The Business Cycle: Theories and Evidence
The Business Cycle: Theories and Evidence
The Business Cycle: Theories and Evidence
edited by
Michael T. 8elongia
Federal Reserve 8ank of St. Louis
and
Michelle R. Garfinkel
Universityof California at Irvine
"
~.
Preface xi
Acknowledgments xxi
SESSION I
1
What Is a Business Cycle? 3
Victor Zarnowitz
SESSION II 119
3
For a Return to Pragmatism 121
Olivier Jean Blanchard
v
vi CONTENTS
4
The Cowles Commission Approach, Real Business Cycle Theories,
and New-Keynesian Economics 133
RayC. Fair
5
How Does It Matter? 161
Benjamin M. Friedman
Vll
President's Message
Asking what we know about business cycles seems, in one sense, a curious
topic for a conference of professional economists. After all, it is not as
though the cycle is a new phenomenon. From the less well documented ups
and downs of the colonial economy through the various booms and busts of
the 1800s, the turbulent decade of the 1920s, and the nine complete cycles
of the postwar period, the U.S. economy has had ample experience with
sustained economic expansion followed by periods of decline. The sum
total of this experience, however, has produced few firm conclusions about
the "whys" or "hows" ofthe business cycle.
To get a little perspective on the issue, I looked back to those days of
the New Frontier when Walter Heller and Co. sat down "to the levers of
control" as a Time magazine cover story described it. The first impression
to catch my eye was the seeming harmony within the economics profession.
Time asserted that "by broadening the areas of fact, the professionalization
[of economics] has narrowed the areas of theory, of disagreement, and
blurred old boundaries between liberals and conservatives." Indeed, the
accepted wisdom of the day seemed to be that the cycle, though a bit of
an annoyance, could be dealt with by the enlightened application of the
appropriate mix of tax and budget policies. This state of affairs is in sharp
contrast to the factional disputes that have dominated at least the last
decade.
This confidence was based, again according to the Time story, not on
the insights of Keynes's General Theory but on Wesley Clair Mitchell's
Business Cycles. This book, labeled as "the most important of all U.S.
contributions to economics," and Mitchell's call for "a body of statistical
information on how the economy actually behaves under the impact of
various policies" were cited as key to transforming economics from "the
IX
x PRESIDENT'S MESSAGE
Thomas C. Melzer
President
Federal Reserve Bank of St. Louis
Preface
Xl
xu PREFACE
task from several perspectives, Zarnowitz argues that the business cycle is
"pervasive." Although business cycles historically have differed in their
duration and intensity, they are all generally characterized by a decline and
contraction and a subsequent rise and expansion of aggregate economic
activity, as measured by total employment, output, real income, and real
expenditures. National in scope and typically lasting several years, business
cycles manifest themselves in the co-movements of and interactions among
many economic variables. Not all variables are perfectly synchronized,
however. Some lead and others follow the cycle. In addition, while most
economic variables are procyclical, they do not generally move with the
cycle to the same degree; other variables are countercyclical.
Zarnowitz also finds that the characteristics of business cycles have
changed over time and differ across nations. For example, Zarnowitz finds
that, in the United States, postwar cycles have become milder: Business
contractions have become shorter and less severe, and business expansions
have become longer relative to the cycles experienced before the 1930s. As
possible reasons for this observed change, Zarnowitz suggests "the shift of
employment to production of services, automatic stabilizers, some financial
reforms and avoidance of crises, greater weight and some successes of
government actions and policies, and higher levels of public confidence."
He also finds that the postwar recessions in France, Italy, West Germany,
and Japan were even milder and attributes this difference to the relative
strength of their economic growth.
Thus, in trying to explain cycles, we must be guided not only by the
features common to all business cycles but also by their diversity and
evolution. By limiting the focus to features shared by all cycles, economic
analyses potentially fail to gain a comprehensive understanding of aggre-
gate economic tluctutations. The processes by which shocks affect eco-
nomic activity can depend on a nation's institutions and stage of economic
development and thus could be changing also.
James Stock, in his comments on this chapter, commends Zarnowitz for
his useful and thorough overview of the business cycle, including his ana-
lysis of international business cycles. In his discussion, Stock focuses on
only two main points. First, by drawing on recent research, he argues that
Zarnowitz's evidence of the shortening of postwar recessions and lengthen-
ing of postwar expansions might be "biased" by the National Bureau of
Research's (NBER) dating chronology, which is based on different time
series depending on the historical period: "The prewar dating relied on
series with more cycles, longer contractions, and shorter expansions than
the series used for the postwar dating." Stock notes that, alternatively,
the differences in the series used might accurately capture fundamental
PREFACE xiii
theorists empirically. Zellner points out, for example, that the actual struc-
ture of the economy is subject to much uncertainty. In addition, the
estimated coefficients obtained from the Cowles Commission approach
are not constant over time. Moreover, they are likely to change not only
because of changes in policy, but also because of adaptive optimization
by economic agents responding to large aggregate shocks. Zellner also
expresses concern about the problems of aggregation, regime changes,
measurement errors, and seasonal adjustments in the data.
He suggests, as an alternative to the Cowles Commission approach and
fixed-parameter models, what he has dubbed the "structural econometric
modeling, time series analysis" (SEMTSA) approach. With this approach,
the researcher posits a tentative structural model based on theory and, from
that model, derives "transfer" functions. In going back and forth between
the structural formulation of the model and the transfer functions in
estimation, the researcher ensures compatibility, thoroughly tests the
structural model's components, and compiles them in a reasonable way
to formulate a model. The result is a final model that can be tested further.
Zellner believes that the SEMTSA approach might be quite successful in
producing an empirical model that can explain the essential characteristics
of business cycles and predict future outcomes with satisfactory precision.
Most economists would agree with the notion that understanding the
causes and mechanisms of business cycles is necessary in making informed
policy decisions. The issue receiving considerable attention in recent policy
debates, however, is more fundamental-namely, whether macroeconomic
policy could possibly enhance social welfare. Without sufficient empirical
evidence to resolve the debate among competing camps of different
normative (as well as positive) prior beliefs, one naturally wonders whether
macroeconomics has anything to offer policy makers in the way of useful
advice.
In "How Does It Matter?" Benjamin Friedman expresses his doubt that
recent research on business cycles can be of much help to policy makers.
His doubt is not driven by the lack of consensus among economists, however.
Indeed, he argues that the principal distinction between new-Keynesian
economics and real business cycle theories has less relevance for policy
than is commonly thought. That is to say, whether the sources of business
cycles originate on the demand side or the supply side of the economy
might not matter in deciding whether a policy response would be welfare-
improving. The reason is that exogenous shocks to the supply side typically
xviii PREFACE
Where Do We Stand?
With so many unsettled issues in the study of business cycles, it might
appear that the foundation on which future research should build is weak.
That there is much room for further progress is hardly arguable. In the
panel discussion closing this conference the participants offered their views
PREFACE xix
on where we now stand and what areas of inquiry would likely prove most
fruitful in future research.
Alan Blinder, in "Deja Vu All Over Again," expresses much agreement
with Laidler, Fair, and especially Blanchard in arguing that macro-
economic research since 1972 has made little progress in resolving the
controversial issues about how the economy works. In addition, Blinder
emphasizes, the "fact that such issues remain so controversial for so long
is a condemnation of our profession." Although he is not inclined to
condemn the new-Keynesians for the "nonempirical flavor" of their
research, Blinder does question the real business cycle models for their
lack of empirical basis. After reviewing the historical development of
macroeconomic models, starting with the early Keynesians, he offers a
"new, post-RBC consensus," which is hardly distinguishable from that
reached in 1972 with the resolution of the positive issues of concern in the
Keynesian-monetarist debate. The primary differences include the recog-
nition of the importance of supply shocks and the general acceptance of
rational expectations by macroeconomists. Blinder argues, in agreement
with Fair and Laidler, that macroeconomists should return to empirical
work, "the task that was so unfortunately abandoned in 1972."
