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Op/ed: Everything we know about recessions might be wrong

By   /   Friday, February 13th, 2015  /   Comments Off on Op/ed: Everything we know about recessions might be wrong

Economists are simply frightened of models where bad permanent things can happen by random chance — even if the data show that’s what really happens.

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By Noah Smith

What are business cycles? Many people think that booms naturally lead to busts — that excesses built up during good times lead inevitably to a crash. Today’s economists don’t see it that way. Modern macroeconomists think that recessions and booms are random fluctuations around a trend. These fluctuations tend to die out — a deep recession leads to a fast recovery, and a big expansion tends to evaporate quickly.

Eventually, the trend re-establishes itself after maybe five years. No matter what happens — whether the central bank lowers interest rates, or the government spends billions on infrastructure — the bad times will be over soon enough, and the good old steady growth trend will reappear.

This was the model endorsed by Milton Friedman and enshrined in both of the major schools of thought in the 1980s and 1990s: the Real Business Cycle school and the New Keynesians. In fact, it’s now built into essentially every macro model.
But what if it’s wrong? There have always been those who suspected, deep down, that the reigning wisdom was wrong — that recessions deal permanent injuries to an economy, and that booms bring lasting benefits.

One seed of doubt was sown in 1987 by Greg Mankiw, a Harvard economist who was later an adviser to President George W. Bush. Along with noted financial economist John Campbell, he published the paper “Are Output Fluctuations Transitory?” That’s economist-ese for “Do recessions naturally heal?” Mankiw and Campbell look at the evidence — what there is of it — and conclude that there’s a strong possibility that recessions don’t naturally heal. If gross domestic product goes down by 1 percent, it stays 1 percent lower until something bumps it back up.

In the language of econ math, that means GDP has what is known as a “unit root.” In 2009, the middle of the Great Recession, Mankiw bet that this recession would cause a lost decade. Interestingly, Paul Krugman was among the optimists — and turned out to be wrong. Six years later, our economy is healing, but very slowly — and what healing there is may have been due to unexpected positive developments such as the shale boom.

In fact, as University of Oregon professor Mark Thoma finds, the same kind of thing has happened to many other economies within recent memory. Some negative shock, usually a financial crisis of some sort, left each economy at a lower level of GDP for many years. The recoveries were usually L-shaped.

So if this is a normal thing that happens to recession-hit economies, it means that most of our modern macroeconomic models — even the ones that have won the Nobel prizes — are missing something big. Why don’t economies bounce back?

A few intrepid economists have bucked the trend and tried to develop new models. One of them is Roger Farmer of UCLA.

For inspiration, Farmer goes beyond Milton Friedman and back to John Maynard Keynes. But Farmer’s models are neither of the New Keynesian type (which are much closer to Friedman’s thinking) or of the simple Old Keynesian type advanced by Paul Krugman. Farmer asks the question Keynes asked: What if human sentiment, or “animal spirits,” drives the economy?

His approach is mathematically sophisticated, and uses the complex modern techniques that are ubiquitous in academic literature. The economic agents in Farmer’s models are not dupes — their bursts of optimism and pessimism become self-fulfilling prophecies. Farmer finds that this leads inexorably to a result that most macroeconomists dread: the existence of “multiple equilibria.” A burst of pessimism can knock the economy from a good equilibrium into a bad one, and it can then stay there until a burst of optimism comes along to knock it back.

If Farmer is right, then no matter how rational it looks, our economy is driven by the vagaries of shifting human expectations. It is not a self-correcting system like Milton Friedman envisaged, but a fragile thing. And that opens up the possibility that maybe we need government to knock us out of the bad equilibrium — somehow.

The macroeconomics establishment, for its part, is quite invested in the idea of booms and bust as self-correcting fluctuations. Farmer’s ideas have been published in prestigious journals — with his fearsome math skills and deep understanding of how modern models work, it would be surprising if they weren’t. But they have failed to spark a revolution in the macro world. Economists are simply frightened of models where bad permanent things can happen by random chance.

Even if the data show that’s what really happens.

• Noah Smith writes for Bloomberg View.

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