Observational Equivalence, Again

Suppose that prior to the recession, I told you that I had a theory of the business cycle. My theory suggested that shocks to net worth were a significant explanation of the business cycle. Following a shock to net worth, consumption, investment, and hours worked would decline. Suppose that I also told you that increases in the monetary base by the Federal Reserve would keep inflation close to the implicit objective, but have little effect on consumption, investment, and real GDP. Given the events of the last four years, this theory seems to fit pretty well with what we have actually observed. What might surprise you, however, is that the framework I am describing is a real business cycle model with financial market frictions. This view seems largely consistent with James Bullard’s interpretation of events.

Suppose instead that I told you that I had the following theory of the business cycle. My theory suggested that liquidity shocks were a significant explanation of the business cycle. Following a shock to liquidity, and without appropriate Federal Reserve policy, nominal and real GDP would decline and unemployment would rise. In addition, suppose that I told you that if the Federal Reserve increased the monetary base without an explicit target or goal that such an expansion would have little effect on real economic activity. Given the events of the last four years, this theory seems to fit pretty well with what we have actually observed. This view is largely consistent with Scott Sumner’s interpretation of events.

I have used these two examples to illustrate a couple of points. First, neither Bullard nor Sumner (or anybody else associated with similar views) are crazy. They have logically consistent ideas that are consistent with casual observation. Second, confirmation bias is dangerous. It is very tempting to have a theory, look at the world, observe events consistent with your theory, and conclude that your theory is correct. But that is just confirmation bias. What is necessary is to provide evidence to support your theory in light of other theories that have observationally equivalent observations. This is substantially harder to do — even for those who realize it is necessary. Third, and perhaps most importantly, the ability to distinguish between these and other competing theories is incredibly important given the vastly different monetary policy implications.

7 responses to “Observational Equivalence, Again

  1. What you you say about a causal explanatory mechanism which subsumed and unified both of your two explanations above into one simplifying and overarching explanatory framework?

    We usually identify that as explanatory power — the sort of explanatory power Darwin brought to biology.

    Hayek’s monetary economics / trade cycle theory essentially encompasses and integrates both theories you’ve given above in a simplified and unified causal explanatory framework.

    Perception and data are theory-laden and often theory-dependent.

    What you see is what your theory looked for and told you was there to be seen.

  2. Josh: your post here ties in with a vague thought that’s been running through my mind. Has investment in (college and university) education declined? From what (little) I have read, education is countercyclical. This makes perfect sense in a monetarist/keynesian model. Kids can’t get jobs (or can’t get good jobs) so the opportunity cost of education is lower, so they invest more. Other types of investment is procyclical, because firms can’t sell the newly-produced investment goods they just produced. How would RBC explain why education is so different from other forms of investment?

    • Nick,

      I think this depends on a number of different questions. For example, is the shock temporary or permanent? If the shock is permanent, there might be (depending on the model) lower returns to education. However, this also requires that we incorporate some measure of human capital. McGrattan and Prescott have a new paper on what they call intangible capital that might (indirectly) get at the issue your talking about: http://www.minneapolisfed.org/research/wp/wp694.pdf

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  4. I tend to get put off by any business cycle proposal that starts with “shock”,, as if some magic pixie dust was scattered across the world and financial markets everywhere got sick.
    If you want to define “shock” as we did stupid things and now we have to pay – fine, but the first step is to recognize the real problem – what caused the “shock”.

    Past that the St. Louis FOMC report seems somewhat self serving.
    Bad things happened – that we don’t want to talk about because they were partly our fault, our efforts to mitigate have not worked very well – because some other experts proposed that they won’t in this kind of crisis.

    Sorry, We had an asset bubble burst – that is the shock, the financial crisis is a secondary consequence. Government and/or federal reserve policies that created a credit bubble, created the asset bubble.

    This time is not different. The record – particularly the modern record makes little distinction between financial crisis’s and others. Three features seem to drive the depth and duration of the problem – the durability of the asset the bubble was in – long term assets like houses are a poor choice and take longer to clear, how big was the bubble, and how extensive was government fiscal and monetary intervention – the more of each the shallower but longer the recession and weaker the recovery.

    Regardless, if you are unwilling to go beyond the “shock” and look at root causes, trying to pretend you have a clue about what to do and how it will work is ludicrous.

    When a patient enters the ER in kidney failure – dialysis will get them out of the immediate crisis, but without determining the cause of the kidney failure the trajectory is inevitably down until find the cause and treat it.

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