In "Business Cycle Developments and the Agenda for Business Cycle
Research," Herschel Grossman discusses how the evolution of research in
this area was influenced by historical business cycle developments. These
developments, in turn, suggest where it should go in the future. Before the
mid-1970s, business cycle research centered on understanding the determi-
nation of nominal aggregate demand, its relation to real aggregate demand,
and policies to stabilize nominal aggregate demand. The first development
that influenced the direction of research, in Grossman's mind, was the oil
price shock of 1973, which suggested that a possibly important source of
economic fluctuations could be exogenous changes in resource endow-
ments. He interprets the U.S. recessions of 1974-1975 and 1981-1982,
as well as the recession of 1991, with their uneven regional and sectoral
effects, as suggesting that research also should examine the determina-
tion of economic activity on regional and sectoral levels. In addition, exper-
ience in recent years suggests that the Federal Reserve System is able and
willing to stabilize nominal aggregate demand without attempting to go
beyond the nation's resource constraints. Grossman points out, neverthe-
less, that there is little to ensure that the Fed will continue to "give priority
to this objective" indefinitely, for neither the preferences of our policy
makers nor the institutions that constrain their choices have changed.
Thus, he emphasizes, the events of the past two decades suggest that
research efforts should be directed not only toward the implications of
xx PREFACE
aggregate supply shocks and the cyclical aspects of economic activity from
a regional and sectoral perspective, but also toward enhancing our "under-
standing of the political-economic structure underlying monetary and fiscal
policy."
Michael Parkin, in "Where Do We Stand?" offers a characterization of
the current debate quite different from that of Blanchard, suggesting that
the current path of macroeconomic research might not be just a dead
end. Parkin argues that the criticism against the new-classical research
program-that it merely aims to "build beautiful models"-is not well
founded. The research program currently being pursued by young macro-
economists aims to resolve economic puzzles by building models, with
the ultimate goal of sUbjecting the models to empirical verification. In his
view, the important distinctions between the new-Keynesians and the
new-classical economists do not concern with methodology and ideology.
Rather, they are "based on views about which abstractions might turn
out to be useful and which might not." The new-classical economists
emphasize intertemporal substitution to explain economic fluctuations.
new-Keynesians, while accepting the importance of intertemporal sub-
stitution, emphasize problems of coordination and rigidities to explain
economic fluctuations. But the new-classical economists do not deny the
existence of these problems, and their modeling strategy does not preclude
the incorporation of these features of the economy. Parkin suggests,
in addition, that the empirical evidence offered by the new-classical
economists should not be dismissed because of its lack of conformity with
traditional empirical analyses, for that evidence is consistent with the view
that "policy is a process, not an event." But, without a feasible commit-
ment technology, this process is a discretionary one. Thus, Parkin believes
that macroeconomists in the future should study alternative institutional
arrangements to determine which would best stabilize the economy.
Over all, these proceedings offer many reasons for macroeconomists to
feel humble about their work. At the same time, they contain a great deal
of constructive criticism about which avenues of future research are most
likely to produce useful results. Macroeconomists from all schools of
thought should find plenty of stimulus in this volume for their own research
agendas.
Note
1. It should be noted that Blanchard's chapter in this volume differs considerably from the
paper he presented at the conference. This earlier paper, entitled "The New Classicals and
the New Keynesians: The Long Pause" included comments on a variety of topics omitted in
the published version. We regret that, due to time constraints, not all of conference par·
ticipants were able to incorporate these changes in their own contributions to this volume.
Acknowledgments
XXI
SESSION I
1 WHAT IS A BUSINESS CYCLE?
Victor Zarnowitz
Sober men, whose projects have been disproportioned to their capitals, are
as likely to have neither wherewithal to buy money, nor credit to borrow it,
as prodigals whose expence has been disproportioned to their revenue.
Before their projects can be brought to bear, their stock is gone, and their
credit with it. ... When the profits of trade happen to be greater than ordi-
nary, overtrading becomes a general error both among great and small
dealers.
-Adam Smith (1776, p. 406)
When prices fall, production is arrested until the expences of production fall
in equal degree; and whilst production is thus arrested, consumption is
also diminished . .. the inducements to employ labour . .. are diminished
... and the prices of labour fall. The consumption of labour is thus dimin-
ished., and the prices of property again fall, and again act in depressing
labour, and in crippling production. ... It is the deficiency of money
which has occasioned the depression ofprices. ...
-Thomas Attwood (1817, pp. 99, 101)
3
4 THE BUSINESS CYCLE
But though men have the power to purchase they may not choose to use it.
For when confidence has been shaken by failures, capital cannot be got to
start new companies or extend old ones. ... In short there is little occu-
pation in any of the trades which make Fixed capital. ... Other trades,
finding a poor market for their goods, produce less; they earn less, and
therefore they buy less. ... Thus commercial disorganization spreads. ...
The chief cause of the evil is a want of confidence.
-Alfred and Mary Marshall (1881, pp. 154-155)
Well before the concept of a business (or trade) cycle originated, serious
episodes of commercial and financial instability were observed repeatedly
by contemporaries. The preceding quotations, from Adam Smith (1776) to
Alfred Marshall (1881), illustrate the reactions of some of the classical
economists and politicians in England. Smith's brief mention of "over-
trading" is the only one in The Wealth of Nations'! Attwood, a banker
and politician, blamed reductions in the money supply under the gold stan-
dard for the resulting deflation and interacting declines in spending and
incomes (see Link, 1958, pp. 6-35; Backhouse, 1988, pp. 134-34). The
"famous words" of Lord Overstone, who may have been the first to write
about a multistage "cycle of trade," were cited with approval by Marshall a
quarter-century later. Marshall's stress of the confidence factor recalls not
only Pigou of 1929 but also Keynes of 1936 (Marshall and Marshall, 1881).
There is much in these and other early theories of crises and cycles that
deserves to be rediscovered and reconsidered today.2
Because of the predominance of classical tradition, problems of long-
term equilibrium constituted the principal concern of the prominent
theorists in the nineteenth century, and short-term business cycle problems
were at best a secondary interest. Yet throughout that century, from
Sismondi and Malthus to Marx and Hobson, intense controversies
prevailed about the validity of Say's law, that supply creates its own
demand, and about the possibility of a "general glut" (Sowell, 1972). There
WHAT IS A BUSINESS CYCLE? 5
can be little doubt that this controversy was so great because of the pres-
sure of events: the need to account for the recurrent "crises." the related
decreases in sales and profits. and the increases in unemployment.
A study of monetary statistics for France and England (since 1800) and
the United States (since 1836) led Juglar (1889) to believe that crises are
merely stages in recurrent business cycles. Although the title of his work
refers to the "periodic return" of the crises. the durations of his cycles vary
considerably.3 According to Juglar. cycles are principally a feature of eco-
nomies with highly developed commerce and industry. division of labor.
external trade, and the use of credit. This idea was accepted and developed
further by most of the leading scholars in the field.
The association of business cycles with modem capitalism is reflected in
the National Bureau of Economic Research (NBER) reference chrono-
logies. which begin (for annual dates of peaks and troughs) in 1792.1834.
1840, 1866 for Great Britain, the United States. France, and Germany,
respectively.4 There is substantial agreement that wars, poor harvests, and
other episodic disturbances played a greater relative role in the preindustri-
alization era than afterward, and the endogenous cyclical influences a
smaller role. The main reason, presumably, is the pronounced cyclicality of
investment in "fixed" capital-plant, machinery, and equipment. It was
only after the great technological innovations of the latter part of the eight-
eenth century were adopted that the size of such investment, and its share
in output, began to increase rapidly, in England, then in Western Europe
and in the United States. In earlier times, processing of raw materials by
labor must have represented a much larger part of total production. It is
likely, therefore, that fluctuations of trade and inventory investment
accounted for most of the overall economic instability prior to the Indus-
trial Revolution. But these movements tend to be shorter in duration and
more random in nature than the fluctuations related to investment in busi-
ness plant and equipment.5
Differences of opinion still persist on when modem business cycles came
into being. Schumpeter (1939. vol. 1, chap. 6B) argues that capitalism goes
"as far back as the element of credit creation" and that "there must have
been also prosperities and depressions of the cyclical type" in the seven-
teenth and eighteenth centuries. 6 Indeed. there is a modest amount of
evidence on how harvests, grain prices, exports, imports, and sales and
profits of a small sample of enterprises changed from year to year in Great
Britain between 1720 and 1800. Four economic historians compiled chrono-
logies of commercial crises for this period that show a fair amount of con-
sensus. There may have been six or eight major contractions of credit and
several more downturns of profit. 7 The problem is not with the existence
6 THE BUSINESS CYCLE
of some substantial fluctuations but with their nature. How comparable are
they with the later business cycles? Unfortunately, there is no conclusive
answer because of severe limitations in the available data.
