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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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Dornbusch believes that recent financial crises in Asia, Russia, and Mexico differed from most preceding crises because they centered on capital markets rather than on the balance of payments. Both types of crises often are associated with currency crises as well, but the vulnerability or risk imposed on an economy by a capital market crisis is fundamentally different. He explains that financial systems experiencing a capital market crisis exhibit five characteristics: (1) borrowing short and lending long generates a mismatching of maturities between liabilities and assets; (2) borrowing in foreign currency units and lending in domestic currency units generates a mismatching of denominations; (3) borrowing to carry assets exposed to large fluctuations in price generates market risk; (4) high risk exposure throughout a country generates a national credit risk;

and (5) the central bank is weakened by gambling away foreign exchange reserves.

According to Dornbusch, the capital market crisis in Asia made the regional economy vulnerable, or at risk, to adverse external factors. And two such factors happened. First, “Japan went into the tank.” Just as the Japanese economy was starting to show signs of emerging from several years of sluggish growth, the Japanese government tightened fiscal policy and the economy slumped again. This time the weakened economy exposed underlying banking problems that exacerbated the situation so much that the Japanese economy eventually began to contract. Because Japan is the largest economy in the region and the leader in regional export and import markets, the Japanese slump put stress on the foreign trade structure of the entire region, which is characterized by extensive export and import linkages.

A second adverse factor was the sharp depreciation of the yen vis-a-vis the U.S. dollar, “leaving the dollar peggers high and dry.” Asian ` 16 Jeffrey C. Fuhrer and Scott Schuh economies that were dependent on robust exports to Japan but had pegged their currencies to the dollar suddenly found their exports priced too high, in yen terms. Export demand fell sharply among Asian trading partners, and almost overnight domestic economies throughout the region began experiencing severe contractions. Together these adverse external factors turned vulnerable economies into collapsing economies.

Thus, Dornbusch attributes the Asian economic downturn to a confluence of capital market vulnerability and adverse external factors.

Obstfeld also believes that the primary source of economic vulnerability in recent financial crises was capital markets, but he emphasizes shifts in expectations as the central factor driving the economic fluctuations. He notes that “exogenous fluctuations in capital flows have become a dominant business cycle shock” for developing countries in the modern era, and that similar financial crises were quite common prior to World War II.

Obstfeld describes two main types of crises— exchange rate (currency) crises, and national solvency crises—and explains that although they can occur separately, they often “interact in explosive ways.” The main linkage between them is self-fulfilling expectations. An economy with a weak and vulnerable capital market can avoid crisis so long as there is no expectation of one. But when expectations change, the desirable but tenuous equilibrium will give way abruptly to a crisis. A sudden new expectation of currency depreciation can start the process rolling, once speculators perceive the threat that public debt will be paid through inflation. He cites Indonesia as an example of this phenomenon.

In Persaud’s view, moral hazard and inadequate oversight were key factors in generating the underlying capital market vulnerability. “Moral hazard [induced by International Monetary Fund bailouts]... probably played a role in the exponential rise in foreign bank lending to Emerging Asia,” and “crony capitalism” may have further “impaired the proper allocation of resources.” Furthermore, Asia’s economic success was “unbalanced” in the sense that lending went toward overinvestment that was concentrated in a limited number of sectors. Inadequate supervision and unreliable information about this worsening capital situation allowed the rise in risky lending and overinvestment to go unchecked until it was too late.

Persaud also cites the weakened Japanese economy and depreciating yen as important factors, but he identifies the collapse of the Thai baht on July 2, 1997 as the “trigger” that set off the Asian crisis. The effect of this trigger was amplified as investors suddenly realized new or mispriced risks in the region and greatly reduced their “appetites for risk”; this led to widespread and simultaneous capital outflows from the region.

A key factor contributing to this capital flight, says Persaud, was the sudden discovery that domestic corporate investment positions were highly concentrated. When the crisis emerged, heavyweight investors in


the region discovered that their peers were also deeply vested in the same small number of collapsing Asian economies. Thus, these influential investors not only wanted to get out of Asia because of the inherent financial problems, they also wanted to get out first, because they knew that a massive capital outflow would dramatically reduce asset prices in the region.

The panelists generally agreed that unwise economic decisions had promoted an environment of vulnerability, and that Japan’s economic weakness and other events turned a precarious situation into turmoil.

However, their recommendations about how to respond to the current crisis, and how to prevent future crises, were notably different.

Dornbusch believes that the key to preventing future capital market crises is to control financial risk. He proposes using model-based valueat-risk ratings and disseminating “right thinking” within the international financial community regarding controlling and pricing such risk.

Controlling capital flows themselves, however, is not appropriate. He advocates International Monetary Fund (IMF) inspections of financial market conditions during country consultations, but he is doubtful the IMF will become sufficiently forward-looking and preemptive, because IMF member countries will resist such changes. For this reason, he particularly opposes an Asian IMF. Dornbusch advocates moving toward regional currencies like the euro. Regarding the appropriate response to current developments, Dornbusch is adamant that tight money policies are required to restore financial stability; debt restructuring can be negotiated later. Fiscal policy is not a viable tool because of the fiscal deterioration associated with the recent crises.

