Home > The Economics Profession > Real business cycles – transmogrifying obfuscation

Real business cycles – transmogrifying obfuscation

from Lars Syll

Real business cycles theory (RBC) basically says that economic cycles are caused by technology-induced changes in productivity. It says that employment goes up or down because people choose to work more when productivity is high and less when it’s low. This is of course nothing but pure nonsense – and how on earth those guys that promoted this theory could be awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel is really beyond comprehension.

In yours truly’s History of Economic Theories (4th ed, 2007, p. 405) it was concluded that

the problem is that it has turned out to be very difficult to empirically verify the theory’s view on economic fluctuations as being effects of rational actors’ optimal intertemporal choices … Empirical studies have not been able to corroborate the assumption of the sensitivity of labour supply to changes in intertemporal relative prices. Most studies rather points to expected changes in real wages having only rather little influence on the supply of labour.

And this is what Lawrence Summers – in Some Skeptical Observations on Real Business Cycle Theory – had to say about RBC:

The increasing ascendancy of real business cycle theories of various stripes, with their common view that the economy is best modeled as a floating Walrasian equilibrium, buffeted by productivity shocks, is indicative of the depths of the divisions separating academic macroeconomists …

If these theories are correct, they imply that the macroeconomics developed in the wake of the Keynesian Revolution is well confined to the ashbin of history. And they suggest that most of the work of contemporary macroeconomists is worth little more than that of those pursuing astrological science …

The appearance of Ed Prescott’ s stimulating paper, “Theory Ahead of Business Cycle Measurement,” affords an opportunity to assess the current state of real business cycle theory and to consider its prospects as a foundation for macroeconomic analysis …

My view is that business cycle models of the type urged on us by Prescott have nothing to do with the business cycle phenomena observed in The United States or other capitalist economies …

Presoctt’s growth model is not an inconceivable representation of reality. But to claim that its prameters are securely tied down by growth and micro observations seems to me a gross overstatement. The image of a big loose tent flapping in the wind comes to mind …

In Prescott’s model, the central driving force behind cyclical fluctuations is technological shocks. The propagation mechansim is intertemporal substitution in employment. As I have argued so far, there is no independent evidence from any source for either of these phenomena …

Imagine an analyst confronting the market for ketchup. Suppose she or he decided to ignore data on the price of ketchup. This would considerably increase the analyst’s freedom in accounting for fluctuations in the quantity of ketchup purchased … It is difficult to believe that any explanation of fluctuations in ketchup sales that did not confront price data would be taken seriously, at least by hard-headed economists.

Yet Pescott offers an exercise in price-free economics … Others have confronted models like Prescott’s to data on prices with what I think can fairly be labeled dismal results. There is simply no evidence to support any of the price effects predicted by the model …

Improvement in the track record of macroeconomics will require the development of theories that can explain why exchange sometimes work and other times breaks down. Nothing could be more counterproductive in this regard than a lengthy professional detour into the analysis of stochastic Robinson Crusoes.

Thomas Sargent was awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2011 for his “empirical research on cause and effect in the macroeconomy”. In an interview with Sargent in The Region (September 2010), however, one could read the following defense of “modern macro” (my emphasis):

Sargent: I know that I’m the one who is supposed to be answering questions, but perhaps you can tell me what popular criticisms of modern macro you have in mind.

Rolnick: OK, here goes. Examples of such criticisms are that modern macroeconomics makes too much use of sophisticated mathematics to model people and markets; that it incorrectly relies on the assumption that asset markets are efficient in the sense that asset prices aggregate information of all individuals; that the faith in good outcomes always emerging from competitive markets is misplaced; that the assumption of “rational expectations” is wrongheaded because it attributes too much knowledge and forecasting ability to people; that the modern macro mainstay “real business cycle model” is deficient because it ignores so many frictions and imperfections and is useless as a guide to policy for dealing with financial crises; that modern macroeconomics has either assumed away or shortchanged the analysis of unemployment; that the recent financial crisis took modern macro by surprise; and that macroeconomics should be based less on formal decision theory and more on the findings of “behavioral economics.” Shouldn’t these be taken seriously?

Sargent: Sorry, Art, but aside from the foolish and intellectually lazy remark about mathematics, all of the criticisms that you have listed reflect either woeful ignorance or intentional disregard for what much of modern macroeconomics is about and what it has accomplished. That said, it is true that modern macroeconomics uses mathematics and statistics to understand behavior in situations where there is uncertainty about how the future will unfold from the past. But a rule of thumb is that the more dynamic, uncertain and ambiguous is the economic environment that you seek to model, the more you are going to have to roll up your sleeves, and learn and use some math. That’s life.

Are these the words of an empirical macroeconomist? I’ll be dipped! To me it sounds like the same old axiomatic-deductivist mumbo jumbo that parades as economic science of today.

Neoclassical economic theory today is in the story-telling business whereby economic theorists create make-believe analogue models of the target system – usually conceived as the real economic system. This modeling activity is considered useful and essential. Since fully-fledged experiments on a societal scale as a rule are prohibitively expensive, ethically indefensible or unmanageable, economic theorists have to substitute experimenting with something else. To understand and explain relations between different entities in the real economy the predominant strategy is to build models and make things happen in these “analogue-economy models” rather than engineering things happening in real economies.