1.3 Economists'Definitions
Mitchell, "The problem of how business cycles come about is ... insepar-
able from the problem of how a capitalist economy functions." They were
"not content to focus analysis on the fluctuations of one or two great
variables, such as production or employment" but "sought to interpret the
system of business as a whole ... to penetrate the facade of business
aggregates and trace the detailed processes-psychological, institutional,
and technological-by which they are fashioned and linked together.,,13
Similarly, Schumpeter's opening statement in his 1939 treatise that
"analyzing business cycles means neither more nor less than analyzing the
economic process of the capitalist era" conveys the sense of a most inclus-
ive conception. Although "economic fluctuations properly so called [are]
those economic changes which are inherent in the working of the economic
organism itself," the effects of "external factors" or disturbances are also
numerous and important; indeed in many instances they "entirely over-
shadow everything else" (1939, voL 1, pp. 7, 12). But Schumpeter has no
single definition of a business cycle. Rather, his "really relevant case" is
that of interaction of "many simultaneous waves" (p. 212). The scheme
involves 3-4, 7-10, and 48-60 year cycles (named after their investigators
Kitchin, Juglar, and Kondratieff, respectively; see chap. 5). But there is
little support from the data for periodicities in the occurrence of groups of
major and minor cycles, although it is certainly true that individual cycles
vary greatly in amplitude, duration, and diffusion (Burns and Mitchell,
1946, chap. 11; Zarnowitz and Moore, 1986, pp. 522-523).
relation between the value and the cost of capital goods, and Fisher's
(1907) concept of the "rate of return over cost." But Keynes adds the ex
ante discrepancies between investment and saving, the multiplier, and the
cycle-induced changes in the liquidity preference and the propensity to
consume. He stresses the instability of investment due to sharp fluctuations
in business confidence under uncertainty about long-run returns.
Keynes' leading role in the development of the macroeconomics of
income determination is beyond doubt, but his analysis of business cycles
was quite fragmentary and his influence on the subsequent work in this
area proved rather limited.1 4 Formal models of dynamic disequilibrium
based mainly on an interaction of the investment accelerator and the
consumption multiplier enjoyed considerable popUlarity between the late
1930s and the early 1950s (Samuelson, 1939; Metzler, 1941; Hicks, 1950).15
But it soon became apparent that these models are limited to a mechanical
treatment of relations between a few aggregates and neglect potentially
important factors of prices, money, finance, and expectations. A more last-
ing impact is attributable to the general idea that random shocks and
changes in exogenous factors provide impulses that are propagated into
cyclical movements by the dynamics of the interdependent market econ-
omy. This conception had some earlier origins but was first formalized by
Frisch (1933).
Starting in the 1930s, econometric models came into use as vehicles
for testing business cycle theories (Tinbergen, 1939). Their early postwar
versions were heavily influenced by the Frisch impUlse-propagation model
and the Keynesian I-S model of Hicks (1937). The development of macro-
econometric models depended critically on the growth of modern statistics,
and particularly the system of national income accounts.
Hansen (1964, p. 4) defines the business cycle as "a fluctuation in (1)
employment, (2) output, and (3) prices." Although he refers to Mitchell's
1927 definition, he is content to use only the aggregative measures of
output and employment, plus the indexes of consumer and wholesale
prices. More recent studies tend to restrict the criteria further to measures
of real income and output, dropping the comprehensive price indexes
because of their continued rise during the business contraction of the past
30 to 40 years. Other measures, such as those of the diffusion of cyclical
movements, attract little attention. However, the dates of business cycle
peaks and troughs as identified by the NBER continue to be generally
accepted.
Views on the nature and scope of business cycles remain disparate. The
once prevalent theories of endogenous or self-sustaining cycles have been in
retreat for some time, though surviving in various nonlinear macrodynamic
WHAT IS A BUSINESS CYCLE? 13
The preceding sections have shown that the documented history of busi-
ness cycles goes back at least two hundred years. The popular awareness of
recurrent crises and alternations of prosperous and depressed times is
reflected in similarly long records. Serious thought about the nature and
causes of major economic fluctuations accompanied serious thought about
the nature and causes of industrial development and economic growth
since the early writings on political economy.
If this is so, should it then not be clear by now what a business cycle is?
Why the need to raise this question time and again? The reason is that
business cycles are changing as well as complex. A process that repeats
itself with substantial regularity over long periods of time will not withhold
its secrets from inquiring minds over many decades of intensive study, even
if it were quite complicated. But business cycles involve many interacting
processes (economic, political, and broadly social) whose roles vary and
evolve. They are most probably caused in part by uncontrollable outside
disturbances and in part by errors of public policy and private decision
makers that may be avoidable, but they are also, just as plausibly, to a large
extent self-sustained and self-evolving. They are certainly not the same at
all times and in all developed market economies, although they show a
great deal of international interdependence.
To improve our understanding of business cycles, it is necessary to learn
from their past as well as present and to study both their common features
and diversity, continuity and change. In what follows, I shall consider the
main lessons from the chronologies of business cycles in the United States
and abroad and from research on the indicators and measures of cyclical
and related processes. The discussion will include examples of stable and
changing behavior and of some international similarities and differences.
studies and Thorp's annals, are available for the United States and Great
Britain between 1790 and 1858. Monthly (as well as quarterly and annual)
reference chronologies from the same source cover the United States and
Britain for 1854-1938, France for 1865-1938, and Germany for 1879-
1932. Table 1-1 sums up the record of durations of business expansions,
contractions, and full cycles as derived from these dates. Part A lists the
means and standard deviations for the overall periods covered and
consecutive segments of 3-6 (mostly 4 and 5) cycles each. Part B lists the
shortest (S) and the longest (L) durations over the same periods and some-
what fewer successive subperiods.
It is clear that the durations have varied greatly, as shown by the huge
S-L ranges in part B. For example, the U.S. expansions ranged from 10
to 72 months, contractions from 8 to 72 months, and full cycles from 24
to 108 months (trough-to-trough) or 17 to 101 months (peak-to-peak). The
results for the other countries are very similar: slightly larger S-L differ-
ences still for the British cycles, slightly smaller for the shorter histories of
the French and German cycles.
These are comparisons between outliers, however, that can greatly
overstate the more common differences between the duration measures.
Indeed, U.S. business expansions in peacetime averaged 22-26 months in
each of the four segments of 1854-1938 and 25 months in the period as
a whole}6 Remarkably, the corresponding contractions were not much
shorter, averaging 19-20 months in three segments, 27 months in one, and
21 months over the total 1854-1938 period. Expansions varied relatively
much less than contractions, as shown by the standard deviations attached
to these averages. For full cycles, most of the mean durations are close to
four years, with overall standard deviations of 18-20 months. These stat-
istics disclose no systematic changes in phase and cycle durations. They
surely justify the phrase "recurrent but not periodic" in the NBER
definition. Still, the central tendency of the duration figures suggests a
modest degree of regularity. Thus, 15 of the 19 peacetime expansions of
1854-1938 (79%) fall into the range of 1~ to 21h. years, and the same
proportion applies to contractions in the range of 1 to 2 years.
The cycles in the other countries show more variability in durations both
across and within subperiods. The U.S. cycles tended to be more numerous
and shorterP They numbered 21 in 1854-1938, averaging 4 years, while
the British cycles numbered 16 and averaged 5 % years. For the longest
common period, 1879-1938, the comparison is shown in the following
table. Figure 1-1 compares the timing of business cycle peaks and troughs
in the four countries by means of a schematic diagram. It suggests a fairly
high degree of correspondence between the chronologies. Of the total of
Table 1-1. Durations of Business Expansions and Contractions in Four Countries, Selected Periods Between
1790 and 1938
A. Phase and Cycle Durations, in Months: Means and Standard Deviations (S.D.)
Tto T PtoP Mean S.D. Mean S.D. Mean S.D. Mean S.D.