Obstfeld asserts that “policy must counteract the severe capitalaccount shocks by creating a new expectational climate” that will restore confidence in these economies. He sees no economic prescription for this change “short of infeasibly extensive official financial support from abroad.” In contrast to Dornbusch, Obstfeld concludes that fiscal expansion is the least risky policy prescription, particularly in Japan. Monetary expansion in Japan might also help, but it carries the risk of further yen devaluation and is insufficient until Japan resolves its banking problems.

He ends by warning that monetary tightening now by the Federal Reserve and the new European Central Bank to fight domestic inflation “would be an error of perhaps historic proportions.” Persaud highlights the need to develop policies that “work with financial markets and not against them.” He views many actual and proposed policies as counterproductive. Capital controls intended to curb outflows would implicitly curb much-needed inflows. Looking to the IMF for faster and more lucrative assistance is also unwise. He doubts that the IMF loans can keep pace with the magnitude of required private capital flows, and in any case further IMF assistance worsens the moral hazard problem.

18 Jeffrey C. Fuhrer and Scott Schuh Instead, Persaud wants an international financial system that permits countries access to an international pool of foreign exchange reserves if—and only if—they meet certain “selectivity criteria” intended to reflect sound and prudent financial operations. The criteria, which must be “public, clear, and transparent,” would consider the extent of external debt, the productivity of capital inflows, the competitiveness of exchange rates, the soundness of government finances, and the openness of governance. Countries or financial institutions that do not meet these criteria should be allowed to fail. Indeed, Persaud believes that selective assistance is a critical requirement for eliminating moral hazard.


Susanto Basu tackles another of the most contentious questions among modern macroeconomists: Do fluctuations in technological change or productivity growth actually cause business cycle fluctuations?

Some prominent neoclassical macroeconomists assert not only that the answer is yes, but that technology change is the primary determinant of such fluctuations. This assertion is contested by macroeconomists like Basu who adhere to the Keynesian tradition of emphasizing fluctuations in aggregate demand as the primary contributor to business cycles.

Because these two views of the sources of business cycles lead to radically different macroeconomic models and prescriptions for government policy, resolution of this debate is critical.

Basu argues that neoclassical economists have misinterpreted the link between technological change and business cycles by misusing the standard measure of technological change: the Solow residual, named

after M.I.T. economist Robert Solow. Solow’s methodology is simple:

measure the growth of output; subtract the appropriately weighted growth of all observable inputs such as labor, capital, and materials; and the difference, or residual, is an estimate of unobserved technological change. Economists use this sensible but indirect measure because they do not have direct data measures of technological change.

Thus far, most attempts to construct Solow residuals with conventional data on inputs yield a measure that is positively correlated with output, giving rise to the claim that technological changes cause business cycles. But Basu argues the Solow residual was only intended to estimate the long-run impact of technology on the economy, not the cyclical impact. He notes that Solow warned long ago that his measure would be spuriously correlated with output and the business cycle because firms adjust to fluctuations in demand by varying the rates at which they utilize capital and labor.

Basu has developed a new measure of technological change that adjusts for features that could lead to an excessively positive correlation


between technological change and output. Basu’s methodology, developed in earlier research with John Fernald and Miles Kimball (henceforth the BFK technology measure), adjusts for four factors: (1) variable utilization of capital and labor; (2) variable worker effort; (3) imperfect competition and other special advantages firms may have in production;

and (4) different characteristics of firms across industries. In other words, it adjusts for many of the demand-side features Solow was concerned about. The BFK methodology requires relatively few controversial restrictions or assumptions; indeed, previous measures of technological change are special cases of it.

The salient and distinguishing feature of the new BFK technology measure is that it is essentially uncorrelated with output and the business cycle. Unlike the Solow residual, which is positively correlated with output and the business cycle, it exhibits no simple statistical evidence of causing business cycle fluctuations. Moreover, the BFK measure is much less variable than the Solow residual. Together, these features reduce, if not eliminate, the likelihood that unexpected technological changes cause business cycles. Basu shows that this conclusion holds up in simple statistical models of the production process.

Another potentially important characteristic exhibited by the BFK technology measure is that it suggests what all workers fear: that technological improvements reduce employment. At least initially, the BFK measure is very negatively correlated with factor inputs, such as labor and factor utilization. In other words, when firms improve their technical efficiency by installing the latest and greatest machines, they are able to produce the same output with fewer inputs, so they reduce costs by cutting their work force rather than reducing their prices and producing more. Only much later, as profits rise, do they expand their output and hire workers. This interpretation of the data stands in stark contrast to interpretations based on the conventional Solow residual, in which employment and other factor inputs rise with technological improvements.

In the second part of his investigation, Basu uses his technology measure to evaluate whether the dynamic properties of two state-of-theart macroeconomic models match the postwar data. One is the real business cycle (RBC) model, which features technological change as the main source of business cycle fluctuations. It also assumes complete, competitive markets with fully adjustable prices. The other model is basically similar but introduces slowly adjusting or “sticky” prices. Sticky prices are a common feature of macroeconomic models that emphasize fluctuations in aggregate demand as the main source of business cycles.

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