Friday, February 15, 2013

Is the business cycle a cycle?



Modern "business cycle" models used by mainstream macroeconomists are, for the post part, not actually models of cycles. When we think of a "cycle", most of us think of something like this:



This is a wave, also known as a harmonic function. When things like this happen in nature - like the Earth going around the Sun, or a ball bouncing on a spring, or water undulating up and down - it comes from some sort of restorative force. With a restorative force, being up high is what makes you more likely to come back down, and being low is what makes you more likely to go back up. Just imagine a ball on a spring; when the spring is really stretched out, all the force is pulling the ball in the direction opposite to the stretch. This causes cycles.

It's natural to think of business cycles this way. We see a recession come on the heels of a boom - like the 2008 crash after the 2006-7 boom, or the 2001 crash after the late-90s boom - and we can easily conclude that booms cause busts.

So you might be surprised to learn that very, very few macroeconomists think this! And very, very few macroeconomic models actually have this property.

In modern macro models, business "cycles" are nothing like waves. A boom does not make a bust more likely, nor vice versa. Modern macro models assume that what looks like a "cycle" is actually something called a "trend-stationary stochastic process" (like an AR(1)). This is a system where random disturbances ("shocks") are temporary, because they decay over time. After a shock, the system reverts to the mean (i.e., to the "trend"). This is very different from harmonic motion - a boom need not be followed by a bust - but it can end up looking like waves when you graph it:

File:ArTimeSeries.svg

See? Kind of looks like waves, but actually is something completely different. The fact that peaks and valleys seem to alternate is not caused by "restorative forces" like a spring, it's just a statistical property of the randomness of the shocks. (Aside for nerds: Yes of course it's possible to write down an AR model with oscillatory behavior, but this isn't what's done in any macro model I've ever seen.)

So in other words, most modern "business cycle" models assume that the "cyclical" appearance of the business cycle is an illusion.

When I first realized this in grad school, I scoffed. But in fact, economists might have good empirical reasons for thinking that what we're looking at is not a wave. Harmonic motion is inherently periodic; it repeats at regular intervals, while the fake cycles of a trend-stationary AR-type process generally do not. You can look at a time-series (such as "detrended" GDP) and look at how periodic it is, by looking at a Fourier Transform or spectral density plot. Real cycles will show up as spikes or bumps on the spectral plot, while most AR-type processes will show up as flat lines or exponential decays - basically, garbage.

And it turns out that when we look at business cycles this way, we can't see a wave. One reason is because our time series are just really short - we've only been measuring things like GDP since WW2, and certainly nothing much longer than a century...and usually at monthly or quarterly frequencies. That's not a lot of data. But the other reason is that the things we call "recessions" don't seem to come at any sort of regular interval. Just take a look (the gray bars are official recessions):



Also, there's the fact that the picture above is just one kind of "detrending" (a Hodrick-Prescott Filter, invented by Ed Prescott of "Real Business Cycle" fame). Other assumptions about the trend will lead to other frequency distributions. Different trend assumptions basically redefine the phenomenon of the business cycle.

(In addition, the "business cycle" might actually be several different types of phenomenon! GDP might go up and down for a number of different reasons (Robert Lucas now believes this). . If some of those reasons are periodic and some aren't, it will make it difficult to extract the signal from the noise, especially if the periodic cycles have very long periods. For example, some people now think that there are "business supercycles" that take much longer than what we usually call the "business cycle", and which are periodic. My advisor, Miles Kimball, is very interested in this idea. But of course, very long cycles make our lack-of-data problem much, much worse.)

But in any case, there was one famous literary economist who claimed that booms lead inevitably to busts. This was Hyman Minsky. Very few macroeconomists followed Minsky's line of thinking, but a few did, and even in the modern day there are some who do. Steve Keen is one of these.

Keen is currently constructing a software tool that allows people to make simple business-cycle models. These are not "microfounded" models of the type normally published in mainstream economics journals (DSGE models). Instead, they model aggregate economic variables directly, using ordinary differential equations. The tool, appropriately, is called "Minksy" (here is a link to the Kickstarter page for Minsky).

True to its name, Minsky pops out business cycles that are true waves. See here for a video of these cycles. Sure enough, booms cause busts and busts cause booms.

But what are the prospects for tools and models of this type to forecast the business cycle? Well, I have to say, as far as I know, the prospects are not good at all, for reasons listed above. The actual business cycle does not look periodic (except possibly at many-decade-long frequencies), so "cycles" of the type produced by the Minsky tool - or at least, of the type shown in the videos - seem highly unlikely to have predictive power in the real world (and predictive power is precisely what modern macro most sorely lacks!).

But even so, I personally am very fond of the idea that booms cause busts - that the business "cycle" is not just a statistical illusion. My gut tells me that this is really going on. But business cycles don't look periodic! They don't look like waves. So maybe there is another type of "restorative force" acting on the economy, causing some kind of non-periodic cyclical motion?

There are mathematical models that have this property. In particular, I'm thinking of Hidden Semi-Markov Models, or HSMMs. In an HSMM, there are two "states" of the economy - a good state, and a bad state. Transitions between these states are abrupt and sudden, rather than smooth as in a harmonic wave. Also, these transitions happen randomly, unlike the predictable periodic motion of waves. But still, booms cause busts! Because in an HSMM, the likelihood of a transition increases as the time since the last transition increases. In other words, the longer your economy stays in a "boom" state, the bigger the chances that you're about to suddenly experience a crash and a transition to a "bust" state.

HSMM's capture some of my own intuition about business cycles. The idea of two different "regimes" definitely fits with the notion of the "balance sheet recession", in which people's behavior toward debt shifts quickly between "borrowing mode" and "saving mode", and the likelihood of shifting into "saving mode" is higher when you've accumulated more debt from being in "borrowing mode" for longer. It also fits loosely with the idea that the regimes could be linked to financial markets, since financial market models often have "bull" and "bear" regimes; usually these are modeled by a Hidden Markov Model, which is a bit different, but an HSMM is not too far removed from that.

Anyway, I'd be interested to see people pursue Minsky's alternative concept of business cycles by trying out models like that. Here, for anyone interested, is a good summary of the technical particulars of Hidden Semi-Markov Models.


Update: A commenter asks whether an HSMM could really "explain" business cycles. Good question! Well, it depends on what "explain" means. If you want to describe business cycles in terms of more general classes of economic phenomena, then you'll need to microfound the model in some way (of course, if business cycles turn out to be emergent, then this will not be possible to do). If business cycles can be microfounded, that will almost certainly improve forecasts, too. And if you want to offer policy advice, e.g. on how government could act to damp out business cycles, you'll need some assumption of structural-ness. so my suggestions in this post just apply to people who want to forecast (i.e. predict) business cycles based on observations of aggregates.

Update 2: Commented ivansml finds a paper that tried the HSMM approach in 1994! The paper was published in the Journal of Business and Economic Statistics (a publication of the American Statistical Association).

96 comments:

  1. Noah this is very interesting. By the way it is clear that economic waves break on the shore like sea waves break on the shore - i.e. they are not sinusoidal (the way down is much steeper than the way up).

    Any model that is symmetric is suspicious in my view. Asymmetry is important in any realistic model.

    ReplyDelete
    Replies
    1. Anonymous5:14 AM

      Have a look at Morley's research.
      https://sites.google.com/site/jamescmorley/research

      There it is: Asymmetry, Markov switching, permanent effects of 'cyclical' shocks...