Line (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
United States
Excluding Civil War & WWI
1 1854-1879 (4) 1857-1882(4) 26 7 27 26 53 31 61 27
2 1879-1897 (5) 1882-1899 (5) 25 7 19 11 44 17 41 11
3 1897-1915 (5) 1899-1913 (4) 22 8 20 5 42 4 40 11
4 1919-1938 (5) 1918-1937 (5) 26 15 20 13 46 16 45 29
5 1854-1938 (19) 1857-1937 (18) 25 9 21 14 46 18 46 21
All cycles d
6 1854-1938 (21) 1857-1937 (20) 26 11 22 14 48 18 48 20
7 1790-1938 (35) 1790-1938 (33) 28 14 23 16 50 24 50 20
Great Britain
Excluding WWI
8 1854-1879 (5) 1857-1882 (5) 40 9 36 28 76 37 79 32
9 1879-1914 (5) 1882-1912 (5) 43 17 25 16 68 26 67 36
10 1919-1938 (5) 1918-1937 (5) 26 24 20 10 47 21 45 33
11 1854-1938 (15) 1857 -1937 (15) 36 18 27 19 63 29 64 34
All cyclesd
12 1854-1938 (16) 1857 -1937 (15) 37 18 26 19 63 29 64 33
13 1790-1938 (29) 1796-1937 (28) 39 18 22 16 60 24 62 28
France
Excluding WWl
14 1865-1887 (5) 1867-1881 (5) 22 3 30 23 52 25 56 31
15 1887-1914 (5) 1881-1913 (4) 39 21 26 14 65 28 67 32
16 1919-1938 (6) 1920-1937 (6) 24 11 15 8 39 14 38 10
17 1865-1938 (16) 1867-1937 (15) 28 15 23 17 51 24 52 26
All cycles
18 1865-1938 (17) 1867-1937 (16) 29 15 22 16 51 23 52 25
Germany
Excluding WWl
19 1879-1914 (6) 1882-1913 (5) 39 16 32 21 71 26 75 34
20 1919-1932 (3) 1918-1929 (3) 29 12 23 15 53 25 43 8
21 1879-1932 (9) 1882-1929 (8) 36 15 29 18 65 26 63 31
All cycles
22 1879-1932 (10) 1882-1929 (9) 37 14 27 18 64 24 63 29
Table 1-1. (Continued)
United States
23 1790-1855 14 13 12 72 12 72 24 108 24 84
24 1854-1899 10 10 18 461 8 65 30 99 30 101
25 1899-1938 11 10 10 50 71 43 28 64 17 93
Great Britain
26 1792-1858 14 14 24 72 12 36 36 84 36 108
27 1854-1900 6 6 30 64 6 81 39 135 36 123
28 1900-1938 10 9 8 61 61 37 26 79 17 98
France
29 1865-1895 6 5 19 41 11 68 34 95 33 109
30 1900-1938 11 11 8 52 8 30 24 92 24 110
Germany
31 1879-1904 4 3 17 61 18 61 35 102 41 122
32 1904-1932 6 6 16 52 12 40 28 77 34 69
Source: National Bureau of Economic Research. For details, see Moore and Zamowitz (1986, tables A.2 and A.3).
aThe years are those of the initial and terminal business cycle troughs (T) in column 1, and those of the initial and terminal business cycle
peaks (P) in column 2, according to the NBER monthly chronology. The numbers in parentheses refer to complete T to T or P to P cycles in
the given period. The entries in columns 7 and 8 correspond to the dates in column 1; the entries in columns 9 and 10 correspond to the dates
in column 2. The wartime cycles consist of expansions during the Civil War (for the United States) and World War I (WWI) for all four
countries, and of the immediately following contractions (for the T to T cycles) or the immediately preceding contractions (for the P to P
cycles).
b Measured from troughs (T) to peaks (P).
C Measured from peaks (P) to troughs (T).
d The reference cycle chronologies contain annual segments for the United States, 1790-1855, and Great Britain, 1792-1858. In Part A,
lines 7 and 13, observations based on these dates but converted from annual to monthly durations are combined with the observations based
on the monthly reference chronologies that begin in 1854 for both the United States and Great Britain.
e Years refer to the earliest and latest reference dates in each segment. Entries in lines 23 and 26, columns 4-10, are converted from
annual to monthly durations (see note d).
f Refers to a wartime cycle.
20 THE BUSINESS CYCLE
Figure 1-1. Timing of reference cycles for four countries and matched turning
pOints, 1854-1938
Note: For each country, the lines connect the dates of business cycle peaks (upper turning
points) and troughs (lower turning points). Thus, the upward-sloping segments of each country
line represent expansions, the downward-sloping segments, contractions. The dashed links
between the country lines connect the matched peaks or troughs for two or more countries.
The sign x denotes an unmatched tum. For France before 1865 and for Germany before 1879,
the reference dates are annual. They are plotted at the midpoint of the given calendar year
and connected with dashed and dotted lines. All other reference dates are monthly and
are connected with solid lines. Question mark (?) denotes a dubious turning point (see text).
Sources: German annual turning points 1855-1963 estimated from Hoffman by Rostow
(1980, pp. 38-39). All other dates are from Bums and Mitchell (1946, pp. 78-79).
146 turning points shown, 92 (63%) match for all four countries and
another 36 (25% ) for three countries. Four turning points can be matched
for two countries, and only 14 (10%) are unmatched. Practically the same
proportions apply to peaks and troughs taken separately.
United States Great Britain France Germany
Number of cycles (T to T) 17 13 14 10
Mean duration (months) 48 65 53 64
Standard deviation (months) 18 31 25 24
WHAT IS A BUSINESS CYCLE? 21
When examined more closely, figure 1-1 shows that during the first
quarter-century covered, French and German cycles diverged consider-
ably, probably in part because of annual dating. The U.S. cycles conformed
better to the British and German than to the French cycles. In the period
1879-1914-the heyday of the pre-World War I gold standard-the
conformity between the business cycles in the European countries was
particularly close, but the U.S. economy followed a different pattern
of shorter and more frequent fluctuations. The timing of the wartime
expansions (1914-1918) and contractions (1918-1919) was very similar in
all four countries. In the 1920s and 1930s the European economies were
much less in phase with each other than in the preceding 40 years, but the
degree of conformity between their cycles and those in the United States
increased (see Morgenstern, 1959, chap. 2).1 8
This does not mean, however, that all the identified cycles (let alone
their precise dates) are equally well confirmed. A few episodes are doubt-
fuI. They include four NBER contractions: 1845-1846,1869-1870,1887-
1888, and 1899-1900, of which the first one is most uncertain. (The peaks
and troughs of the last three are denoted by a question mark (?) in figure
1-1.) The information on hand seems to me insufficient to make a con-
clusive determination of whether these were periods of actual declines
or retardations below average growth. There are some problems with a few
other minor contractions as well, but they are easier to resolve (Zarnowitz,
1981).
If these episodes were treated as slowdowns instead of contractions,
the average durations of expansion (£) would be considerably increased,
both absolutely and relative to those of contractions (C). The following
tabulations shows this for the two periods principally affected. 19
1834-1855 1854-1919
Number of cycles (T to T) 5 4 16 13
Expansion, months (E) 26 36 27 37
Contraction, months (C) 24 27 22 23
Ratio (Elt) 1.1 1.3 1.2 1.6
Some of the reference dates for the other countries may also be
questioned. Burns and Mitchell (1946, p. 113) mention explicitly the
German 1903-1905 contraction20 and France "after 1932." Consequently,
in figure 1-1, question marks denote these French and German contrac-
tions (as well as the three pairs of U.S. turning points already noted).
In addition, the authors of the NBER dating methodology warn that
"the chronology for France in the 1860s and 1870s requires careful con-
sideration." It is therefore possible that some of the several discrepancies
between the French and the other turning-point dates in this period are
spurious (but, for lack of more specific information, these dates are left
unquestioned in the diagram).
