Monday, August 18, 2014

RBC models we can believe in?

At Bloomberg View, I wrote an article trying to explain the basics of RBC models to the masses, and give a little history-of-thought. Of course anyone who actually knows the situation will realize that my treatment is pretty simplistic, but you try explaining RBC in 800 words to people who know nothing about modern academic macro, in a way that's entertaining and grabs eyeballs. It is harder than it sounds. ;-)

Anyway, the post only talked about the original, historical RBC model, and mentioned a couple follow-ups, such as news shock models. But if you define "RBC" as "any macro models where aggregate uncertainty is mainly driven by productivity shocks," then the field gets a lot wider. 

In fact, if you put a gun to my head and asked me why recessions happen, first I'd kiss my ass goodbye, but then I'd say that some of them happen because of sector-specific productivity shocks, amplified by network effects and by some departures from Rational Expectations. Actually, there are a number of models popping up that try to model something like this, and I think it's a hugely interesting literature. Here are a couple examples, with abstracts.

"Noisy Business Cycles", by George-Marios Angeletos and Jennifer La'O (2009)
This paper investigates a real-business-cycle economy that features dispersed information about the underlying aggregate productivity shocks, taste shocks, and, potentially, shocks to monopoly power. We show how the dispersion of information can (i) contribute to significant inertia in the response of macroeconomic outcomes to such shocks; (ii) induce a negative short-run response of employment to productivity shocks; (iii) imply that productivity shocks explain only a small fraction of high-frequency fluctuations; (iv) contribute to significant noise in the business cycle; (v) formalize a certain type of demand shocks within an RBC economy; and (vi) generate cyclical variation in observed Solow residuals and labor wedges. Importantly, none of these properties requires significant uncertainty about the underlying fundamentals: they rest on the heterogeneity of information and the strength of trade linkages in the economy, not the level of uncertainty. Finally, none of these properties are symptoms of inefficiency: apart from undoing monopoly distortions or providing the agents with more information, no policy intervention can improve upon the equilibrium allocations.

"The Network Origins of Aggregate Fluctuations", by Daron Acemoglu et al. (Econometrica 2012)
This paper argues that in the presence of intersectoral input-output linkages, microeconomic idiosyncratic shocks may lead to aggregate fluctuations. In particular, it shows that, as the economy becomes more disaggregated, the rate at which aggregate volatility decays is determined by the structure of the network capturing such linkages. Our main results provide a characterization of this relationship in terms of the importance of different sectors as suppliers to their immediate customers as well as their role as indirect suppliers to chains of downstream sectors. Such higher-order interconnections capture the possibility of “cascade effects” whereby productivity shocks to a sector propagate not only to its immediate downstream customers, but also indirectly to the rest of the economy. Our results highlight that sizable aggregate volatility is obtained from sectoral idiosyncratic shocks only if there exists significant asymmetry in the roles that sectors play as suppliers to others, and that the “sparseness” of the input-output matrix is unrelated to the nature of aggregate fluctuations.

And just for fun, I'm going to throw in "Intermediate Goods, Weak Links, and Superstars: A Theory of Economic Development", by Charles I. Jones (2008), which bills itself as a theory of development, but seems like it could pretty easily be modified to be a business-cycle theory for developed countries.

(Also there's this Gabaix paper, which is about firm-level heterogeneity. I originally included it here, but it doesn't really fit with the others so I took it out. Heterogeneity is a very different story from networks and complexity. Still, good to see heterogeneity getting more attention.)

The basic idea here is actually pretty simple. Angeletos actually said it, when he came to present his paper at Michigan: "One firm's productivity determines other firms' demand." In other words, these network models go way beyond the traditional, typical framework of aggregate supply and aggregate demand. (Other models also do this, but usually across time rather than across firms or sectors.) 

Like I said, if you held a gun to my head, I would say that something like this is actually going on in the actual economy. Why? Because aggregate shocks are sometimes really hard to identify. There were the oil price shocks in the 1970s and Volcker's tightening in the early 1980s, but a lot of recessions don't seem to be externally provoked. So maybe that means there is some kind of random mass-psychological sentiment thing going on, or maybe it means that recessions are sunspots caused by the interaction of a whole bunch of frictions, and thus completely unknowable. But this network/linkage idea seems like a promising alternative to those unhappy possibilities. That doesn't mean I think any of these models is right - they're all going to have empirical issues, because they are basically proof-of-concept papers. But I suspect they're on to something that many have expected for a long time - the idea that economic fluctuations are the result of the complexity of economic systems.