      Delete
  2. Minsky is right... that the reduction in the quality of debt is likely to induce instability especially when considered in light of A.W.H Phillips work on stability in a closed economy (see Stabilization Policy in a Closed Economy, Economic Journal 64 pp 290-323 and his later paper which added time lags to his simulations, Time Form of Lagged Response Economic Journal 67, 1957 pp265-267)

    If one were to assume a Minsky type debt event, with no other inputs, a sufficiently stable economy would damp out the resultant cyclic oscillations. However, Phillips clearly shows that corrections made out of phase with the cyclic behavior of the upset could lead to dynamic instability.

    Rather than a Markov type model with abrupt changes of state, the Minsky reduction of debt stability will cause the economy to change from a dynamic to neutral to eventually dynamically unstable condition, progressively becoming more sensitive to endogenous factors. In this case, Phillips and Friedman actually agreed that improperly applied monetary and fiscal policy based corrections could actually further destabilize the economy,with Friedman assuming that anything other than monetary controls were too risky.

    Phillips felt that his work on feedback loops with proportional, integrated and derivative corrections could be further developed to come up with a more complete and useful analog simulation.

    Rather than a mathematical model, this behavior can be demonstrated on a three degree of freedom non-linear dynamic simulation, essentially an extension of Phillip's hydromechanical models to incorporate inertial effects and friction losses. Such a model indicates that the economy exists in a variable state of trim, rather than seeking a general equilibrium, and that long periods of economic growth tend to push investments and bank behavior in a direction that gradually alters the trim of the economy towards a more unstable condition through more relaxed control such as by legislation, and more willingness to assume risk, which as previously noted, renders the economy more liable to shocks.

    Such simulations are great fun to play with, and I feel that Reis is correct in his call for more such simulations in economics. See "A Plea for (Good) Economic Simulations, Nudging Economics Towards an Experimental Science" at http://www.jreiss.org/papers/S%26G_42(2)_2011.pdf



    ReplyDelete
  3. One thing that seems missing here is the idea that the depth of recession may be related to the height of the boom (i.e. the degree of financial imbalance) - strongly suggested by the diagram above. From your description of HSMM models - that doesn't seem to be the case (since the likelihood of change of state is an increasing function of time in that state - but what about the previous state). Or am I missing something.

    ReplyDelete
    Replies
    1. Haha, you're seeing an illusion of the H-P Filter. When there's a recession the H-P Filter yanks the trend down, to make the earlier boom look bigger; it basically forces the pattern you're seeing.

      Do bigger booms cause bigger busts? You can certainly model this with a HSMM very easily. But I'm not at all sure it's true. Historically speaking, the "Bush boom" looks pretty weak, though it was followed by an enormous bust...and the 2001 recession looks pretty mild, though it was followed by our biggest postwar boom. So while this could be easily modeled, I'm not at all sure it's actually going on.

      Delete
    2. OK Agreed, but then I will modify my original thought. I am fairly certain that financial balances are what drives a lot of this. Net wealth is much more volatile than income (especially so when interest rates are low as Andy Harless has pointed out) and so can easily magnify disturbances. I think Minsky had the mechanism regarding perceived risk (which I although think is crucial - but that is another story) basically correct. But these net balances are also an accumulated effect. That is - history matters, not just recent history, but all of history. Does this sort of model forget history or not? (I did look quickly at the paper, but I hope you know off the top of your head).

      If you want to know where I think the assymetry comes from -

      1. Behavioural asymmetry - it is well known that people react more to bad news than good
      2. Bankrupcy is as assymetric as it gets
      3. Investment, building a team, learning all take time. Throwing people out the door, not much at all. It is much easier to destroy things than build them (entropy you know).

      Delete
    3. I wish one could show images in one's responses, as the curves produced by Phillips work mentioned in my earlier response address many of your points. The first paper is available on line, but I couldn't find a link to the full second paper, which discusses a far more sophisticated simulation. (See reference to Phillips collected works at end of this response)
      http://xmlservices.unisi.it/depfid/joomla/iscrizione/materiali/16888/Phillips%20EJ%201954.pdf

      Most interesting are the response curves in Fig 3 and Figure 9, the latter showing the effects of various levels of proportional, integral and derivative policy response. (from classic control theory...after all, Phillips started out as an engineer.) Incidentally, one can see the beginnings of the Phillips curve in Figure 11.

      I strongly recommend the book, A.W.H. Phillips: Collected Works in Contemporary Perspective by Leeson. Information and excerpts available on-line at: http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511521980

      Delete
  4. dudebroman3:29 AM

    Isn't "government intervention" a good candidate for the "restorative force?" Weren't recessions much more periodic before the prevalence of central banks, and before fiscal policy played such a large role in the economy?

    ReplyDelete
    Replies
    1. Government intervention, if done right, should be a damping force. If it's restorative, then we get "overshoot", as detractors of stabilization policy often point out...

      Delete
    2. dudebroman3:56 AM

      Right, I guess "restorative" isn't the best word, but government intervention can obviously change the nature of the business cycle. In particular, it can change the length between peaks and troughs, as well as he height of the peaks and the depth of the troughs.

      My point - maybe it's possible that the business cycle is relatively periodic in nature, because of government intervention, it's hard to tell.

      Delete
    3. dudebroman3:58 AM

      *but because of government intervention

      Delete
    4. Noah, I disagree with your comment that a restorative force necessarily causes overshoot, which Phillips discusses at length in the papers I cited. He felt that, given the competence of government, the safest policy control intervention would be a robust proportional response to an upset, sufficiently large to arrest any acceleration of the upset, but not so large as to induce excessive oscillations as the economy returns to the initial state. He also shows that the time lag in policy response is crucial to the degree of correction.

      It would appear that the recent government stimulus polices were sufficient to arrest the downward acceleration, but is returning us to the previous trends at a very slow pace.

      Delete
  5. Per my earlier post, for Friedman's position, see: Friedman, Milton. “The Effects of Full Employment Policy on Economic Stability: A Formal Analysis,” in Essays in Positive Economics, Chicago: Univ. of Chicago Press, pp117- 32, 1953.

    ReplyDelete
  6. "True to its name, Minsky pops out business cycles that are true waves. See here for a video of these cycles. Sure enough, booms cause busts and busts cause booms."

    In case it was unclear: the cycle that is displayed in the part of the video you linked to is a Goodwin cycle. It does not incorporate Minsky'ite buildups of unproductive debt. It is only based on an interaction between wage earners and employers that react to incentives in a dynamic context. It is a small component of the Minsky model and the particulars of it's design are of secondary importance to Minsky's argument.

    ReplyDelete
  7. Anonymous6:21 AM

    Noah, you have done a great service for pointing out misuse of the word "cycle," especially as such is also a false metaphor, badly abused by Taylor and Cochrane, among others. Both have repeatedly argued that the deep drop should have lead to a vigorous bounce back.

    May I suggest you write a paper unifying the several definitions of waves and cycle in science, reaching a conclusion about when economists may say there is either a cycle or wave or both.

    ReplyDelete
    Replies
    1. Trend reversion means that deep recessions are followed by strong recoveries.

      Production falls below "normal" and then returns to it.

      If every shift in output is a shift in the trend, then there is never a reversion to trend. A recession occurs, and then from the low level of the trough, production rises at the trend growth rate. It is a new trend.