Figure 1-1 indicates that elimination of such dubious phases as U.S.
1887-1888 and France 1933-1935 would clearly improve the intercountry
correlation of cyclical movements. But in other cases the opposite effects
are suggested: Note U.S. 1899-190021 and Germany 1903-1905. Treating
the U.S. 1869-1870 period as a slowdown rather than a contraction would
improve the conformity with Great Britain but worsen the conformities
with Germany and France (the dates for which, however, are themselves
uncertain).
WHAT IS A BUSINESS CYCLE? 23
Tto T PtoP Mean S.D. Mean S.D. Mean S.D. Mean S.D.
Line (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
a T denotes initial and terminal troughs, P denotes initial and terminal peaks. Entries in columns 7 and 8 correspond to the dates in
column 1; the entries in columns 9 and 10 correspond to the dates in column 2. The wartime cycles consist of expansions during the Civil War,
World Wars I and II, the Korean War, and the Vietnam War, and of the immediately following contractions (for the T to T cycles) or the
immediately preceding contractions (for the P to P cycles).
b Measured from troughs (T) to peaks (P).
C Measured from peaks (P) to troughs (T).
Through the great contraction of the early 1930s, prices in the United
States and Europe followed alternating upward and downward trends
(table 1-3). This is best seen in the wholesale or producer price indexes,
which also have the longest records, but even the less flexible consumer
price indexes show alternating periods of inflation and deflation. The
complete upswings in wholesale prices lasted generally between 20 and 30
years; the downswings varied more, from 9 to 32 years. Over long stretches
of time the deflations nearly offset the inflations, even when the war
periods are included, so that the level of wholesale prices at the bottom of
the depression in 1932 was not much higher than in the early times of the
Republic, more than 140 years earlier. However, no significant deflationary
trends appeared in the nearly 60 years since, only brief price declines in the
recessions of 1937-1938 and 1948-1949. Ours is the age of the most
persistent and pervasive inflation on record.
The long-period averages in table 1-3, column 2, are instructive, even
though they conceal much variability over shorter time intervals. Before
1950 comprehensive price indexes had generally, in addition to the longer
trends, clear procyclical movements, up in expansions and down in
contractions. Thereafter, disinflation replaced deflation as a frequent
concomitant of business recessions and some major slowdowns. Inflation
became a grave and stubborn problem primarily because the deflationary
slumps have disappeared, not because the booms have grown more
inflationary. This is a very important but relatively neglected point.
Periods of rising trends in prices witnessed relatively long business
expansions and relatively short contractions, whereas periods of declining
trends in prices witnessed the opposite. This was observed as early as 1926
by Mitchell (in his introductory chapter to Thorp, 1926, pp. 65-66) and
confirmed by Bums and Mitchell in 1946 (pp. 437-438,538). Table 1-3
provides a summary of their findings and of the generally consistent later
results (see also Moore, 1983, chap. 15; Zarnowitz and Moore, 1986,
pp. 525-531). In times of rising prices, the expansion-contraction duration
WHAT IS A BUSINESS CYCLE? 27
Are business expansions, contractions, and full cycles more likely to end or
less likely to end as they grow older; that is, do they exhibit a positive or
a negative duration dependence? Diebold and Rudebusch (1990, 1991)
attempt to answer this question by fitting hazard functions to the NBER
duration data. 26 Using an exponential-quadratic hazard model, which
is relatively flexible yet parsimonious, they find evidence of a positive
Table 1-3. Trends in Wholesale Prices and the Business Cycle Phase Durations, United States 1789-1990 and Three
European Countries between 1854 and 1935
United States
Rising
1 1789-1814 3.1 5 42 4 22 1.9
2 1843-1864 4.7 6 (5) 32 (30) 5 15 2.1 (2.0)
3 1896-1920 5.1 7 (6) 23 (20) 6 18 1.3(1.1)
4 1932-199Qd 4.1 11 (8) 53 (44) 10 11 4.6 (3.8)
5 Total or Averaged 4.2 29 (24) 40 (34) 25 16 2.5 (2.1)
Falling
6 1814-1843 -3.1 6 27 7 27 1.0
7 1864-1896 -3.2 7 25 8 26 1.0
8 1920-1932 -6.9 3 23 4 22 1.0
9 Total or average -3.9 16 25 19 25 1.0
Great Britain
Rising
10 1854-1873,1896-1920 3.6 10 30 8 17 2.2
Falling
11 1873-1896,1920-1933 -2.3 5 30 7 38 0.8
France
Rising
12 1865-1873,1896-1926 6.4 11 31 9 15 2.1
Falling
13 1873-1896,1926-1935 -2.6 4 30 6 34 0.9
Germany
Rising
14 1895-1923 2.3 6 40 6 18 2.2
Falling
15 1922-1933 -4.2 4 32 4 42 0.8
• Through 1932 based on Burns and Mitchell (1946, p. 432). For 1932-1982, see Moore (1983, p. 240).
b For the United States 1789-1982, see Zarnowitz and Moore (1986, p. 527). For other countries, see the sources listed in Burns and
Mitchell (1946, p. 432). Author's calculations are based on the data for the initial and terminal years; the averages are weighted by the
durations in years of the periods covered.
C The NBER monthly business cycle chronologies are used. See Zarnowitz and Moore (1986, pp. 528-529). Entries in parentheses
exclude wartime expansions (Civil War, World Wars I and II, Korean War, and Vietnam War).
d Updated by author's calculations.
30 THE BUSINESS CYCLE
Business contractions in the United States have become not only much
shorter but also much milder in the post-World War II era compared with
earlier times. Severe depressions like those of the 1870s, 1880s, and 1930s
appear to have disappeared for good. Table 1-4 compares measures of
depth and diffusion for the five contractions of 1920-1938 and the eight
contractions of 1948-1982. The former set includes two major depressions
(1920-1921 and 1937-1938), one disastrous depression (1929-1933), one
mild recession (1926-1927), and one more severe recession (1923-1924).
The latter set includes three mild recessions (1960-1961, 1969-1970, and
1980) and five more severe recessions (1948-1949, 1953-1954, 1957-1958,
1973-1975, and 1981-1982). The presently available, incomplete data
WHAT IS A BUSINESS CYCLE? 33
indicate that the U.S. recession of 1990-1991 (not covered here) will qual-
ify as another mild one.
Table 1-4 leaves no doubt about the relative shallowness of even the
most severe of the recent recessions (1973-1975 and 1981-1982), which
contrasts sharply with the depth of either of the two interwar depressions,
let alone that of the 1929-1933 collapse. Despite the upward trend in
joblessness during the recent period, the maximum unemployment rate in
the early 1980s was still less than half those reached in the 1930s (column
5). Consistent evidence is also provided by diffusion measures, although
here the differences are less striking, with the proportions of industries
with declining employment ranging from 71 % to 100% (column 7).
For the pre-World War I period, comprehensive estimates of economic
activity are scarce and their quality leaves much to be desired. Quarterly
data used in table 1-5, lines 1-3, suggest that output was H2 times more
volatile in 1919-1945 than in 1875-1918 and twice as volatile in 1919-1945
as in 1946-1983 (column 3).30 Although the pre-1919 figure may be an over-
estimate (Romer, 1986), there is little doubt about the ranking of the three
periods in terms of both quarter-to-quarter and cyclical variability. In
percentage terms and on average, the trough-to-peak increases were the
largest in 1919-1945 and somewhat larger after 1945 than before 1919
(column 6). The peak-to-trough decreases were very large in 1919-1945,
much smaller in 1875-1918, and the smallest by far in 1946-1983 (column 9).
Before 1945 wholesale prices tended to rise in expansions and fall in
contractions, as shown clearly in table 1-5 (see lines 4-6, columns 6 and 9).
The trend in prices was just moderately up in 1875-1918 and mildly down
in 1919-1945, despite the big inflations of World Wars I and II, but it was
strongly up in 1946-1983 (column 2).
Even though economic growth decreased and cyclical instability
increased in the latter part of the postwar era (since the early 1970s),
business cycles remained moderate in comparison to the pre-World War I
and, a fortiori, the interwar periods. In other major countries with higher
growth rates, business contractions became much less frequent and much
milder still (see section 3). Several not mutually exclusive hyptheses may
explain the observed reduction of the business cycles in the United States.