But explaining to Bloomberg View readers that these models may or may not deserve the moniker "RBC" would have distracted from my main point, which is to teach people a little about the history of macroeconomic thought (read: academic politics in the macro field), so someday I can explain my theory of why Mike Woodford is the most important macroeconomist in the world. But now I'm getting ahead of myself...


  1. "One firm's productivity determines other firms' demand."
    Yes, this is the correct track to take for the business cycle. Ultimately aggregate productivity (and don't forget profit rates) bump into the effective demand limit. At the ED limit, as one firms increases profit rate, another loses. Same goes for productivity increases. Once you have a calculation of the effective demand limit, the pieces fall into place and you see where recessions form.

    1. Anonymous3:21 PM

      Why oh why are you so incredibly stupid?

  2. If somebody put a gun to your head and asked you why do hurricanes happen, what would you say?

    That's how science works. Try the same process with econ and work backwards. You'll never reverse engineer any of the nonsense above for a number of reasons, but the most obvious one is that no observer of humans would say rationality was the norm. No one. It's like watching a baseball game and then telling someone that the ball travels based on it's predictions of where bats and fielders will be in the future. That is to say, psychotic.

    1. If somebody put a gun to your head and asked you why do hurricanes happen, what would you say?

      Warm water evaporates off of the ocean and then cools down and falls, and conservation of angular momentum makes it swirl around in a circle?

    2. Anonymous1:56 AM

      And predicting the path of a baseball using Newtonian physics is equally nonsensical. No observer of the physical world would believe in "action at a distance." No one.

      Newtonian physics is pseudo-science, just like econ.

    3. @Anonymous: too clever by half. Newtonian physics predicts a certain arm motion will propel the ball to the catcher. Then we throw a ball.

      @Noah Smith: assuming your meteorology is better than your European history, let's say that's correct. What should academic meteorologists say when asked to predict where hurricanes will strike one month out? What would you say about academic meteorologists if you found out that their models didn't include hurricanes? That they called them "exogenous shocks?" You'd ask for your tax and tuition back is what you'd do.

    4. Just to be clear, economists in the same situation would say: Exactly 30 days from now, Havana, but not San Juan. In 32 days Myrtle Beach, category 3. But tomorrow will have revisions, could be category 4 and 33 days. So if you build hurricane proof houses in Miami with government money you are a communist who doesn't understand how the world works.

    5. I get your point, but let's rephrase that a bit:

      "Exactly 30 days from now, Havana, but not San Juan. In 32 days Myrtle Beach, category 3. So if that doesn't happen, this constitutes conditions for falsification of my models and core hypothesis, which should then be trashed, and it's back to the drawing board for me."

      Wouldn't that be refreshing to hear from an economist?

    6. "no observer of humans would say rationality was the norm"

      Please, do not try to judge what the norm is by looking at the mirror!

    7. I'm looking at you!

  3. My little version of that is there are profit makers and profit takers. Profit makers grow faster than the economy producing the funds for the growth of rest of the economy while profit takers grow no faster than the economy, slower, or even decline. Profit makers bubble up and occasionally pop becoming takers while new profit makers take their place, but when there are only a few profit makers that individually become very large, the imbalance of one popping can't readily be made up.

  4. It's great to see theory advancing in this area, as the network, "one firm's productivity is another firm's demand" model is pretty fundamental to how we (buy side asset manager) view the world. So to have a normative framework for our seat-of-the-pants "model" gives some needed grounding (and feeds the confirmation bias monster).

  5. I am more of the opinion that “Shite Happens”. According to the NBER, ( )there have been 12 periods of contraction and 11 + 1 ( current Expansion ) periods of expansion since 1945. The basic stats of durations are:
    expansion contraction
    average 60.2 10.8
    median 51.5 10.0
    stdev 34.0 3.8
    Max 120.0 18.0
    min 12 6
    The expansion duration distribution is fairly even:

    Duration Count
    0 to 25 Mos 2
    25 to 50 Mos 4
    50 to 75 Mos 2
    75 to 100 Mos 2
    100 to 125 Mos 2

    Thus indicating a somewhat random length of expansion with a bias towards median. The current expansion period is at 50 months and counting. In terms of a distribution we are just about at the median expansion duration.

    In terms of trying to predict the length of the current expansionist period is trying to pick the winner of a maiden claiming race with all first time starters. Good Luck!!

  6. but a lot of recessions don't seem to be externally provoked.

    Rhetorical question: could an economy consisting of ten actors who are in constant, open communication with each other, and who have the ability to co-ordinate, suffer a recession?