      If you think about the economy and not the math (literary economics,) you can think of things that would cause temporary shifts and things that would cause permanent shifts. Since such things do happen in the real world, it would seem likely that both things might happen.

      Also, I don't see how it is possible to get very far without comparing and contrasting things that impact aggregate nominal expenditure and things that impact productive capacity.

      What (if anything) brings nominal (and real) expenditure in line with capacity? Again, literary theory suggests that this is dependent on monetary regime. On the other hand, shifts in productive capacity (a plague, poor harvest, or war,) could be very temporary, or very persistent.

      Delete
  8. Didn't macroeconomists already waste a lot of time on this line of research? I'm thinking of Schumpeter specifically who wrote a whole book with different length cycles adding up and canceling each other out.

    I think there's a difference between (1) an AR process with random shocks (2) true cycles where booms cause busts and vice versa and (3) a deterministic model where pressures can build up and make certain situations more likely in the next period.

    I'm more in camp 3 than 1 or 2 (and maybe you are too). To me, cycles sound overly deterministic.

    ReplyDelete
    Replies
    1. Anonymous9:12 AM

      That's sort of the crux of the problem though, right? We're humans. We overly ascribe patterns to randomness (like seeing shapes in clouds) or seeing waves in stochastic shock process. But "it's random" also isn't satisfying. We know cause and effect does exist in economics. Plus, much like people want to know what caused the big bang, you look at something like Prescott's simple RBC model and ask, "well what caused the shock?" (and Technology in all it's random glory isn't a terribly satisfying answer. Recessions, etc. are bad! To say, "well, that was the draw of the shock this period," or, "well, there was a probability theta, between 0 and 1, that we'd switch to the other equilibrium in this markov chain process, isn't going to cut it.

      So here we all are, debating between randomness and deterministic patterns, finding neither satisfying all by itself, and having pretty poor theories or explanations for either.

      Delete
    2. Phil Koop9:41 AM

      Here is an example. As an ice sheet retreats at the end of a glaciation, meltwater pools at the edge and forms a "proglacial lake". The basin of this lake is formed partly by ordinary geography, but partly by ice barriers. As the lake rises, the pressure against these ice dams increases at the same time as the buoyancy lifting them increases. Eventually, the dam lifts and gives way, causing a catastrophic drainage of the lake. This sequence (called a "jokelhlaup" by analogy to a geothermic phenomenon) may be repeated many times, but it is not periodic. Furthermore, the proximate cause of the events - rising water - is understood, yet future jokelhlaups cannot be predicted deterministically. We know neither the exact level that will cause the ice dam to fail nor the future rate at which the lake will rise. This is a candidate for a HSMM.

      Delete
    3. This is a great example Phil. I too am sympathetic to this viewpoint.

      Delete
  9. Phil Koop9:21 AM

    A deterministic model that makes situations more likely seems a contradiction. I think that you mean a stochastic model with deterministic intensity.

    A semi-Markov model has that property. The "hidden" part of HSMM means that the Markov state cannot be observed, and must be inferred probabilistically from some observable proxies. That means the transition density is not truly deterministic, because the state itself is a random variable.

    Even if we believed that some observable factor, say public debt/income, completely explained transitions between booms and busts, a HSMM would still be appropriate unless the evolution of the factor itself could be described deterministically.

    ReplyDelete
  10. Has our host studied non-linear systems?

    Many deterministic non-linear models behave in ways that look random, in some sense. And you can tweak the parameters and find after, say, some bifurcation, that some behavior is more likely. I point to Kaldor's model of the business cycle as an example.

    Kitchin, Juglar, Kuznets, and Kondratiev cycles are all supposed to be of different periods. I think that the characteristics of the shorter cycles would change with technological and managerial innovations, such as techniques for managing inventories. The way I understand Schumpeter's ideas, he did not think that one can simply superimpose such cycles. But Schumpeter did not have the nonlinear mathematics to explore how they would combine. His student, Richard Goodwin famously did, though.

    I take these ideas as metaphors. I am not familiar with the literature exploring empirical applications, although I know there is some.

    ReplyDelete
    Replies
    1. Has our host studied non-linear systems?

      Non-linear systems of what kind of equations? Nonlinear algebraic systems? Nonlinear ODEs? Nonlinear PDEs? ;-)

      Delete
    2. Nonlinear dynamic systems are typically specified by either difference equations (discrete time) or ordinary differential equations (continuous time). I find the variations in the qualitative behavior of the Kaldor business cycle model of interest: http://robertvienneau.blogspot.com/search/label/Kaldor%20Business%20Cycle%20Model

      Delete
    3. Our host could start with the Lotka-Volterra equation, a "canonical" nonlinear 2nd order ODE with non-sinusoidal cycles.

      Then he might profitably consider the way that delayed-feedback introduces instability, oscillation and chaos, for instance here: http://www.azimuthproject.org/azimuth/show/Delayed+feedback

      Macroeconomists are so fond of AR(1) systems... How about an AR(1) system with a delay? That will be unstable.

      Delete
  11. Zathras11:24 AM

    Noah,

    You make it sound like no one is seriously looking at regime-switching models. In the business forecasting world, we are using these models all the time for demand and price predictions. They often work very, very well. The real surprise for me is how little interest academics have in these models. There's a real disconnect between theory and practice here that needs to be addressed.

    ReplyDelete
    Replies
    1. You make it sound like no one is seriously looking at regime-switching models. In the business forecasting world, we are using these models all the time for demand and price predictions. They often work very, very well. The real surprise for me is how little interest academics have in these models. There's a real disconnect between theory and practice here that needs to be addressed.

      You've hit the nail on the head...where do you think I learned about these models? From quant finance people, of course. But look at the mainstream macro literature, and there are a few regime-switching models, and essentially no semi-Markov models.

      Delete
  12. Wouldn't a plucking model have to explain the absence or at least much less frequent and smaller upward plucks?

    Minsky was more interested in supercycles although he did see in them an accumulation of the results of shorter ones. There are many ways to predict though, not just fixed periodicity in time. Time may vary but shape and levels may be predictive. Cities scaling by the power of 1.15 a la West. We may be able to determine times of rising and falling risk or the depth of the fall or the speed of the recovery.

    ReplyDelete
  13. Few disjointed thoughts:

    - Minsky wasn't the first one to come up with endogenous business cycle. For example, Austrians (Mises, Hayek) argued that boom causes busts (through malinvestments caused by interest rate distortions) decades before him. Then there's Samuelson's 1939 paper that models GDP as oscillating AR(2) process (the oscillations are caused by "investment accelerator"), or Goodwin model mentioned by Rademaker above. And more recently (but still before Keen), there was a wave of papers in 1980s applying ideas from nonlinear dynamics and chaos theory to build models which fluctuate even without exogenous shocks (Jess Benhabib has a short survey his website).

    - Now, I have a question (perhaps a stupid one) - if there really was an oscillatory dynamics behind the business cycle, shouldn't we find evidence for it in estimated vector-autoregression models? In principle, you can get oscillations (that die out eventually) as impulse responses from VAR model, but typically you don't - and since DSGE people try to build models that match estimated IRFs, maybe their approach makes sense.

