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«BEYOND SHOCKS: WHAT CAUSES BUSINESS CYCLES? AN OVERVIEW Jeffrey C. Fuhrer and Scott Schuh* In the summer of 1997, when the Federal Reserve Bank of ...»

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BEYOND SHOCKS: WHAT CAUSES

BUSINESS CYCLES? AN OVERVIEW

Jeffrey C. Fuhrer and Scott Schuh*

In the summer of 1997, when the Federal Reserve Bank of Boston

selected the topic for its forty-second annual economic conference, many

pundits were asking: “Is the business cycle dead, or at least permanently

dampened?” By the time the Bank’s conference convened in June 1998,

the same pundits queried: “What caused the massive recessions in Asia?” and “Can the United States remain ‘an oasis of prosperity,’ as Fed Chairman Alan Greenspan termed it, while economies worldwide are under siege from financial crises?” How quickly things change!

Beyond Shocks: What Causes Business Cycles? turned out to be a particularly timely conference. Of course, the answers to the pundits’

questions are inextricably tied to an underlying fundamental question:

What makes economies rise and fall? To determine whether the business cycle is dead, one must first determine whether economic fluctuations arise from the decisions of governments, financial market participants, and businesses, or simply from unexpected events (that is, “shocks”). To determine why Asian economies plunged into severe recession, it is necessary to understand how external pressures on vulnerable financial markets can lead to a sudden collapse, with severe consequences for nonfinancial sectors. And to determine whether the robust economic expansion in the United States will continue, it is necessary to evaluate how a slew of adverse economic factors, financial and real, could interact to end it.

So, what caused the Asian crisis, the recessions of the 1970s and 1980s, and even the Great Depression? According to many modern *Vice President and Economist, and Economist, Federal Reserve Bank of Boston. The authors thank Lynn Browne for helpful comments on this summary.

2 Jeffrey C. Fuhrer and Scott Schuh macroeconomists, shocks did. This unsatisfying answer lies at the heart of a currently popular framework for analyzing business cycle fluctuations.

This framework assumes that the macroeconomy usually obeys simple behavioral relationships but is occasionally disrupted by large “shocks,” which force it temporarily away from these relationships and into recession. The behavioral relationships then guide the orderly recovery of the economy back to full employment, where the economy remains until another significant shock upsets it.

Attributing fluctuations to shocks—movements in important economic variables that occur for reasons we do not understand—means we can never predict recessions. Thus, a key goal of the conference was to try to identify economic causes of business cycles, rather than attributing cycles to “shocks.” The greater the proportion of fluctuations we can classify as the observable and explainable product of purposeful economic decisions, the better chance we have of understanding, predicting, and avoiding recessions.

Several themes emerged during the conference. One was the concept of “vulnerability.” It was especially prominent in discussions of the recent Asian crises and bears on the distinction between shocks and systematic economic behavior. Rudiger Dornbusch perhaps put it best in the following analogy. Consider the collapse of a building during an earthquake. While the proximate cause of the collapse was the earthquake, the underlying cause may better be attributed to poor construction techniques. Because of its structural defects, the building was going to collapse when the right “shock” came along. So it goes with financial and real economic collapses, Dornbusch and many others would argue.

While it will always be difficult to anticipate the particular event that precipitates a collapse, it is important to constantly assess the vulnerability of financial, product, and labor markets to potential shocks.

Macroeconomists and forecasters tend to focus primarily on the overall health of the economy as measured by aggregate demand or by the unemployment rate; they may be able to improve their economic models by incorporating vulnerability. Likewise, policymakers should be vigilant against vulnerability. To do so, they will need to develop new tools. In Asia, for example, policymakers should have had a better assessment of the ability of the financial system to absorb shocks to currency valuations.

Developing such an assessment would likely have been hampered, many conference participants pointed out, by the inability to obtain key data on the debt portfolios of financial institutions, the performance of bank loans, and the exposure of the country as a whole to exchange rate risk. Proposals abounded for more accessible banking data and new indexes of risk exposure. Although little agreement was reached on exactly what information would be most useful, most agreed that policymakers and investors need new and more timely measures to adequately assess the vulnerability of economies to severe disruptions.

BEYOND SHOCKS: WHAT CAUSES BUSINESS CYCLES? AN OVERVIEW 3

A second theme of the conference discussion was the role of systematic monetary policy in causing and preventing business cycles.

Many have blamed the bulk of recessions on monetary policy. But as pointed out by Peter Temin, Christina Romer, and Christopher Sims, in assigning blame, it is important first to distinguish the systematic response of monetary policy to existing conditions from policy regime shifts and exogenous policy shocks. To take a leading example, did the Fed cause the Great Depression by raising domestic interest rates to maintain the gold standard, or was the outflow of gold from the United States following Great Britain’s abandonment of the gold standard the cause, and the response of the Fed a “business as usual” response to that triggering event? Such questions are very difficult to answer, but a careful attempt to do so must be made if we are to understand the role of monetary policy in cycles.





Most participants agreed that the Fed played a significant role in causing many of the recessions of the past century, largely in the pursuit of its goal of long-run price stability. The degree to which monetary policy did or could moderate the effects of cyclical downturns was less clear. Many pointed to the apparent diminution of the amplitude of business cycles in the postwar period as evidence of the Fed’s ability to lessen the severity of contractions.

Interestingly, Sims’s more formal analysis of this question raised doubts that the systematic component of monetary policy either causes fluctuations or can offset them, at least through interest rate movements.