Formalistic deductive “Glasperlenspiel” can be very impressive and seductive. But in the realm of science it ought to be considered of little or no value to simply make claims about the model and lose sight of reality.

Neoclassical economics has since long given up on the real world and contents itself with proving things about thought up worlds. Empirical evidence only plays a minor role in economic theory, where models largely function as a substitute for empirical evidence. But “facts kick”, as Gunnar Myrdal used to say. Hopefully humbled by the manifest failure of its theoretical pretences, the one-sided, almost religious, insistence on axiomatic-deductivist modeling as the only scientific activity worthy of pursuing in economics will give way to methodological pluralism based on ontological considerations rather than formalistic tractability.

When that day comes The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel will hopefully be awarded a real macroeconomist and not axiomatic-deductivist modellers like Thomas Sargent and economists of that ilk in the efficient-market-rational-expectations camp.

  1. Ken Zimmerman
    August 10, 2013 at 12:12 pm

    Lars, I understand your frustration. However, when someone says to you that you have been awarded the Nobel Prize, it would be even more surprising than the substitution of models for reality if the awardee were to turn it down, saying I don’t deserve it as I only play around with model ships in the bathtub rather than ships in the ocean. Give it to someone who works with real ships and real oceans. When a prize is offered we all become certain that we deserve it, and even more that we’ve always deserved it.

  2. August 10, 2013 at 10:15 pm

    The real world of economics should begin with the honest study of the actual structure of money and banking, the one thing economists absolutely ignore. The business cycle is probably as natural as the seasons and should be accepted as inevitable human behavior. Why downturns have such nasty effects like mass foreclosures, is the question worth asking.

    WEA paper:

    Graphic empirical proof:

  3. August 11, 2013 at 2:32 am

    You said, “Since fully-fledged experiments on a societal scale as a rule are prohibitively expensive, ethically indefensible or unmanageable, economic theorists have to substitute experimenting with something else.” What do you think Bernanke and other central bankers are doing?

  4. Robert Locke
    August 11, 2013 at 12:23 pm

    Lars, historians know that argument never makes headway before conviction, conviction, sure it is right, never engages in argument.

  5. August 11, 2013 at 8:04 pm

    It is with a sad sense of deja vu that I read the above musings about the not so faded ghost of “Real Business Cycle” theory. But there is a self-serving reason behind the futile attempts of hundreds of economists, such as Edward Prescott, to continuously resurrect the cult of “SHOCKS” as an explanation for the historical phenomenon of business [or trade] cycles. This stuff continues to flood hundreds of economic journals in the guise of convoluted lemmas, theorems and propositions; A great mine field layed-in to protect the crumbling fortress of general equilibrium [GE] against its fading value as an explanation of any economic phenomena.
    To summarize directly from TELOS & TECHNOS:
    “The cult of SHOCKS as Proxies for the exogenous in the neoclassical paradigm”
    If anything, by way of the consequences of human action [individual & collective] that cannot be explained by the equilibrium/field metaphor is described as a “shock”, then nothing is a shock. Frederick the Great said it first.” A commander in the field who tries to defend everything, ends up by defending nothing”. The cult of shock, baptised as “Real Business Cycle” theory has been elevated to metaphysical status in order to defend the hyper-ergodic requirements of the equilibrium artifice. Against the “dark forces of time & ignorance” [Keynes’s memorable phrase]. The more frustrating these natural limitations to equilibrium-based Economics become, the greater the hunger for some kind of “lawful regularity” or even forced symmetry. Which would sublimate the natural asymmetry that surrounds all economic actions & decisions. The knee-jerk resort to explanation by “shock” is just another construct to evade Business cycles,as real omnipresent history. Every business or financial cycle is not a “crisis” ! Consequently,Real business cycle theory invokes the cult of SHOCK as the culprit that causes unnatural deviation from the “steady-state equilibrium growth paths” that are built into the neoclassical fantasy. Their fantasy is that economic history can be, indeed ought-to-be, “predictable” [and therefore controllable ?]: As an intrinsically positive series of events where “growth” is congruent with development, As with risk and uncertainty, these are related concepts, BUT not the same. It’s one more example of David Hume’s warning that we cannot deduce what ought-to-be from what is.In this way the guardians of the equilibrium “fortress can deny the reality of time-path dependent real history. By “proving” that Economic history can be easily “predictable” [including future financial “crises” ?] by time-series analysis. With underlying revelations of a one-to-one correspondence between chronological time and “progress”. Finally, there seems to be a “sotto-voce” acknowledgement that “shocking” economic events are more “real” than the artificial constructs they are “deviating” from. The shallowest example, being Robert Solow’s ludicrous consignment of technological change to the status of an “exogenous” residual operator, rather than a primal human [Promethean] force in itself; Which requires very rigorous inclusion into an interactive system of Economic thought. In that respect the interested reader should refer to the concept of TECHNOLOGICAL TIME,[Chapter 3] which is one of the foundations of TELOS & TECHNOS.
    Thank you for your patience.
    Norman L. Roth, Toronto, Canada. Please GOOGLE [1] Norman Roth, Technos [2] Norman Roth, Origins of Markets [3] Norman Roth, Economics of Technology [4] TELOS & TECHNOS, Roth

  6. August 25, 2013 at 8:18 pm

    The economic cycle is a consequence of the positive feedback loop generated by the interaction between the land market and the banking system.

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