    - HSMM models look interesting, but in the end would they really explain the cycle? "The economy slid into recessions because productivity (or whatever) switched into bad state, according to its stochastic law of motion described by this HSMM" is not much better explanation than "recession happened because of negative TFP shocks". There are theory papers (in finance, but few also in macro) that do use hidden Markov chains, but my understanding is that their focus is on how learning by agents about the hidden state affects the model, and HMM is meant just as a tractable "reduced form" way of capturing the underlying business cycle, not really an explanation for it.

    ReplyDelete
    Replies
    1. Now, I have a question (perhaps a stupid one) - if there really was an oscillatory dynamics behind the business cycle, shouldn't we find evidence for it in estimated vector-autoregression models? In principle, you can get oscillations (that die out eventually) as impulse responses from VAR model, but typically you don't - and since DSGE people try to build models that match estimated IRFs, maybe their approach makes sense.

      Not a stupid question in the slightest! Yes, you would see oscillations in VAR impulse responses. But you would not see the HSMM type thing, unless your VAR had a stochastic lag structure, and even then it would be very difficult to see.

      HSMM models look interesting, but in the end would they really explain the cycle?

      Depends on what you mean by "explain". If you want to just forecast, then reduced form is fine. If you want to give policy advice, you'd need a microfounded model, which is of course much harder. For example, a model of people's behavior toward debt and saving might be able to microfound an HSMM type model; that's the kind of process I had in mind when I wrote this post. But there could be others.

      Delete
    2. For example, a model of people's behavior toward debt and saving might be able to microfound an HSMM type model

      Have you seen Brunnermeier & Sannikov's paper? I haven't looked at it very closely (not exactly an easy reading), but from their introduction it sounds pretty similar to what you describe - small shocks cause standard fluctuations around the steady state, but occasional bigger shock can set off a downward spiral and push the economy into a volatile financial crisis.

      Delete
    3. I have seen that paper!

      Delete
    4. Noah: So my suggestions in this post just apply to people who want to forecast (i.e. predict) business cycles based on observations of aggregates.

      Ah, I thought you were talking more about theory, not econometric forecasting. Since I'm in my procrastinating mode, I've tried to learn a bit more about this stuff, and it seems that regime-switching models have been used in empirical macro for some time, for example see Hamilton's survey [1], and extending them to allow for duration-varying transition probabilities has also been done [2].

      [1] http://dss.ucsd.edu/~jhamilto/palgrav1.pdf
      [2] http://www.jstor.org/stable/1392084

      Delete
    5. Hey, great work!! Thanks! I knew the first paper but not the second...

      Delete
  14. If I am not mistaken, models looking for predictable patterns will not work for the same reason that Technical Analysis does not work in the stock market.

    I think the essential insight that Keynes had in his analysis was that "we" collectively could act and change the course of the economy.

    I think this became the consensus opinion among economists of all stripes. Conservatives tending to favor Central Bank actions, and Liberals tending to favor Fiscal policy actions. Either way, the ideas was that recession was preventable.

    Clearly this wasn't always true, as we did have a recession.

    However, it seems more than likely that this consensus was partially true. There was a 'great moderation', and more than likely fiscal and monetary actions did change the course of the economy.

    This is a problem for people looking for cycles, unless you start making assumptions to make the math in the models tractable. The first assumption you would have to make is that people don't learn. While its true that history repeats itself, and its true that many of the responses to the financial crisis are strikingly similar to responses to the Great Depression, its also true that there were very significant differences that represent learning. Exhibit A would have to be the choices the Central Bank made in each situation.

    Learning has a mathematically inconvenient habit of producing results that are out of sample.

    ReplyDelete
    Replies
    1. If I am not mistaken, models looking for predictable patterns will not work for the same reason that Technical Analysis does not work in the stock market

      Actually I don't think that's right. EMH arguments don't preclude the possibility that recessions are predictable. The more predictable recessions are, the earlier asset prices will react to the predictions (in the EMH world), leaving people unable to make excess profits from predicting the recessions. That doesn't mean the recessions will stop happening.

      However, it would be neat if just by making macro models, we could eliminate recessions!

      Delete
    2. No, it is not that people don't learn, but that they learn too well. They avoid the mistakes of their fathers only to repeat those of their grandfathers. We don't learn well enough to avoid both, but if we could learn well enough, we could avoid both, or more closely, our grandchildren could, the limitation being how effectively those lessons are transmitted intergenerationally.

      Delete
    3. My 2c worth on "the great moderation" - it wasn't. It was a once off hysteresis curve based on a policy of flooding the greater (globalised) world with dollars until the US middle class noticed their declining real wealth and panicked. Secular trends in declining savings rates, interest rates and large international imbalances doesn't sount like long term equilibrium to me.

      I think the macro world is not exponential, but the sum of lots of hysteresis curves. This can look exponential in the short term, but will always eventual reach some sort of inflexion point. If we learn to think of the world this way (i.e. understand the impossibility of long term exponentials) we will be able to manage it better.

      Delete
  15. TruthIsThereIsNoTruth4:09 PM

    Why is there such a fixation with the study of economics to have predictive power? Economic numbers are aggregation of human economic behaviour. We can understand human behaviour, we can understand the macro mechanics behind the aggregate numbers, but we can no more predict what will happen than a biologist can predict what I will have for breakfeast tomorrow.

    DSGE and the Minsky Model is neither right or wrong, neither are they mutually exclusive. They both capture some aspect of the complexity of aggregate outcomes as a result of the behaviour of 6 billion+ economic individuals. The economy is both random and cyclical and a whole bunch of other things no one has any idea about, on top of that it is always changing.

    Forecasts in the professional world are used as a benchmark to understand how this change is occuring. To understand the economy you need to constantly adjust your understing of it.

    ReplyDelete
  16. I regretted the TA analogy as soon as I sent it, you are right that the EMH is not the issue here. I am simply saying that it is highly unlikely that there will be an observable pattern or regular cyclicality to recessions because policy makers observe the signs of looming recession and make choices which change the pattern.

    I don't think I suggested that recession won't happen, just that the pattern will be disrupted in unpredictable ways. It is a basic problem with forecasting anything where people are involved. The actual path of events depends on the choices people make, and the way people make choices changes over time. Bernanke explicitly has stated that he is making different choices today because of what was learned from the 1930s, its hard to see how that hasn't changed the course of this recession, making it shallower, shorter, and avoiding a double dip, which more than likely has changed the timing and nature of the next recession.

    This strikes me as fundamentally the same issue as Expectations and is the central challenge Economics has. I don't mean to make a cliche argument against models. But I do think that just as your very first commenter noted that models had to lack symmetry, I think they also need to include the ability to forecast outcomes that have never happened. And I don't just mean with fat tails, but with changing underlying distributions.


    ReplyDelete
  17. Anonymous7:07 PM

    Consider the following model of a recession:

    The recession is caused by a bubble. The bubble grows in an asset class that people can buy on margin. Initially, the market goes up due to fundamentals. Then people begin to see it as a good investment, so they buy it for more speculative reasons. Then it becomes seen as a sure investment, so they buy it with borrowed money. During all of this, the market goes up at more or less a constant rate (that is, the price is exponential in time).

    The bubble breaks when the banks won't lend any more, or else can't lend more due to reserve requirements. Then, as there's no more money coming in, the market stops growing. Then, because it's no longer automatically going to go up, some people start looking at fundamentals, decide the market is overvalued, and sell. The market drops. People who have borrowed money panic and sell. The market crashes. A lot of people get wiped out, and a lot of loans can't be repaid. This drives the economy into a recession.