I can only list them briefly here (Zarnowitz, 1991, offers an extended
discussion).
d Before 1948 based on cyclical changes in employment in 41 industries. Since 1948 based on changes in employment over six-month
spans in 30 industries (1948-1959); 172 industries (1960-1971); and 186 industries (1972-1982).
e 1920-1921 and 1937-1938 (as marked D above).
f Includes the recessions of5/1923-7/1924 and 7/1953-5/1954 in addition to the four marked S above.
g Includes the recession of 4/1960-211961 in addition to the three recessions marked M above.
Table 1-5. Variabilities of Relative Change and Amplitudes of Cyclical Movement, Real GNP and Prices, 1875-1918,
1919-1945,and1946-1983
Source: Calculated from data in Balke and Gordon (1986, pp. 788-810) (see note 30).
a Number of quarterly observations per series: 1875-1918, 175; 1919-1945, 107; 1946-1983, 151. The annual dates refer to the first and
last turning points of the series during each period.
b Identified by specific cycle peaks and troughs in the series. Expansions are measured from peaks to troughs, contractions from troughs
to peaks. Only complete upward and downward movements are counted.
WHAT IS A BUSINESS CYCLE? 37
World War II devasted the economies of Continental Europe and the Far
East. The physical wealth and capital of once rich nations---cities, factories,
machinery-lay in ruins and in dire need of reconstruction. But human
capital was much better preserved; that is, people retained their high
productive potential-education, skills-and the backlog of effective
demand was huge. Monetary, fiscal, and political reforms enabled both the
defeated nations and the nations liberated by the Allies to make a rela-
tively smooth transition from closed-war to open-market economies, and
from totalitarian and oppressive to democratic and free social systems.
Further, foreign aid, mainly from the United States, was made available to
friend and former foe alike.
The result of this historically rare, perhaps unique, combination of
circumstances was that France, Italy, West Germany, and Japan (as well as
a number of smaller countries) soon came to enjoy extraordinarily high
rates of real economic growth. Of course, the initial activity levels were
very low, which helps explain the long persistence of very high and only
gradually declining growth rates, but nevertheless the progress achieved
in the 1950s and 1960s was spectacular, particularly in the case of West
Germany and Japan.
38 THE BUSINESS CYCLE
'T -
log-scale log-scale
2.25
2.00
2.25
i West Gennany 1.75
2.00
1.50
'$L
1.25
1.75·j
1.00
Japan 0.75
....--
1.25 0, j j r j j -,------,- -. j
050
1948 52 56 60 64 6B 72 76 so 84 sa 1992
A
France Italy
log-scale log-scale
-
2.50 2.25
----.--~--
Italy
2.25 2.00
•
2.00 0
0
.• 1.75
1.75 1.50
1.50 1.25
1.25 1.00
l
1948 52 56 60 64 68 72 76 80 84 sa 1992
B
WHAT IS A BUSINESS CYCLE? 41
Canada U.K.
log-scale log-scale
250 , - - - - - - - - - - - - - - - - - - - - - - - - - - - , 2.25
•
..
2.25 2.00
2.00
-
United Kingdom o
o
o
1.75
o
t.75 1.50
1.50
--. .
Canada
•
1.25
Australia U.S.
log-scale log-scale
2.50 - - - - - - - - - - - - - - - - - - - , 2.25
2.25 2.00
United States
2.00 1.75
1.75 1.50
1.50 -
Australa
1.25
both length and amplitude, whereas the contractions varied much less in
both dimensions.
Table 1-6 presents a summary based on the data plotted and the
specific-cycle turning points identified in figure 1-2. It demonstrates that
the cyclical rises in the U.S. index were on average much shorter than the
rises in the foreign indexes (column 6), and also much smaller in percent-
age terms than the indexes for the other countries, with the sole exception
of the United Kingdom (column 7). As for the cyclical declines in the U.S.
index, they were on average considerably deeper than the declines in the
other indexes, but not particularly long (columns 9 and to). The entries on
mean durations and mean amplitudes quantify the impression from the
charts that expansions differed greatly across the countries (even apart
from the extreme cases of West Germany and Japan), while contractions
differed only moderately.32
A comprehensive assessment of how business cycles in the different
countries compare would require an analysis of the performance of many
individual indicators, which is not possible here. However, I examined the
industrial production and employment components of the coincident
indexes under consideration and found that a few general observations
deserve to be made. The industrial production indexes cover sectors of
high cyclical sensitivity (manufacturing everywhere, mining and/or public
utilities in most countries).33 Therefore they have at least as many specific
cycles as the coincident indexes (which cover less sensitive sectors and
processes as well), often significantly more. Thus the industrial production
series for Japan (mining and manufacturing) clearly shows seven
expansions and six contractions in the 1953-1990 period.
In the United States, although nonfarm employment has a much
broader coverage than industrial production, the cyclical profiles of the two
indicators are quite similar. This is definitely not the case in some of the
other countries, however. In Japan total employment of "regular workers"
had only one cyclical contraction (4/1975-5/1976) between 1954 and 1990.34
In the United Kingdom employment in production industries followed a
gradual downward trend since 1966, and the same applies to West German
employment in manufacturing and mining from 1971 until mid-1984 as well
as to French nonfarm employment between mid-1974 and mid-1985. In
contrast, in the United States an upward trend in employment prevailed
throughout. It is well known that, after having stayed very low in the earlier
postwar years, unemployment in Western Europe increased rapidly
(quadrupled) between 1970 and 1985, from well below to well above the
U.S. levels. Yet, despite the downtrends in employment and clear cyclical
movements around them, business cycles apparently remained milder in
Table 1-6. Average Durations and Amplitudes of Expansions and Contractions in Composite Indexes of Coincident
Indicators, Eight Countries, 1948-1991
Dates of
Turning Points Expansions Contractions
Source: Center for International Business Cycle Research, Graduate School of Business, Columbia University.
• The following initial or early low values are assumed to represent trough dates: Italy, 111948; West Germany, 111950; Japan, 6/1954 (see
figures 1-2A and 1-2B).
b The following late or terminal values are assumed to represent peak dates: France, 111991; Italy, 111991; West Germany, 4/1991; Japan,
211991 (see figures 1-2A and 1-28).
44 THE BUSINESS CYCLE
Europe than here. This suggests that the persistent rise in European unem-
ployment was largely noncyclical in nature, which is consistent with most
recent hypotheses. 35
There are no tested hypotheses, let alone accepted knowledge, on why the
United States may be subject to more frequent and deeper recessions than
Japan, West Germany, or France. However, there is much debate about
the sources of differences in longer-term growth rates between the major
industrial and trading countries. Insights from this literature bear on the
present problem insofar as higher growth is in fact conducive to greater
cyclical stability.
The central argument here is simple. Investment in human and physical
capital produces advances in knowledge, technological progress, and
increased rates of growth in factor productivity, output, and real income.
What is desired, therefore, is higher maintained rates (and shares in total
output) of saving-cum-investment in real terms. 36 There is no need here to
cite the voluminous theoretical and empirical work on sources of economic
growth, which generally supports this basic position. As a practical out-
come, there is considerable consensus that the most successful economies
are those that have the highest average long-term rates of capital invest-
ment. For some time, the United States has had relatively low shares of
private saving and total productive investment; hence it is widely and vari-
ously urged to perform better in this respect, as its main competitors in
Europe and the Far East do.
On the other hand, fluctuations in business and consumer capital outlays
have long been recognized to be a major source of cyclical instability in
aggregate demand. The preceding argument seems to ignore or assume
away the problem. Since investment is much more cyclical than consump-
tion, is it not necessarily true that a larger share of investment will increase
the fluctuations of the economy, along with its growth?
The short answer is no. Investment can be both high and stable,
provided it is a part of, and a response to, growth in aggregate demand that
is sufficient to keep the economy near full employment. As the classical
long-run version of the accelerator theory has it, net investment is in the
end only justified by growth in the demand for the product of the new capi-
tal (which ought to be given the broadest interpretation). But, as noted
before, it is equally true that growth itself depends positively on prior rates
of investment. Increases in real capital, physical and human, generate
WHAT IS A BUSINESS CYCLE? 45
improvements in productivity that can reduce costs and prices. This fact is
particularly important in the competitive world of open economies.