Using econometric substitution of modern interest rate policy back into the Great Depression era, Sims found that modern policy would have had little effect on employment or prices. While this finding met with a good deal of skepticism from participants, one skeptic who tried to prove Sims wrong— discussant Lawrence Christiano—reported that he could not. In any case, the suggestion that conventional interest rate policy is limited in its ability to offset major recessions is thought-provoking. Of course, the limitations of interest rate policy do not preclude alternative policies, such as deposit insurance and acting as lender of last resort in financial crises. These policies may be at least as important as interest rate policy.

A third conference theme was the importance of a deeper understanding of the contribution of changes in the efficiency and structure of production to business cycle fluctuations. Recently, some macroeconomists have advanced the idea that shocks to these supply-side or “real” factors cause many, if not most, of the ups and downs in the economy.

This idea contrasts sharply with the traditional macroeconomic notion that changes in aggregate demand cause most fluctuations, and the two views generate quite different policy implications.

Two real shocks were evaluated. One is a shock to the technological efficiency of firms’ production of goods and services. Technological changes are very positively correlated with output and business cycles, a 4 Jeffrey C. Fuhrer and Scott Schuh relationship that has led many observers to conclude that technology shocks cause fluctuations. Susanto Basu, however, demonstrates that more detailed and sophisticated estimates of technological change substantially reduce, if not completely eliminate, the correlation between technology shocks and the business cycle. He also shows how modern macroeconomic models, especially those that rely primarily on technology shocks, have difficulty fitting the data. Proponents of technologyoriented models were predictably skeptical of his results.

The second real shock is a change in the desired distribution or allocation of economic resources across firms, industries, and regions.

Restructuring involves the costly and time-consuming reallocation of factors of production, especially workers, between firms, industries, and regions through the processes of job creation and destruction. It also typically involves lower output, higher unemployment, and often even recessions. In fact, job reallocation and job destruction rise sharply during recessions, leading some to surmise that shocks to the process of reallocation itself may be responsible for recessions and should therefore be taken into consideration by macroeconomic models. Scott Schuh and Robert Triest discover strong correlations between job reallocation and the primary determinants of how jobs are allocated across firms and industries: prices, productivity, and investment. Correlations between these determinants and job reallocation suggest that it is not mysterious allocative shocks that cause business cycles, but significant changes in observable economic variables.

Together, the two studies of real shocks reaffirm the fact that the production and employment behavior of firms is subject to substantial variation over the business cycle, but they deepen doubts that the variation is due to real shocks. Instead, the correlations between output and simple measures of real shock reflect the failure of conventional analyses to incorporate a sufficiently detailed specification of production and market structure. As more and more of firms’ behavior is accounted for in macroeconomic models, less and less scope remains for real shocks to generate business cycles. However, much is still to be learned about business cycles from the behavior of factor utilization, investment, prices, productivity, and the like.

SUMMING UP BUSINESS CYCLES

ON Paul Samuelson’s opening address begins with the question “Is the business cycle dead?” While the macroeconomy appears to have stabilized over the past 50 years, perhaps owing to successful countercyclical macropolicy, Samuelson sees no evidence of a trend toward the elimination of business cycle fluctuations. He notes that after most periods of extended expansion, especially those accompanied by outstanding performance in asset markets, suggestions of a “new era” of recession-proof

BEYOND SHOCKS: WHAT CAUSES BUSINESS CYCLES? AN OVERVIEW 5

prosperity have arisen, and they have been received “with increasing credulity” as the expansion rolls on. Acknowledging this historical association between healthy economies and booming asset markets, Samuelson takes a more realistic view, stressing also the intertwined histories of business cycle downturns and bubbles and crashes in asset markets.

Samuelson cites Victor Zarnowitz’s recent observation that in the seven decades between 1870 and World War II, the United States suffered six major depressions. In the past 50 years, we have had no declines of comparable severity. Samuelson attributes this improved performance to changes in “policy ideology, away from laissez-faire and toward attempted countercyclical macropolicy.” But despite the gains in policy’s management of the economy, Samuelson sees no “convergence towards the disappearance of non-Pareto-optimal fluctuations. We are not on a path to Nirvana.” The scope for improved performance arising from better government policies appears marginal today.

So pronounced fluctuations in production, prices, and employment are here to stay, despite the best efforts of policymakers. But why? In the end, Samuelson argues, fluctuations are usually the product of two factors. First, on the upside, asset price bubbles will always be with us, because individuals have no incentives to eliminate “macromarket inefciency.” While we have made tremendous progress toward “microefficiency”—making individual financial markets more efficient through the widespread use of options and other derivatives, for example—little evidence can be found, either in economic history or in economic theory, that “macromarket inefficiency is trending toward extinction.” One can make money by correcting any apparent mispricing of a particular security, but one cannot make money attempting to correct apparent macro inefficiencies in the general level of stock market prices.

Economists and financial market participants simply have no theory that can predict when a bubble will end. As a result, an individual investor will be perfectly rational in participating in a bubble, as he will make money from the bubble so long as it continues, which could be indefinitely. As Samuelson puts it, “You don’t die of old age. You die of hardening of the arteries, of all the things which are actuarially...

associated with the process. But that’s not the way it is with macro inefficiency.” Bubbles go on until they stop, and no one has ever been able to predict when that will be.

Downturns can develop from the asset markets themselves, and they can develop quite quickly. Because asset prices are based on the “prudent ex ante expectations” of market participants, swings in market expectations can produce large and rapid swings in asset prices, causing massive revaluation of asset-holders’ wealth. This was in part the cause of the ongoing Asian crisis, according to Samuelson. Market participants reasonably reassessed the valuation of investments (and therefore currenJeffrey C. Fuhrer and Scott Schuh cies) in Asia and quickly altered the direction of capital flow, precipitating a currency and banking crisis there.



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