The Business Cycle: Theories and Evidence: Proceedings of the Sixteenth Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis PDF
Preview The Business Cycle: Theories and Evidence: Proceedings of the Sixteenth Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis
The Business Cycle: Theories and Evidence The Business Cycle: Theories and Evidence Proceedings of the Sixteenth Annual Economic Policy Conference ofthe Federal Reserve Bank of St. Louis edited by Michael T. 8elongia Federal Reserve 8ank of St. Louis and Michelle R. Garfinkel Universityof California at Irvine " ~. Springer Science+8usiness Media, LLC Ubrary of Congress CataIoging-in-Publication Data Economic Pc>icy Conlerence of the Federal Reserve Bank 01 SI. Louis (16th: 1991: Federal Reserve Bank of SI. Louis) lhe business cycle: theories and evidence: proceedings 01 the Sixteenth Annual Economic Policy Conlerence 01 the Federal Reserve Bank of SI. Louis I edited by Michael T. Belongia and Michelle R. Garfinkel. p. cm. Includes bibliographical references. ISBN 978-94-010-5312-9 ISBN 978-94-011-2956-5 (eBook) DOI 10.1007/978-94-011-2956-5 1. Business cycles-United Slates-Congresses. 1. Belongia, MichaelT. II. Garfinkel, MichelleR., 1960- III. Title. HB3743.E24 1991 338.5' 42'0973-dc20 92-11616 CIP Copyright © 1992 Springer Science+Business Media New York Originally published by Kluwer Academic Publishers in 1992 Softcover reprint of the hardcover 1s t edition 1992 AII rights reserved. No pari of this publication may be reproduced, stored in a retrieval system ar transmitted in any form or by any means, mechanical, photocopying, recarding, OI otherwise, without the prior written permission 01 the publisher,Springer Science+Business Media, LLC. Printed on ac;d-free pape,. Set in 1O /I2pt Times Roman by Graphicralt Typesetters Ud .. Hong Kong Contents Contributing Authors vii President's Message by Thomas C. Melzer ix Preface xi Acknowledgments xxi SESSION I 1 What Is a Business Cycle? 3 Victor Zarnowitz Commentary by James H. Stock 73 2 The Cycle Before New-Classical Economics 85 David Laidler Commentary by Ben S. Bernanke 113 SESSION II 119 3 For a Return to Pragmatism 121 Olivier Jean Blanchard v vi CONTENTS 4 The Cowles Commission Approach, Real Business Cycle Theories, and New-Keynesian Economics 133 RayC. Fair Commentary by Arnold Zellner 148 SESSION III 159 5 How Does It Matter? 161 Benjamin M. Friedman Commentary: Whatever Happened to Contracyclical Policy? 179 by Michael R. Darby CONFERENCE OVERVIEW 187 Commentary: Deja Vu All Over Again by Alan S. Blinder 189 Commentary: Business Cycle Developments and the Agenda for Business Cycle Research by Herschel f. Grossman 197 Commentary: Where Do We Stand? by Michael Parkin 202 Contributing Authors Ben S. Bernanke Herschel I. Grossman Princeton University Brown University Robertson Hall BoxB Princeton, NJ 08544-1013 Providence, RI 02912 David Laidler Olivier Jean Blanchard Department of Economics Department of Economics University of Western Ontario E52-391 Social Science Centre Massachusetts Institute of Technology London, Ontario N6A 5C2 Cambridge, MA 02139 Canada Michael Parkin Alan S. Blinder Department of Economics Department of Economics University of Western Ontario Princeton University Social Science Centre Princeton, NJ 08544-1021 London, Ontario N6A 5C2 Canada Michael R. Darby James H. Stock Andersen School of Management Harvard University University of California 79 John F. Kennedy Street Los Angeles, CA 90024 Cambridge, MA 02138 RayC. Fair Victor Zarnowitz Yale University University of Chicago Cowles Foundation Graduate School of Business P.O. Box 2125 Yale Station 1101 East 58th Street New Haven, CT 06520-2125 Chicago, IL 60637 Arnold Zellner Benjamin M. Friedman University of Chicago Harvard University Graduate School of Business Littauer Center 127 11 01 East 58th Street Cambridge, MA 02138 Chicago, IL 60637 Vll President's Message Asking what we know about business cycles seems, in one sense, a curious topic for a conference of professional economists. After all, it is not as though the cycle is a new phenomenon. From the less well documented ups and downs of the colonial economy through the various booms and busts of the 1800s, the turbulent decade of the 1920s, and the nine complete cycles of the postwar period, the U.S. economy has had ample experience with sustained economic expansion followed by periods of decline. The sum total of this experience, however, has produced few firm conclusions about the "whys" or "hows" ofthe business cycle. To get a little perspective on the issue, I looked back to those days of the New Frontier when Walter Heller and Co. sat down "to the levers of control" as a Time magazine cover story described it. The first impression to catch my eye was the seeming harmony within the economics profession. Time asserted that "by broadening the areas of fact, the professionalization [of economics] has narrowed the areas of theory, of disagreement, and blurred old boundaries between liberals and conservatives." Indeed, the accepted wisdom of the day seemed to be that the cycle, though a bit of an annoyance, could be dealt with by the enlightened application of the appropriate mix of tax and budget policies. This state of affairs is in sharp contrast to the factional disputes that have dominated at least the last decade. This confidence was based, again according to the Time story, not on the insights of Keynes's General Theory but on Wesley Clair Mitchell's Business Cycles. This book, labeled as "the most important of all U.S. contributions to economics," and Mitchell's call for "a body of statistical information on how the economy actually behaves under the impact of various policies" were cited as key to transforming economics from "the IX x PRESIDENT'S MESSAGE dismal science" to one of optimism. The new generation of economists was the first to use econometric models to evaluate the effects of pulling on different policy levers. They genuinely believed that it was possible to "tinker successfully" with the economy and "do a lot more good than harm in the process." Kenneth Arrow summed up the prevailing view by claiming "you have to find a real crackpot to get an economist who doesn't accept the principle of government intervention in the business cycle." If this is what it means to be a crackpot, I know now why members of our staff here may have readily accepted the alternative designation, "maverick." They