In sum, higher rates of saving, investment, and growth can coexist with,
and indeed may favor, greater cyclical stability. The problem is how to
maintain them. But several heavily export-oriented countries in Europe
and Asia did very well on this score, and their experiences may hold useful
lessons.
The other side of the argument that more growth promotes more stab-
ility is that economic fluctuations can have costly long-term consequences
in the form of suboptimal investment and growth. In a recent model, firms
must make technology commitments in advance, and unanticipated vola-
tility causes errors in these decisions (for example, on the scale of a new
plant or size of the work force) that have substantial negative output
effects (Ramey and Ramey, 1991).37
To be sure, there are other factors to be considered. Business cycles
have historically been more frequent and shorter in the United States than
in Europe, as shown in section 2.1 and table 2-1. This difference points in
the same direction as that observed in recent times, but it is much weaker
and there are no large and systematic disparities in country growth trends
to account for it. To my knowledge, it was never explained. Possible
reasons include a larger role of short inventory fluctuations in the United
States and more frequent financial disturbances.
CANADA
UNITEDKNGOOM ~l-_=-~l~
WESTGERMANY ~L-....~_J~
FRANCE ~1 ~=~=_J~
.v.PAN ~I~ ~~I~
1948 50 52 54 56 58 60 62 64 66 68 70 72 74 76 76 80 82 84 86 88 90
As we have seen, business cycles vary greatly in duration and intensity, less
in diffusion. They are not only diverse but also evolving. What they have
in common is not their overall dimensions but the makeup, features, and
interaction of their many constituent processes.
Thus in each cycle-whether long or short, large or small-production,
employment, real incomes, and real sales tend to expand and contract
together in many industries and regions, though at uneven rates. Other
variables-for example, hours worked per week, real new orders for
manufactured goods, and changes in prices of industrial raw materials-
rise and fall correspondingly but earlier, with variable leads. Still others
-for example, inventory-sales ratios, real business loans outstanding,
and changes in unit labor cost-also rise in business expansions and fall
in contractions but somewhat later, with variable lags. These sequential
movements usually recur in each successive cycle. They all are significantly
persistent and pervasive.
Systematic differences exist not only in the timing of cyclical movements
in different variables but also in their relative size and conformity or coher-
ence (that is, correlation with business cycles). Among the earliest and most
important observations in this area is that activities relating to durable
(producer and consumer) goods have particularly large and well-
conforming cyclical fluctuations. Other variables long and rightly viewed
as highly cyclical are business profits; investment in plant, equipment,
and inventories; and cost and volume of bank credit used to finance such
investments.
More than any other sector of the modem economy, manufacturing
has historically been central to both economic growth and fluctuations.
Mining, construction, transportation, communication, and public utilities
have varying but significant degrees of cyclical sensitivity. Other nonfarm
sectors, which produce largely services rather than goods, tend to be much
less responsive to business cycles. Employment in broadly defined service
WHAT IS A BUSINESS CYCLE? 49
economy as well as influencing it. Money supply variables are of even more
mixed nature in this regard. The extent to which a central bank controls the
stock of money or (which is more relevant) its rate of growth depends on
factors that vary across countries and over time. They include the national
and international monetary systems; the powers, objectives, and perform-
ance of the bank; and the definition and composition of the supply of
money.
In the United States, narrowly and broadly defined monetary aggregates
normally trend upward in both expansions and contractions, though often
at reduced rates before downturns. Long absolute declines in Ml or M2 are
rare and as a rule associated with business depressions or stagnations.
Monetary growth rates tend to lead at business cycle peaks and troughs but
by intervals that are highly variable and on average long (Friedman and
Schwartz, 1963a, 1963b). Cyclical changes in the deposit-reserve ratio and
particularly the deposit-currency ratio, which reflect the chain of influence
that runs from business activity to money, contribute on average strongly
to the patterns of movement in money growth during business cycles
(Cagan, 1965; Plosser, 1991). Money shows a systematic tendency to grow
faster in business expansions than in contractions, and so does the domestic
nonfinancial credit, but the stability of monetary relationships in the cycli-
cal context is subject to much doubt and debate (Friedman, 1986; Meltzer,
1986). Certainly, there is more regularity in the long-term relation between
money growth and changes in the price level, and in the procyclical
behavior of interest rates and the income velocity of money (allowing for
its long trends).
For all of this, there is no denying that business cycles have important
monetary and financial aspects. A six-variable, four-lag quarterly vector
autoregressive (VAR) model applied to postwar and earlier U.S. data by
Zarnowitz and Braun (1990) shows that the rate of change in real GNP was
significantly affected by lagged rates of change in the monetary aggregates
(base, Ml, and particularly M2) but much more strongly yet by lagged
values of short-term interest rates. However, the influence of changes in
the planned volume of fixed and inventory investment and purchases of
durable goods (represented by series of new orders and contracts) proved
to be strong as well. 41
In the original monetarist theory, the money supply was treated as the
main exogenous factor driving the business cycle. In the more recent
WHAT IS A BUSINESS CYCLE? 51
column 6 are average changes, without regard to sign, between consecutive values in the cyclical component, which is a smooth, flexible moving
average of the seasonally adjusted series. Entries marked x are average actual changes in the series, in its original units of measurement; all other
entries are average percentage changes.
d The transformation codes (column 7) are N = no transformation; D = first differences of the series; DLN = first differences of the natural logs
of the series (Le., growth rates). The transformations are generally from the original levels of the (s.a.) series. Entries in column 8 (k) are leads (-) or
lags (+), in months, which are associated with the maximum correlations r(k), as listed in column 9. These statistics are based on the cross-
correlogram between filtered log ICI and the filtered series, using the 24-month moving average filter a24 (L). ICI is the new experimental index of
coincident indicators by Stock and Watson; it covers the period January 1959 to May 1989.
Abbreviations: rnfg = manufacturing; duro = durable; insur. = insurance; mtls = materials; invent. = inventories; contr. = contracts; comm. =
commercial; cons. = consumer; instal. = installment; pers. = personal; inc. = income; outst. = outstanding; pmts. = payments; nonag. =
nonagricultural; / = ratio (inventory/sales in Line 26; credit/income in Line 29); c$ = in constant dollars; inv. = inverted (peaks in the series are
matched with business cycle troughs, troughs in the series are matched with business cycles peaks); detrend. =adjusted for (deviations from) trend.
WHAT IS A BUSINESS CYCLE? 57
(columns 2-6) and new measures of filtered cross correlation with an index
designed to approximate aggregate economic activity in real terms. The
first set of statistics, from the Bureau of Economic Analysis (Commerce
Department), refers to the 1948-1980 period; the second, from an NBER
study by Stock and Watson (1990), refers to the 1959-1989 period. The two
are entirely independent and based on very different methods, yet they are
generally consistent and complementary.
The first 17 series listed in table 1-7 are classified as leading at both
peaks and troughs of business cycles and include ten components of the
BEA index of leading indicators as of 1984 (marked with an asterisk, "*").
They reflect marginal employment adjustments, which under uncertainty
are made ahead of decisions that result in changes of employment and
unemployment (lines 1-3); adjustments of delivery periods and activities
marking the early stages of investment processes, which tend to lead
production, shipments, construction, and installation of equipment (lines
4-10); changes in inventories and sensitive prices (lines 11-13); and
changes in money and credit conditions (lines 14-17).