    First, you don't get a nice sine wave out of this model. You get an exponential rise that stalls and then collapses.

    Second, and perhaps more to the point: How long is it between recessions? Well, that depends. It depends on how long from the last recession before there's a market that is consistently going up. It depends on how long from the last recession before people believe "it has to go up, so it's safe to borrow money to invest in". It probably depends on what the Fed is doing with interest rates during this whole span. It depends on how badly the banks got burned last time around, and how willing they are now to lend for investment purposes. It depends on the banks' margin limits and reserve requirements.

    ReplyDelete
    Replies
    1. It sounds like a convincing story to me...now how can we model it quantitatively?

      Delete
    2. I think Blake Lebaron is doing some interesting work along these lines. See http://people.brandeis.edu/~blebaron/wps/minsky.pdf

      "Minksy conjectures that financial markets begin to build up bubbles as investors become increasingly overconfident about markets. They begin to take more aggressive positions, and can often start to increase their leverage as financial prices rise. Prices eventually reach levels which cannot be sustained either by correct, or any reasonable forecast of future income streams on assets. Markets reach a point of instability, and the over extended investors must now begin to sell, and are forced to quickly deleverage in a fire sale like situation. As prices fall market volatility increases, and investors further reduce risky positions. The story that Minsky tells seems compelling, but we have no agreed on approach for how to model this, or whether all the pieces of the story will actually fit together. The model presented in this paper tries to bridge this gap."

      It's a computational model with adaptive heterogeneous agents. Only a first step, as it doesn't include any mechanism for leverage. But it does produce an irregular history of bubbles and crashes quite naturally. I seem to recall that the time series also has some realistic features such as long-memory in the absolute value of returns.

      Delete
    3. The recession is caused by a bubble. The bubble grows in an asset class that people can buy on margin. Initially, the market goes up due to fundamentals.

      The tech bubble was an equity bubble, the 74 recession was an oil-shock. I don't think all recessions are bubbles, and all bubbles aren't debt financed.

      Delete
  18. http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=TCMDO_GFDEBTN_GDP&scale=Left&range=Max&cosd=1947-01-01&coed=2012-10-01&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=%28a-%28b%2F1000%29%29%2Fc%2A100&fq=Quarterly&fam=avg&fgst=lin&transformation=lin_lin_lin&vintage_date=2013-02-15_2013-02-15_2013-02-15&revision_date=2013-02-15_2013-02-15_2013-02-15

    This is the secular debt-fuelled business cycle Minsky and the Austrians were talking about — private debt as a percentage of GDP. We are currently in the deleveraging phase. The trouble is, the (both nominal and real) GDP path is influenced by many other factors. But if we're looking for a secular, predictable and clear cycle to base the notion of a business cycle (and thus a macroeconomic model) upon, we should start with the leverage-deleverage cycle Minsky, von Hayek and von Mises concentrated on.

    ReplyDelete
    Replies
    1. AMEN!

      Consider also private or total debt relative to circulating money, which is the stock from which income flows.

      Art

      Delete
  19. well, the restorative force is Fed (really macro) policy.

    what i have always found curious is that the business cycle troughs fits a Weibull distribution pretty nicely (like an exponential distribution, this is a distribution often used in engineering failure analysis). The parameters suggest that the longer the cycle goes on, the more likely it is to "fail." But whats failing? hmm, i know what Sumner would say.

    ReplyDelete
    Replies
    1. According to Minsky, Fisher and Veblen, the restorative force is debt deleveraging.

      Macro policy is supposed to work to dampen the business cycle.

      Delete
  20. Anonymous9:56 PM

    I was surprised that no blogs here referred to Marx's analysis of cycles, since he was the first to tackle these and explain why these happen. These blogs and macro-models describe or portray what has happened but, like Bernanke and the politicians, do not tackle the underlying cause. There are no references, so far, in these various blogs or in the original article, to profit and competition.
    As Marx saw it, at the peak of a boom period, when wages are at their highest, precisely at the point when profits are being squeezed, this is when capitalists realize their products are not selling as well as they used to. So they first try reducing prices; then start to make savings - to cut back on planned expansion; next thing there are lay-offs and plant closures, leading in turn to unemployed workers having to cut back on their spending. That is how Keynes's 'vicious cycle' starts.
    Only after a period of recession - when a lot of 'dead capital' is destroyed or consumed - only then is it possible for a few entrepreneurs to think it possible to make a profit. A few open up some new plant or enterprize; with wages and prices at rock bottom, they may find their new ventures are profitable. Or maybe not.
    Or perhaps they have started up in a new and growing sector of the economy, with little competition as yet(e.g. remember the dot-com boom?). But in that case, it will not be long before others enter this new market, all competing for sales and profits, and in time this market becomes flooded with overproduction and so the boom in this field too will sooner or later lead to another bust.
    In Marx's analysis, every depression is caused by massive overproduction. Competition leads to markets becoming saturated.
    Not that too many houses are built in terms of housing the homeless, or other goods ['commodities'] being enough to satisfy workers' needs. Only in terms of competiting to make profits.
    Marx also observed that every time a crisis happened, it seemed as if this was a unique phenomenon, sui generis, something utterly unprecedented. In his time, just as now, it seemed as if people had a sort of collective amnesia about past events.
    Yet this current crisis, originating in the financial sector and the banks' free and easy way of offering credit to people with no jobs or collateral, has many similarities with the Wall Street crash which triggered the 1930s Great Depression. That in turn had a likeness to the long drawn out multi-sector Depression at the end of the 19th century. Lord Randolph Churchill noted then that wherever you looked, every single sector of the British economy was dead or 'mortally wounded'. He was of course wrong.
    The capitalist system - like a hedgehog - has seasons of hibernation but in due course recovers.
    Marx, suffering from ill-health and doctors, likened the cycle to a fever chart. The graphs on this blog resemble the latter, quite uncannily.
    Suggestion: try reading Marx's analysis of how and why crises happen, and remember just why workers are employed and why their employers close down once profitable plants. Try forgetting your prejudices against Marx.

    ReplyDelete
  21. "But in any case, there was one famous literary economist who claimed that booms lead inevitably to busts. This was Hyman Minsky. Very few macroeconomists followed Minsky's line of thinking, but a few did, and even in the modern day there are some who do. Steve Keen is one of these."

    We all love Minsky, but one could also find a credit boom-bust theory of the business cycle in 'literary' form in Veblen (1904) Theory of Business Entreprise (Ch. 7) - which Irving Fisher says "comes nearest to the debt-deflation theory" in the last footnote to his 1933 paper.

    ReplyDelete
  22. Of course an AR(1) system with gaussian noise will display a Lorentzian for its spectral density plot. What this means is that one is likely to observe spurious "cycles" (spurious because we know it's an AR(1) system with no oscillatory response functions) of period of the order of the length of the observed data.

    See http://en.wikipedia.org/wiki/Cauchy_distribution for "lorentzian".

    ReplyDelete
  23. OK, the first part of this post (until Minsky) seems to be the popular "DSGE view" which to me is just that eyeballing the data isn't a good way to reach quantitative conclusions (QC) about the cycles.

    However:

    The US or whatever our home country is, isn't the only country in the world to eyeball. This data may be good enough for things DSGE macroeconomists aren't interested in - like actual policy and providing counterfactuals.

    I can see a scenario where a non-quantitative proposition is still very useful - you are pretty sure a glass is full when there is water spilling from its edge.