have argued, and I tend to agree, that the cycle is littered with all kinds of well intentioned policies that have had all sorts of important, deleterious, and quite unanticipated effects. The present time certainly is a different world from the confident optimism of the early 1960s. Moreover, the distinctions between liberal and conservative or activist and laissez faire economists, if they ever were blurred, now have widened to the point that splits among theories seem to preclude conversation between economists of different camps. This is why we chose to devote our conference this year to a discussion of the cycle. I cannot envision the quality of policy making moving forward until there is agreement on a common language and until a path to resolv ing conflicts among competing theories is identified. Exactly what is this cycle we are trying to explain? Precisely where do our theories differ? And, on what evidence can we defend the idea that we are doing more good than harm by activist meddling with market forces? Thirty years ago, in the same Time story I mentioned earlier, a panel of 17 economists were asked their views on the then-current recession and the prospects for recovery. Sixteen gave authoritative statements on when and why a recovery would begin. The seventeenth, John Kenneth Galbraith, said: "I do not believe anybody in this Administration makes the preten tious mistake of thinking he knows what is going to happen. One of the greatest pieces of economic wisdom is to know what you do not know." I hope that these proceedings offer some guidance both on what we know, and on what we don't know, about business cycles. The former will tell us how far we have come in the past 30 years; the latter will remind us how much further we have yet to go. Thomas C. Melzer President Federal Reserve Bank of St. Louis Preface These proceedings, from a conference held at the Federal Reserve Bank of St. Louis on October 17-18, 1991, attempted to layout what we currently know about aggregate economic fluctuations. Identifying what we know inevitably reveals what we do not know about such fluctuations as well. From the vantage point of where the conference's participants view our current understanding to be, these proceedings can be seen as suggesting an agenda for further research. The conference was divided into five sections. It began with the formu lation of an empirical definition of the "business cycle" and a recitation of the stylized facts that must be explained by any theory that purports to capture the business cycle's essence. After outlining the historical develop ment and key features of the current "theories" of business cycles, the conference evaluated these theories on the basis of their ability to explain the facts. Included in this evaluation was a discussion of whether (and how) the competing theories could be distinguished empirically. The conference then examined the implications for policy of what is known and not known about business cycles. A panel discussion closed the conference, high lighting important unresolved theoretical and empirical issues that should be taken up in future business cycle research. What Is a Business Cycle? Before gaining a genuine understanding of business cycles, economists must agree and be clear about what they mean when they refer to the cycle. In the keynote chapter, "What Is a Business Cycle?" Victor Zarnowitz takes on the difficult task of defining a business cycle. Approaching this Xl xu PREFACE task from several perspectives, Zarnowitz argues that the business cycle is "pervasive." Although business cycles historically have differed in their duration and intensity, they are all generally characterized by a decline and contraction and a subsequent rise and expansion of aggregate economic activity, as measured by total employment, output, real income, and real expenditures. National in scope and typically lasting several years, business cycles manifest themselves in the co-movements of and interactions among many economic variables. Not all variables are perfectly synchronized, however. Some lead and others follow the cycle. In addition, while most economic variables are procyclical, they do not generally move with the cycle to the same degree; other variables are countercyclical. Zarnowitz also finds that the characteristics of business cycles have changed over time and differ across nations. For example, Zarnowitz finds that, in the United States, postwar cycles have become milder: Business contractions have become shorter and less severe, and business expansions have become longer relative to the cycles experienced before the 1930s. As possible reasons for this observed change, Zarnowitz suggests "the shift of employment to production of services, automatic stabilizers, some financial reforms and avoidance of crises, greater weight and some successes of government actions and policies, and higher levels of public confidence." He also finds that the postwar recessions in France, Italy, West Germany, and Japan were even milder and attributes this difference to the relative strength of their economic growth. Thus, in trying to explain cycles, we must be guided not only by the features common to all business cycles but also by their diversity and evolution. By limiting the focus to features shared by all cycles, economic analyses potentially fail to gain a comprehensive understanding of aggre gate economic tluctutations. The processes by which shocks affect eco nomic activity can depend on a nation's institutions and stage of economic development and thus could be changing also. James Stock, in his comments on this chapter, commends Zarnowitz for his useful and thorough overview of the business cycle, including his ana lysis of international business cycles. In his discussion, Stock focuses on only two main points. First, by drawing on recent research, he argues that Zarnowitz's evidence of the shortening of postwar recessions and lengthen ing of postwar expansions might be "biased" by the National Bureau of Research's (NBER) dating chronology, which is based on different time series depending on the historical period: "The prewar dating relied on series with more cycles, longer contractions, and shorter expansions than the series used for the postwar dating." Stock notes that, alternatively, the differences in the series used might accurately capture fundamental
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