It seems to have become the purpose of this blog for me to defend ideas that I don’t particularly believe in. First, I had to defend claims about the stimulus package despite my opposition to it. Now, I must defend real business cycles.
First, our friend Arnold Kling offers an alternative to what he refers to as “hydraulic macro”:
I wish to reject this whole concept of macroeconomics. Instead, I want to get economists to think about unemployment in terms of the economic calculation problem.
I think that in the last 18 months, an unusually high number of people have had their plans go awry. They wish they had made different choices in terms of their education and occupations. Digging out from these mistakes is going to take a long time. A lot of recalculation needs to get done, and the problem is really daunting.
I don’t think that fiscal and monetary policy solve this calculation problem. At best, they substitute the errors of fumbling central planner for the errors of fumbling individuals.
I am sensitive to this perspective. Its elegant and compelling to see real micro problems at the heart of macro fluctuations. There are several problems, however:
— How do you get to unemployment from here. If people are retooling I see a huge demand for retraining. Or them accepting very low wages in a new industry but why persistent unemployment. Why doesn’t the labor market clear.
— How you get from here to monetary induced contractions. Maybe there is still debate over whether the Fed can stop a recession or at what costs. However, how do you get from here to the Fed being able to start a recession. The experience of the early eighties seems to clearly show us that the Fed can.
— How do we get the Great Depression from here?
Ultimately these are the challenges that I think sink most attempts at a real macro theory. [Emphasis added.]
Before proceeding, I would like to remind folks that the original real business cycle models were not used to claim that the entirety of all business cycles were independent of money, sticky wages and prices, etc. Rather, they were used to demonstrate that a significant portion of the business cycle could be explained without these frictions.
In any event, the quote in bold has long been one of the fundamental complaints leveled against real business cycle models. Kling himself references Modigliani calling real business cycles “a sudden breakout of laziness.” Others question the existence of negative productivity shocks. Et cetera, et cetera. However, real business cycle theorists have spent a great deal of time attempting to address these concerns. Kehoe and Prescott recently edited an entire book dedicated to understanding depressions using real business cycle theory.
What’s more, it is not acceptable to pose this question regarding the depression in 2009 as Cole and Ohanian wrote a highly cited paper on the Great Depression using a real business cycle model 10 years ago. Here is the abstract:
Can neoclassical theory account for the Great Depression in the United States — both the downturn in output between 1929 and 1933 and the recovery between 1934 and 1939? Yes and no. Given the large real and monetary shocks to the U.S. economy during 1929–33, neoclassical theory does predict a long, deep downturn. However, theory predicts a much different recovery from this downturn than actually occurred. Given the period’s sharp increases in total factor productivity and the money supply and the elimination of deﬂation and bank failures, theory predicts an extremely rapid recovery that returns output to trend around 1936. In sharp contrast, real output remained between 25 and 30 percent below trend through the late 1930s. We conclude that a new shock is needed to account for the Depression’s weak recovery. A likely culprit is New Deal policies toward monopoly and the distribution of income.
Now, of course, one does not have to agree with Cole and Ohanian or other real business cycle theorists. (See, for example, this paper by Gauti Eggertson entitled, “Was the New Deal Contractionary?”) However, there are explanations out there that address the questions that Smith is asking.
UPDATE: It seems that Will Ambrosini beat me to this.