A cure for a downturn?

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What Causes Recessions?

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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One time, at a dinner, I asked a famous macroeconomist: “So, what really causes recessions?”

His reply came immediately: “Unexplained shocks to investment.”

We really just don’t know the answer. Some people -- the types who think the market is self-adjusting and wonderful and doesn’t need any government help -- believe that recessions are a natural, even healthy process. Maybe recessions are responses to changes in the rate of technological progress, or to news of future progress, or even bursts of creative destruction. Others -- the people who tend to think the market needs a little helping hand -- believe that there’s something blocking the market from adjusting to the shocks that buffet it.

The market adjusts by the price mechanism. If the cost of something goes up, the price goes up to match. If demand falls, the price drops until the market clears. So if you want to show that the market doesn’t naturally self-regulate, the simplest and easiest way is just to show that prices themselves can’t adjust in response to events. This phenomenon is called “sticky prices.” If prices are sticky, then someone -- the Federal Reserve, or perhaps Congress and the Treasury -- needs to nudge markets back into their long-run equilibrium after a big shock.

In 1994, economists Greg Mankiw and Lawrence Ball wrote an essay for the National Bureau of Economic Research entitled “A Sticky-Price Manifesto.” Sticky prices might sound like a strange thing to write a manifesto about (did the prices spill Coke all over themselves?), but the essay heralded the beginning of a macroeconomics mini-revolution. It was a direct threat to the line of research that had been dominant in the 1980s, which tried to explain recessions without sticky prices.

The economic establishment reacted harshly to the upstarts. “Why do I have to read this?" fumed Robert Lucas, the dean of macroeconomics. "This paper contributes nothing.” He went on to accuse the sticky-pricers of being opposed to science and progress.

But Lucas fumed in vain. During the following decade, the sticky-price models went from strength to strength. New math was developed to make them easier to use. Possible reasons for price stickiness were investigated -- for example, “menu costs,” in which the seemingly trivial costs of changing prices add up to a big problem across the broader economy.

Even more telling, sticky-price theorists proved that you didn’t need a lot of price stickiness to mess up the smooth working of the economy. Even the tiniest dash of stickiness would turn all kinds of theories on their heads. Economists Susanto Basu, John Fernald, and my doctoral adviser Miles Kimball, for example, showed that when prices are even a little sticky, bursts of technological progress actually hurt the economy for a short while, by causing a burst of deflation, before eventually boosting growth. Over time, the addition of various other economic mechanisms, like labor search, has further reduced the amount of price stickiness required to cause major recessions.

Sticky-price models have become the dominant models used at central banks. The smoothly adjusting, flexible-price models of the 1980s are basically not used anywhere, by anyone, for anything.

Even some of the biggest skeptics of sticky prices are coming around. In 2004, economists Mark Bils and Peter Klenow looked at how businesses changed prices, and found that the changes were too frequent to be consistent with the sticky-price story. But in 2014, they reversed their stance, looking at evidence on the adjustment of markets in recessions and concluding that “sticky prices...deserve a central place in business cycle research.” Meanwhile, economists Patrick Kehoe and Virgiliu Midrigan, long-time opponents of the mainstream sticky-price models, nevertheless wrote a paper in 2010 entitled “Prices are Sticky After All.”

Sticky-price models still have their dogged opponents here and there throughout the macroeconomics world. Steve Williamson of the Federal Reserve Bank of St. Louis dismisses sticky prices on his blog, saying that the Great Recession went on too long to have been caused by price stickiness, and that sticky-price models have conquered central banks mainly due to slick marketing. Elsewhere, University of California-Berkeley economist Brad DeLong grumbles that the success of the sticky-price models (called “New Keynesian” models even though they have relatively little to do with John Maynard Keynes) could be distracting from the search for deeper reasons for economic dysfunction.

But despite these scattered denunciations and grumbles, sticky prices are enjoying a hard-fought place in the sun. The moral of the story is that if you just keep pounding away with theory and evidence, even the toughest orthodoxy in a mean, confrontational field like macroeconomics will eventually have to give you some respect.

(Corrects authorship of report cited in last sentence of 10th paragraph in article published April 10. )

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net