One way to become a leader in a field of study, such as macroeconomics, is to redefine the field such that people who are doing things other than what you’re doing are, by definition, in some other (now-undefined) field.
According to Edward Prescott, winner of the 2004 Nobel Prize, “[T]he meaning of the word macroeconomics has changed to refer to the tools being used [by Prescott and his cohorts] rather than to the study of business cycle fluctuations.”
And on the basis of a few examples of his and Finn Kydland’s tool-using behavior, Prescott tells us that “macroeconomics has changed as a result of the methodology that Finn and I pioneered. It is now that branch of economics where applied dynamic equilibrium tools are used to study aggregate phenomena.”
These remarks are from an edited version of Prescott’s Nobel address printed in the most recent issue of The Region (published by the Minneapolis Federal Reserve Bank). A couple of substantive remarks in that address are also worthy of note:
“One set of key business cycle facts is that two-thirds of business
cycle fluctuations are accounted for by variations in the labor input, one-third by variations in total factor productivity, and virtually zero by variations in the capital service input.”
And: “The welfare gains from eliminating business cycles are small or
negative.”
Anyone who wants to read more can find it here.
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“One set of key business cycle facts is that two-thirds of business cycle fluctuations are accounted for by variations in the labor input, one-third by variations in total factor productivity, and virtually zero by variations in the capital service input.”
Have I missed something, but doesn’t the level of investment change significantly over the course of the business cycle? And for what it is worth, didn’t Keynes claim that private sector investment is notoriously unstable and unreliable, and is the major cause of the business cycle? Any comments on these questions would certainly be appreciated. But then again, as Mr. Prescott asserts, maybe my questions refer to a now obsolete discipline and set of issues.
Dennis,
Also from the article:
“A second business cycle fact is that consumption moves procyclically; that is, the cyclical component of consumption moves up and down with the cyclical component of output. A third fact is that in percentage terms, investment varies 10 times as much as does consumption. Consequently, investment variation is a disproportionate part of cyclical output variation. This is shown in Figure 3.”
Tom, thanks for the input.
“A second business cycle fact is that consumption moves procyclically; that is, the cyclical component of consumption moves up and down with the cyclical component of output.” This should come as no surprise, since consumption is by far the largest component of national income (output). Mr. Prescott is stating something that follows from the definitions of the terms.
“A third fact is that in percentage terms, investment varies 10 times as much as does consumption. Consequently, investment variation is a disproportionate part of cyclical output variation.” This statement would seem to support variability in investment as the major driver of the business cycle. But unless I’m missing something basic, and of course I could be, this statement does not appear to be consistent with the following: “One set of key business cycle facts is that two-thirds of business cycle fluctuations are accounted for by variations in the labor input, one-third by variations in total factor productivity, and virtually zero by variations in the capital service input.” Maybe I have a mistaken concept of “capital service input” which I am taking to mean capital investment.
Dennis,
I guess he’s considering variations in investment as a consequence of the cycle and not as its cause.
Thanks Larry, and your comment may explain Prescott’s statements. Assuming that is what he means, then what, in the mainstream view, is the cause of the business cycle? I think I am on fairly firm footing in stating that in Keynes’s view the variability in investment expenditures is the main culprit. Maybe, Prescott believes that his framework is some new and improved version of Keynesianism. Or maybe in keeping with the positivist methodology that still dominates economics, Prescott is not all that concerned with cause and effect, but instead with statistical correlation.
Prescott, Kydland and other RBC theorists argue that what appear to be business fluctuations are actually optimal responses to technological changes and demand and supply “shocks.”
Allen,
Thanks for your comment; it helps place the remarks of Prescott, et.al. in context. In defense of ABCT, I believe that theorists working in this framework have previously addressed the arguments that the business cycle is caused by technological changes and demand and supply shocks.
Check out this article by Cochran and Call. It compares and contrasts ABCT, RBC and Friedman’s theories. mises.org/journals/scholar/Cochran.pdf
This doesn’t surprise me so much anymore… we’re the same species that killed people to cover up the existance of irrational numbers, that tortured people for believing that the earth revolved around the sun, etc… now we follow prescription of a ‘scientist’ who blamed the disease on ‘animal spirits’.
Shouldn’t macro-economics be defined as the study of economic phenomena at the level of the entire economy? Should the field not be an attempt to gain some insight into the world that we live in? What is to be gained by defining the field as the use of particular models if those models do not have any level of realism and so tell us nothing about the world? Shouldn’t the definition of the field tell us more about the problem than a particular set of solutions? Potential solutions, then, would be evaluated against the problem itself?
The modern business cycle is caused by the Fed. The infusions of money take place in such a way as to benefit large financial institutions first, which in turn influences corporate borrowing, spending, and profits. Further, the stock market (as represented by the S&P 500) is very sensitive to changes in the rate of M3 growth. As a matter of fact, I am developing a stock market timing strategy based on ABCT, in order to avoid the large “busts” that accompany certain changes in Fed policy. I have backtested the strategy to 1982, and it provides alpha of 3.1% with approximately 90% of time long equities and 10% of time in cash.
There are, IMO, three root causes of the boom/bust cycle.
One is human nature and crowd behavior, i.e. “mania.” Think of the IPO for BIDU.
The second is the time delay/informational inefficiency of the market. Think of y’all observing my high profit margin in capital-intensive industry __. You all, separately and alone, allocate capital to entering this industry. After you enter, the returns diminish, and only the fiscally strongest survive.
The third is credit. This cause existed before the Fed, but at that time credit-related busts were infrequent and localized. In modern times, they are regular and global.
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