    Quantitative Conclusions about the economy always failed miserably anyway - Phillips curve, Okun's law doesn't seem to exist in many countries, M2 growth, Taylor-type rules etc.

    Why not admit macro is not good for this? All we know for sure is how to solve really major crises and models that are supposed to provide us with quantitative advice fail when there are really big problems.

    About Minsky (the program) - why not use Simulink, anyway?

    ReplyDelete
    Replies
    1. Why not admit macro is not good for this?

      Well, maybe it isn't!

      But maybe it is and we're just not doing it right...

      Delete
    2. Mackerel no giod OP.

      Delete
  24. Anonymous11:04 AM

    Noah... Your wave image is actually of 1.5 cycles...

    ReplyDelete
  25. Anonymous4:02 PM

    A non-mathematician's thoughts.

    Economic systems, planetary orbital systems, organisms, are all buffered. In human physiology this buffering is called homeostasis and within the homeostatic constraint the system hovers around a dynamic equilibrium condition in which a built-in restorative force (feedback)is operating.

    This exposition is an expansion of Le Chatelier's Principle to domains beyond those of chemistry at different hierarchical levels of systems:

    "If a chemical system at equilibrium experiences a change in concentration, temperature, volume, or partial pressure (i.e., the system is stressed), then the equilibrium shifts to counteract the imposed change and a new equilibrium is established."

    I believe this is true of the so-called business cycle, of an intervention in a domestic dispute (when the disputants turn on the intervener), the inflammatory reaction of the immune system, perturbations of gravitational interactions of planets, satellites, etc.

    Systems that appear to be linear (e.g., every metric of action has a corresponding linearly scalable metric of reaction) are linear only within a given range of variables; exceeding that range compromises system linearity and the response becomes chaotic and/or non-linear.

    In an organism, stresses exceeding linear constraints that result in disruption of the equilibrium condition is termed shock or trauma and "heroic" efforts may be required to rebuffer the system. In orbital systems perturbation of the gravitational equilibrium by a massive "foreign" can permanently disrupt the system (think of the result of a massive, moon-sized object entering the orbital earth-moon system).

    I think this transition from a linear to a non-linear dynamic is what characterizes the boom and bust transitions of the "business cycle."

    It may be that the stresses pushing the system equilibrium envelope aggregate gradually until the proverbial "straw" is reached or it might be that a very a large stress from economic, political or mass psychological "contagion" delivers a knockout punch.

    In some cases, the disruption is catastrophic (i.e., the Great Depression), really catastrophic (the ending of a civilization), or less so, (various recessions).

    Except for the extreme catastrophic case, our collective experience is that with the removal or dissipation of the disruptive stresses and with intervention or not, the system tends to rebuild and re-establish an equilibrium dynamic (although it may not be the same equilibrium). Much like an ecological system which has been disrupted, if the components and appropriate conditions supporting the sequence of development is accessible, the system reforms driven by favorable energy dynamics. That is, both the development path and the "final" equilibrium state are energetically favored.

    The time required for restoration of such a dynamic equilibrium depends on the extent of the disruption, the effectiveness of the intervention, if any, and collateral issues which involve the interaction of the system under repair with other systems as part of an even larger functional arrangement.

    ReplyDelete
  26. " I personally am very fond of the idea that booms cause busts - that the business "cycle" is not just a statistical illusion. My gut tells me that this is really going on. But business cycles don't look periodic! They don't look like waves. So maybe there is another type of "restorative force" acting on the economy, causing some kind of non-periodic cyclical motion?"

    See I'm the opposite. If anything I'd rather believe that they don't cause them: that would mean at least theoretically we could live wihtout the business cycle-no recessions. Or at least they wouldn't be inevitable.

    Trouble is while I know that maybe mainstream macro doesn't have a lot of use for "stylized facts" the fact is we always at some point end up in a recession again and usually we don't have to wait that long.

    I've admitted to you before I'm just an interested layman and it may be a bit crude to reason like this, however, Prescott and friends are RBC theorists after all. Their whole point is to show tha there isn't any business cycle-that Kenyes was wrong.

    As for the fact that business cycles don't look like waves, well, appearances can be deceiving-no?

    ReplyDelete
  27. Why can't the cycles be nonperiodic? This is very common in chaotic systems. They would certainly seem to make sense in the kind of systems that Keen is trying to model.

    ReplyDelete
    Replies
    1. Think very very carefully about the difference between a "nonperiodic chaotic cycle" and a "stochastic process"... ;-)

      Delete
    2. I don't see your point; they're completely different. A non-periodic cycle has no absolute frequency; it can have an average frequency. However, with data only going back to World War II, I don't know if there would be enough data to see the non-periodic cycles through spectral density analysis. If you assume that the business cycles last every 7-10 years, we would've had around 6-9 cycles so far.

      The non-periodic cycles can show up in stochastic processes, but they can also show up in deterministic systems that are extremely sensitive to the initial conditions.

      I'd also like to add one more point to the cycles. There could be non-periodic cycles of different frequencies on different time scales that all show up(like a fractal). For example, there could be another non-periodic cycle that lasts every 20-30 years and another one that lasts every 60-80 years(I certainly think there's a long-wave cycle for sure). We don't really have enough data to analyze the short term cycles because it only goes back since the Post-war period. However, Reinhart and Rogoff have hundreds of years of data and I would like to see some sort of spectral density analysis on that; it could yield very interesting results.

      Delete
    3. I don't see your point; they're completely different. A non-periodic cycle has no absolute frequency; it can have an average frequency.

      That will show up loud and clear on a Fourier Transform, given sufficient data. Which brings me to:

      However, with data only going back to World War II, I don't know if there would be enough data to see the non-periodic cycles through spectral density analysis. If you assume that the business cycles last every 7-10 years, we would've had around 6-9 cycles so far.

      See original post!

      The non-periodic cycles can show up in stochastic processes, but they can also show up in deterministic systems that are extremely sensitive to the initial conditions.

      So, my point was, given enough sensitivity to initial conditions (i.e. "chaos"), a stochastic model and a chaotic one become equivalent. An example is a gas. Suppose all particles in a gas obeyed Newton's Laws exactly. Predicting the positions and momenta of 100 gas particles just a few minutes from now would be impossible to do, even though philosophically the system is perfectly "deterministic". However, a stochastic model (classical thermodynamics) can easily and parsimoniously predict a lot of stuff about the system, e.g. temperature, pressure, volume, mean free path, etc.

      See?

      However, Reinhart and Rogoff have hundreds of years of data and I would like to see some sort of spectral density analysis on that; it could yield very interesting results.

      Try Googling for this!

      Delete
    4. "So, my point was, given enough sensitivity to initial conditions (i.e. "chaos"), a stochastic model and a chaotic one become equivalent."

      Okay, cool. Thanks for clarifying. After all, we are using models and no model is perfect. Models of all kinds may be able to provide valuable insights; as long as the assumptions are valid.

      Delete
    5. Yep. The question is which model will be the most reliably useful ("reliably" being the problem, since we never really know the domain of validity of any model)...

      Delete
  28. By the way, here's a paper written by Minsky. It's extremely insightful.

    http://www.scribd.com/fullscreen/104546616?access_key=key-1e1y628sss8xqr2iy22z

    ReplyDelete
  29. Anonymous8:19 PM

    "If you want to describe business cycles in terms of more general classes of economic phenomena, then you'll need to microfound the model in some way (of course, if business cycles turn out to be emergent, then this will not be possible to do)."

