Friday, November 16, 2012

Real Business Cycle Theory: A Gag?

Imagine someone says to you, "I have developed a satisfactory explanation of why sunspots sometimes ebb and sometimes flow at various times."

"OK, that's great. And it is?"

"Well, see, I looked at ten variables. None of them explain the sunspot cycle."

"OK...."

"So what explains the sunspot cycle is residuals! The things that are left out of my model!"

I would hope you would dismiss this fellow as a jokester. His model has totally failed to predict sunspots, and what accounts for them is not in his model at all. But when I began reading up on real business cycle theory, I began encountering what seemed to me to be just this sort of explanation for "fluctuations." Surely, I thought, I must not have adequately understood RBC yet: could any serious scholar really advance such a notion? I needed to read more!

But as I did, I realized that other serious thinkers have pointed out just this ridiculous aspect of RBC. So then what explains the persistence of RBC theorizing? Simon Wren-Lewis explains:

"One explanation [for RBC's popularity] is ideological. The commonsense view of the business cycle, and the need to in some sense smooth this cycle, is that it involves a market failure that requires the intervention of a state institution in some form. If your ideological view is to deny market failure where possible, and therefore minimise a role for the state, then it is natural enough (although hardly scientific) to ignore inconvenient facts. For the record I think those on the left are as capable of ignoring inconvenient facts: however there is not a left wing equivalent of RBC theory which plays a central role in mainstream macroeconomics"

I think Wren-Lewis is a little inaccurate here: Austrians, after all, think there really is a cycle, and that policy should be changed to fix this problem, but generally have recommend more free marketness, not less. I suspect that the ideology that drives RBC theorizing is commitment to the status quo, and the continued domination of the financial industry over all of our lives.

2 comments:

  1. Hahaha. I want to do this on my econometrics paper and see what my professor thinks.

    It's the residuals!

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  2. Thanks for delving into this, Gene. I had problems with RBC when I first read about it, but I couldn't quite put my finger on it. Obviously, I had my own beliefs (egads!) and biases going into it, but you've really hit the nail on the head here.

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