    If one created a model using linear first order differential equations with a thousand or so actors, ten or so variables to describe each actors investments, liabilities and conduct and some variables to describe the actor's beliefs (with the beliefs constantly relaxing towards the current true state of affairs as information diffuses) the resulting model would look like:

    y' = Ay + small noise factor.

    If you have one thousand actors and twenty thousand variables then A will have twenty thousand, mostly complex, eigenvalues and the system will inherently oscillate in a very complex fashion as a result of the combined effect of about twenty thousand separate frequencies. External shocks are not needed to make the system oscillate. Now assume you have twenty thousand actors.

  7. You had me at Acemoglu...

  8. Here's another way to look at it: Tyco Brahe had to exist prior in time to Kepler and Newton. Newton first Brahe second can't work.

    1. "Newton first Brahe second can't work." ... well it *could* work, it's just not likely to happen. Newton would have been even more impressive if he'd come up with his ideas prior to Brahe's observations.

  9. The recessions in my life time basically happened when the fuel supply for the boom ran out. The 80s were fueled by women entering the work force to raise household incomes. The 90s were fueled by rising stock market asset prices driven by baby boomer retirement savings. The 00s were fueled by rising housing prices driven by baby boomers who had been burned in the 90s investing in real estate. Eventually, enough women entered the workforce and the value of their additional incomes fell. Eventually, the rate of increase in retirement savings stopped rising. Eventually, the prices of homes grew too high for stagnant incomes.

    I'm sure there are other causes for recessions, but usually it is just some driving sector running out of money. It has been hard not to predict roughly when and how each boom ended.

  10. I suspect they're on to something that many have expected for a long time - the idea that economic fluctuations are the result of the complexity of economic systems.

    This could be as big as the discovery that water is wet!

  11. Anonymous11:52 AM

    Funny you should mention that. Are you aware the the term "Real Business Cycles" was actually the name of a 1983 paper by Long and Plosser where they talk about how business cycles were generated by sectoral shocks? It took 40 years for the idea to be fully worked out, but it was there from the get-go.

    1. Actually until you mentioned that, I had forgotten about that! Good call.

  12. Passing By9:52 PM

    "Because aggregate shocks are sometimes really hard to identify. There were the oil price shocks in the 1970s and Volcker's tightening in the early 1980s, but a lot of recessions don't seem to be externally provoked."

    I'm curious -- which recessions are you referring to? My recollection was that the "external" provocations you dismiss [monetary, fiscal, financial, OPEC, etc.] accounted for pretty much all of them , at least since 1900.

  13. The send-up of RBC was a little funny, but my impression is you don't really know much about business cycles.

    You think recessions are caused by financial panics and asset-price crashes, really? Ummmm, aren't those just symptoms of recessions?

    Caused by central bank tightening, now that makes sense ... indeed most recessions are triggered by central bank tightening, and most exceptions are obvious external shocks. But if central bank tightening is such a reliable trigger, doesn't that tell you something? Could they be making the same mistake over and over and over again? Or are over ebullient credit markets finally being told to cool their jets, just as they would be if they had to rely only on private funding?

    Non-academic economists aren't out of the debate. We don't understand why you think there is a debate. The business cycle is the credit cycle. Try to find a macro hedge fund that doesn't follow the credit cycle theory of business cycles. They don't exist. Read Soros and Dalio, for starters.

    RBC is indeed a joke, though you missed my favorite. Ever since RBC came out, they've been tinkering with it trying to get it to behave realistically. It's really a wonderful business cycle model, it just needs a little credit channels broth. Some exuberant reflexivity spices. And voila, delicious nail soup.

    1. Anonymous3:25 PM

      There is no evidence that most recessions are caused by central bank tightening, and recessions existed (and were more severe) before the Fed even existed. There is a reason no one listens to non-academic economists, and you are Exhibit 1.

  14. "but then I'd say that some of them happen because of sector-specific productivity shocks"

    Any empirical evidence for this?

    The problem with this theory is that if the economy is so vulnerable to network effects, why does it have such a steady trend? Technology change in particular would be massively disruptive. Looking at history, this doesn't seem to be true, tech change seems to effect long term trend, not business cycle.

  15. What a scientist interested in human behavior does:

  16. An important early exponent of this view, Long and Plosser's "real business cycles" had a multisector economy, individual shocks, and linkages produced business cycles. Alas it fell out of favor relative to the Kydland-Prescott one-sector model, largely because (I think) they left out capital, in turn because they wanted to stay analytical and not pursue numerical solutions.

    1. Yeah, I forgot about that! Weren't people in the 80s pretty skeptical that that industry correlation matrix was structural?