    Why do you think it is impossible to "microfound" the model if the phenomenon is emergent? Superconductivity may be an emergent macroscopic phenomenon, but it is based on interactions between electrons and phonons at more microscopic level, isn't it? I've read somewhere that you studied physics.

    ReplyDelete
    Replies
    1. Why do you think it is impossible to "microfound" the model if the phenomenon is emergent?

      Technically, "can't be microfounded" is the definition of "strong emergence". See Wikipedia:
      http://en.wikipedia.org/wiki/Emergence#Strong_and_weak_emergence

      Superconductivity may be an emergent macroscopic phenomenon, but it is based on interactions between electrons and phonons at more microscopic level, isn't it?

      Yes, we have microfounded models that describe superconductivity. Thus, the phenomenon is not "strongly emergent" (though a minority of people do think that certain properties of superconductivity are not described satisfactorily by the current microfounded theory, and are in fact strongly emergent).

      I've read somewhere that you studied physics.

      Yep! I was taught about emergence in an undergraduate statistical mechanics class by Robert Laughlin, who has written a book about "strong emergence":
      http://www.amazon.com/Different-Universe-Reinventing-Physics-Bottom/dp/0465038298

      Delete
    2. Anonymous12:09 AM

      Actually, I was curious about what you think about Laughlin.

      What in nature is truly strongly emergent, then? Sure, the whole can be greater than the sum of its parts. But how one can deny that the macroscopic properties are dependent on the properties of the components. As an ex-condensed matter physics guy, I am sympathetic to people like Laughlin and Phil Anderson criticizing reductionism. But I don't see how a macroscopic property cannot _in principle_ be understood in terms of the properties of the components. (It is more likely that the macroscopic property is not dependent on the details of the properties of the components, as in the case of universality of critical phenomena.) I don't think Anderson was saying something so radical.

      Delete
    3. Well, I look at it as a pragmatic thing. For example, plenty of phenomena in biology can't be predicted from physics. The most useful model of those phenomena will involve "laws" that can't be derived from physics. But the laws look robust. So, I say, use the model that seems to work, and if someday someone comes along and derives it from physics, well, great! But it doesn't seem certain to me that such derivations will always be possible for all phenomena.

      So basically, I say "don't worry about it."

      Does that make any sense?

      Delete
  30. If Keen's differential equations are linear, with coefficients fixed in time, then the eigenvalues of the jacobian have to be real imaginary or complex and the solutions have to be exponentially decaying, exponentially growing, oscillating or some combination of those three.

    ReplyDelete
    Replies
    1. Goodwin's model is nonlinear.

      Delete
  31. bjdubbs2:27 PM

    I got yer cycles right here, guys. Look no further (via breakpointtrades)

    http://stockcharts.com/h-sc/ui?s=$SPX&p=D&yr=1&mn=5&dy=0&id=p56765575570&a=237090701&listNum=12

    ReplyDelete
  32. Noah,

    Seems to me the fundamental issue is whether there is an equilibrium state - Ormerod (Death Of Economics, 1997) made me very dubious about most Macro theory back in the day when I was working as a macroeconomic analyst. Now I've done a lot of micro as a grad student, and I'm really dubious that you can (or rather should) microfound(?) when micro is on an equally dubious set of foundations (see behavioural economics in general). Chaos theory and stochastic modelling to provide some generalised understanding holds some promise, but it is critical to understand that individual decisions are irrational and arbitrary, and that 'equilibria' are not a determinant of the system so much as a temporary chaotic attractor. The invididual components of an economy are not as predictable as physical phenomena - even at the atomic level.

    YMMV - my knowledge of chaos theory and physics is pretty rudimentary

    ReplyDelete
  33. a) If you detrend the S&P500 by inflation and taxes, you see a 37 year cycle
    b) if you look at the recent dot.com and housing bubble you have a period length of about 7 years, peaks end of 2000, 2007, would give us the bond bubble crash for 2014 : - )
    c) if the postings would have not only hour, but day as well, it would enhance the readability

    ReplyDelete
  34. The post plus 74 comments, and no one (except one comment, in passing) mentions Nikolai Kodratiev and his Kondratiev Wave cycle, the original economic wave model. Which seems quite accurate over hundreds of years of history, and has spawned most other Wave theories:

    http://en.wikipedia.org/wiki/Kondratiev_wave

    He was executed by Stalin for his ideas, perhaps the highest form of validation. Modern K-Wave derivations have been successfully used to predict markets a decade ahead:

    http://dshort.com/articles/2010/BAAC-supercycle-introduction.html

    http://www.financialsensearchive.com/editorials/bronson/0512_Forecast.pdf

    "models looking for predictable patterns will not work for the same reason that Technical Analysis does not work in the stock market"

    hmmm, that's odd, since it is said some 70%-75% of all market trading is now done by algorithmic trading programs (the infamous "bots") that base their trades on.... technical analysis. Technical analysis is just math applied to historic price action. Are you saying math does not work?

    ReplyDelete
    Replies
    1. I linked to the Wikipedia entry for Kondratiev wave cycles in my original post! :-)

      Delete
    2. Are you saying math does not work?
      I think all I said was math can not predict the future when the event being forecast isn't coming from the same population that is being analyzed historically. This is not an original point.

      I am not sure that because 75% of trading is done with math or for any other reason, that that proves it does work.

      Math is a wonderful tool, the more I learn about it, the more I like it.

      Delete
  35. Alan Goldhammer8:48 AM

    Noah, interesting post and set of comments. As a non-economist, I've slogged through Minsky and found his thinking pretty convincing. The difficulty comes in trying to model it as you have noted. That being said, I don't think that one should give up on simplicity. I remember back to my first semester physics class when we were looking at oscillatory behavior and the professor showed us the film clip of the Tacoma Narrows Bridge collapse (http://en.wikipedia.org/wiki/Tacoma_Narrows_Bridge_%281940%29); I'm somewhat surprised that you as an undergrad physics major didn't remember this classic event. It maybe that the accumulation of debt (Ponzi in Minsky terms) is the disrupting force that pushes the resonance over the top.

    Sometimes simple explanations are better (Occam's Razor). :-)

    ReplyDelete
  36. "Sometimes simple explanations are better (Occam's Razor). :-)"

    Well, now, that's true. And sometimes simple explanations are less Occams' Razor than Procruste's Bed. That's where the fun comes in - trying to work out what's going on. Multivariate or just some undetected critical factor? Stories are easy; understanding is hard. I learned a long time ago that most ecologists are not statisticians; perhaps that holds true for economics as well.

    ReplyDelete
  37. This is mostly well beyond my abilities, but it seems to me that the notion of cycles can actually be quite dangerous. As intuitive as it might feel that booms cause busts, do we really want to accept that the inverse might also be true? That busts cause booms?

    As much as that notion gets thrown around when it's time for politicians to make excuses to do nothing, I'm fairly confident it isn't right.

    ReplyDelete
  38. Bill Ellis12:47 PM

    Not that we can repeal the "Hidden Semi-Markov Cycle" either. :-)

    ReplyDelete
  39. Related to HSMMs, there is a whole literature on smooth-transition autoregressive (STAR) models, see e.g. van Dijk et al (2002). These allow "smooth" switching between two regimes.

