions -- firms taking a little time to adjust their production to new levels, for example, rather than doing so instantaneously -- you always end up with an inherently unstable economy. The conclusion is pretty much the opposite of what the Real Business Cycle theory's creators originally intended. They wanted to defend the notion that markets work perfectly, not to entertain the possibility that recessions might reflect an inability of markets to coordinate supply and demand. Their own model actually destroys that hope.
It's an amusing and ironic outcome, with implications beyond recessions. For years, many economists have argued that their assumptions of perfect rationality, self-interest and equilibrium are merely convenient elements in valuable thought experiments; they learn about the real world despite the manifestly false assumptions. That position now looks completely indefensible. It looks more as if Big Shock theorists are worried that relaxing their assumptions will lead to some very different and very inconvenient conclusions.
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Mark Buchanan at email@example.com