    A generalization, multiple-regime STAR (MRSTAR) models, allows smooth switching between more than two regimes. "Modeling Multiple Regimes in the Business Cycle" by van Dijk and Franses (1999) uses this model to study the business cycle.

    ReplyDelete
  40. Sorry, you did link to Kondratiev, in an offhand way (that I missed on first reading):

    "For example, some people now think that there are "business supercycles" that take much longer than what we usually call the "business cycle", and which are periodic."

    That makes it sound like it was posted up recently on some Blog. At least give the man his due and name him, how many times is the name Minsky mentioned in the post? Kondratiev was executed for his theory, a rather high price to pay for developing an economic theory based on historical study, don't you think?

    "Kondratiev's ideas were not supported by the Soviet government. Subsequently he was sent to the gulag and was executed in 1938." is a too short summary of what happened to him, he did 10 years hard labor in Siberia, then was re-tried for the same "crimes", found guilty and shot the same day behind the courthouse. It seems his ideas were deemed so dangerous to the Communist orthodoxy of the era that he was considered a highly dangerous "enemy of the state".

    I get on about this because I see so many websites and authors and "theories" who rip off Nikolai, but never give him his due.

    For the record, his theory is not about the "business cycle", though it is described that way, it is a high level macro-economic theory involving credit expansion then contraction, technological change, and human emotions, all of which make it difficult or near impossible to define strictly as a mathematical formula. He based it on hundreds of years of price data on basic commodities, and the forces that drove those prices up and down, over long periods, and when (and why) inflation and deflation will occur.

    Bob Bronson has taken the K-wave theory and expanded on it, and worked in many shorter period wave theories that can be more properly called "business cycles", you have to read the .pdf I linked.

    Perhaps the most egregious rip-off I am aware of is the book/website "The Fourth Turning" which is heavily influenced by Kondratiev, but never mentions his name, instead the authors claim they thought up their theory all on their own - sure they did.

    ReplyDelete
    Replies
    1. Dang. Sorry, Kondratiev! :(

      Delete
  41. Wow, never seen a so live discussion! :D Nice post! your blog should be an authority on off topic business discussions! :P Keep posting!
    Merchant bankers, business banking. business finance, business loans

    ReplyDelete
  42. Hey Guy,

    this is fun fun fun. let me know if you want to do an actual research party on this...

    ReplyDelete
  43. Another clueless attempt to understand the business cycle, for what it's worth:

    in every economy we have R, "real stuff," which includes a reasonable expectation of future human labour, invention and production.

    Each individual, in looking at R, will perceive it as slightly larger (or sometimes smaller, but usually larger) than its actual value. For example, if a person is employed, his income looks sufficient to justify a car loan, a home loan, credit, et cetera. Each of those lenders is justified, even when all together they might not be.The aggregate hopefully perceived R of a population I will call R[p]. R[p] is generally larger than R.

    (R[p] - R) is the amount of wishful thinking in an economy. In a healthy economy, R[p] -R) must be larger than zero.

    However, when (R[p] -R) becomes too large, such that under the pinpricks of routine testing it is shown to be more false than the investors can tolerate, the wishful thinking field (WTF) will collapse, with the quickest agents recouping their slice of R and many others losing out.

    Can the WTF be sustained indefinitely, through suppression of pinprick testing and concealment of knowledge of the magnitude of (R[p] - R)? How long can the pie in the sky, like a giant hailstone, be supported by contrary winds?

    It seems to me that the growth and collapse of ( R[p] - R) bubbles is necessary to lively economies, but must be pinpricked at levels which will prevent them from popping like bubble gum all over the countryside. Ewww...

    Noni

    ReplyDelete
    Replies
    1. Can the WTF be sustained indefinitely ...

      I laughed out loud. (Although I think you are right that there is some global miscalculation of net present values during booms - this miscalculation may be related to JK Galbraith's concept of the "bezzle".)

      Delete
  44. "Harmonic motion is inherently periodic; it repeats at regular intervals, while the fake cycles of a trend-stationary AR-type process generally do not."

    Harmonic motion is not inherently periodic. Ask any physicist or mathematician. Harmonic motion is just what you get when you are balancing two (or more) opposing forces. What you see that looks like a sine wave when something like a sine wave appears is just an artifact of the complex numbers. What is actually happening is that at various times one direction may dominate, but as there are opposing forces, this domination will eventually weaken. This gets you patterns of boom and bust in physics, populations, pure numbers and economics.

    This view fits the data, the mathematics and any intuitive sense of economics much better than the denialist view. Yes, there are booms. Yes, they are driven by underlying forces. Yes, those forces have their opposing forces. Yes, the boom creates the bust. It is the denialist view that missed the recent housing bust and the slightly less recent dot-com bust. Anyone thinking in terms of cycles was expecting the bust, though most likely off in timing it.

    (It isn't the 19th century anymore. Mathematics has moved on. Predator-prey models are intrinsically cyclic. Animals actually eat other animals, and if they eat enough of them, they will starve themselves. Sometimes you get nice sine waves. Sometimes you get stuff that looks like statistical noise. You are looking at the same system with the same mathematics and the same explanatory forces.)

    ReplyDelete
  45. Booms cause busts...

    But some busts follow busts. (double dip recession in the early 1980s?) Some booms follow booms.

    So we are looking for cycles without frequency that can cycle down, down or up up as well as down up.

    Most explanation for business cycles have to do with either time shifting behavior - pausing or accelerating investment or durable good purchases - or with changes in the availability or price of credit. There is no particular reason that having once deferred an investment, it can't be further deferred, and as in the 30s, that this deferral can't keep happening for some time. Neither is there any particular reason that once banks have tightened lending standards, they can't tighten them further. I think both have happened, and why wouldn't they possibly happen again.

    There is also no reason to think that just because high levels of economic activity may reach some level that is not sustainable it necessarily can only be brought to a sustainable level through a bust.

    The more I think about this the less it seems to me that changing levels of economic activity are determined by time and prior period levels. Though clearly prior period levels will be a big factor, that seems to me to be a definitional artifact that what is being measured is a a change from the prior period.

    ReplyDelete
  46. I scoffed also! :) As someone who came from engineering to economics, I always tell my engineering friends, "Guess what economists call white noise? Cycles, or innovations!"

    BTW random side note - I asked one of my macro profs (who worked in Australia for a while) if he knew Steve Keen, and he said "who?" I was very surprised that Keen, who I consider 'famous' in the blog world seems to be not quite so famous in the 'real world'.

    ReplyDelete
  47. Lost in a mysterious universe without any purpose

    The universe's purpose is to increase entropy.

    Your purpose is to try to reduce local entropy.

    ReplyDelete
  48. Anonymous3:58 PM

    The most interesting person I've come across regarding business cycles is Martin Armstrong of armstrongeconomics.com. He may be considered a heretic to many acedemic economists. He believes we're entering a sovereign debt crisis and has analyzed data going back to the Roman Empire. A recent post of his quoting Paul Volcker:
    "As Paul Volcker himself acknowledged that the whole idea of Marxist-Keynesianism was to empower government with the idea that they were all powerful. “’New Economics’ had become orthodoxy. Its basic tenet, repeated in similar words in speech after speech, in article after article, was described by one of its leaders as ‘the conviction that business cycles were not inevitable, that government policy could and should keep the economy close to a path of steady real growth at a constant target rate of unemployment.’”

    ReplyDelete