Such series have a long history of leading at business cycle peaks and
troughs. They are heavily represented in a group of 75 series whose median
timing at 15 peaks and 16 troughs of the 1885-1937 period was -6 (5) and
-5 (3), respectively (that is, leads of six and five months, with standard
deviations of five and three months; for sources and detail, see Zarnowitz
and Moore, 1986, pp. 565-571). In 1948-1980 the means (s.d.), in months,
of the median leads were -11 (3) at peaks and -2 (2) at troughs (as
calculated from the entries in table 1-7, lines 1-17, columns 2 and 3). Thus,
the relative timing of these indicators remained remarkably consistent
over the past century, although the leads at peaks have become longer
and the leads at troughs shorter since 1948.45
Leads maximize correlations with an index of coincident indicators in
1959-1989 for all but two of the series used in table 1-7, lines 1-17,
columns 7-9.46 This is a strong confirmation of the tendency of these
series to move ahead of aggregate economic activity (output, employment,
real income, and real sales). But because these leads (column 8) average -
2 (3) months, they are considerably shorter than the corresponding "all
turns" leads (column 4), which average -6(3) months.
This would be expected for the following reasons. The differences in
timing are likely to be larger and more systematic for the major cyclical
movements than for the many small and short variations that may often
be caused by random influences affecting many variables more or less
simultaneously. The cyclical measures in table 1-7, columns 1-3, refer
mostly to the indicator levels (except where the title specifies change), but
58 THE BUSINESS CYCLE
economywide scale. Interest rates measure the costs of credit and financing
investments of various types. The larger the inventories are relative to
sales, and the larger the volume of credit is relative to income, the heavier
are the costs of finance, given the level of interest rates. Accordingly, the
lagging increase in these cost factors around the business cycle peak works
to discourage economic activity, and their lagging decrease around the
trough works to encourage it. Indeed, when inverted (divided into one), the
lagging index shows the earliest cyclical signals that anticipate even the
turning points in the leading index (Moore, 1983, chap. 23).
The eight series in the last section of table 1-7 have sizable median lags,
averaging in months about +3(3) at peaks, +7(4) at troughs, and +5(3) at all
turns (columns 2-4). It is broadly consistent with the lagging nature of
these indicators that five of them also show the best correlations for lags
(which are long, except for the two series of first differences in short-term
interest rates; see columns 7 -9). For three series that tend to lag at busi-
ness cycle turns (inventory-sales ratio, unit labor cost, and corporate bond
yields), the correlations with the coincident index refer to leads, but they
are negative. This is consistent with the old and well-established finding
that the inverted lagging indicators lead. 48
The typical leads and lags of the major economic variables constitute
important and relatively enduring features of cyclical behavior. Another
class of such characteristics relates to how close the co-movements of the
variables tend to be in the course of business expansions and contractions.
Still another consists of relative amplitudes of cyclical change in the differ-
ent processes.
The correlations in the last column of table 1-7 provide estimates of
the co-movements of the selected indicators with an index that approxi-
mates well aggregate economic activity on a monthly basis. The Stock-
Watson index of coincident indicators (denoted leI for simplicity)
resembles the BEA coincident index rather closely but has a formal
probabilistic interpretation. Of the leading series (lines 1-17), capacity
utilization, the help-wanted index, and the two aggregates of new orders
show the highest positive r(k) of .89-.96, while unemployment insurance
claims has -.87 (lines 2-6). Average workweek, contracts and orders for
plant and equipment, and inventory change show r(k) correlations of
. 76-.79; seven other indicators, including in descending order real money
supply, change in credit, vendor performance, housing permits, and stock
60 THE BUSINESS CYCLE
prices, have an r(k) of .55-.68; and for two series these measures are very
low indeed (-.40 for failure liabilities and.25 for M1 growth).
Not surprisingly, the correlations of the individual coincident indicators
with the ICI are high (lines 18-24). They range from .92 to .99 for five of
the series, are .87 for real personal income less transfer payments, but are
only .69 for real retail sales. Industrial production indexes for total and
durable manufacturing show the highest r(k) coefficients.
The co-movements of the lagging indicators with the ICI are not very
close. The highest correlations here are the negative ones for unemploy-
ment duration, inventory-sales ratio, and unit labor cost (lines 25-27). Two
series on credit and two on short-term interest rates have an r(k) of .52-
.63, and the bond yield has one of only -.45 (lines 28-32).
The conventional method of analyzing time series for the study of busi-
ness cycles is to estimate and then eliminate their seasonal components.
Working with seasonally adjusted series Gust as working with trend-
adjusted or heavily smoothed series) is often covenient but not without
risks. 49 Even after seasonal adjustment, the month-to-month change in
most series contains a large component of short, random variations; the
cyclical component represents a much longer and smoother movement that
is often much smaller than the total change on a per-month basis (compare
the paired entries in columns 5 and 6).50 Some leading indicators show
great volatility of monthly change, which obscures the relatively small
trend- cycle movement (inventory investment and business failures provide
extreme examples; see lines 11 and 16). In contrast, some other early-
moving series are remarkably smooth to begin with and are dominated by
cyclical fluctuations (for example, the help-wanted index, capacity
utilization, and vendor performance, lines 3, 4, and 7) or by the trend-cycle
(for example, real money supply, line 15). Most of the leading indicators
fall somewhere in the broad intermediate range; that is, they display great
overall sensitivity and have both clear, specific cycles and many smaller
random oscillations.
The coincident indicators have generally much smaller, and also more
uniform, amplitudes of monthly total and cyclical change than the leading
indicators. The following tabulation, which uses only percentage entries
from columns 5 and 6, brings out the contrast between the two groups.
Behind it are important particulars. Thus consider manufacturing of dur-
able goods, where much of the production is to order. Here new orders
move in large swings that are followed with variable but significant lags and
much smaller fluctuations in output and shipments. The resulting changes
in backlogs of unfilled orders and average delivery lags are also large, lead-
ing, and procyclical. Production of nondurable goods is both less cyclical
WHAT IS A BUSINESS CYCLE? 61
and less volatile than that of durable goods (lines 22 and 23), and
production of services (not shown) is least, again on both counts.
5 General Conclusions
In this chapter I have considered the short but not-so-easy question, "What
is a business cycle?" from several angles. Section 1 looked at economic
history and at the development of thinking about business cycles. Section
2 reviewed the chronologies of business expansions and contractions,
the lessons from the duration data, the concepts of periodicity of cycles
and phases, and the evidence and reasons for the apparent moderation
of macroeconomic fluctuations in the post-World War II era. Section 3
compared the postwar business cycles and growth cycles in several major
62 THE BUSINESS CYCLE
instability of profits, investment, and credit has a long history and is well-
documented.
6. Business cycles have varied greatly over the past 200 years in length,
spread, and size. They included vigorous and weak expansions, long and
short; mild and severe contractions, again some long, some short; and many
moderate fluctuations of close-to-average duration (about three to five
years). But since the 1930s the United States suffered no major depression.
Business expansions have become longer, recessions shorter and milder.
The probable reasons include the shift of employment to production of
services, automatic stabilizers, some financial reforms and avoidance of
crises, greater weight and some successes of governmental actions and
policies, and higher levels of public confidence.
7. The postwar recessions are much fewer and generally milder still in
France, Italy, and particularly West Germany and Japan. These countries
also had much higher average rates of real economic growth than the
United States, especially in the early reconstruction phase of the post-
1945 era. In the 1970s and 1980s growth decreased everywhere and
the recessions became more frequent and serious. All this suggests that
countries and periods with stronger growth trends are less vulnerable to
cyclical instability. This is a potentially important proposition in need of
explanation and testing (with possible extensions to regions, industries, and
the like).
8. In sum, business cycles make up a class of varied, complex, and
evolving phenomena of both history and economic dynamics. Theories or
models that try to reduce them to a single causal mechanism or shock seem
to me altogether unlikely to succeed.
Notes
1. In a letter of June 27, 1772, David Hume informed Smith that "We are here in a very
melancholy situation: Continual bankruptcies, universal loss of credit. ... Do these events
any-wise effect your theory?" Smith's answer is unknown (see Mirowski, 1985, pp. 15-18).
2. See Haberler (1964), Zarnowitz (1985), Moore and Zarnowitz (1986), Backhouse
(1988), and Sherman (1991).
3. Thus, for England he listed 14 crises in 1803-1882 at intervals averaging 6.1 years, with
a standard deviation of 2.6 and a range of 1-10 years (see also Burns and Mitchell, 1946,
p.442).
4. See Burns and Mitchell (1946, table 16, pp. 78-79).
5. For arguments and some evidence consistent with the previous discussion, see
Backhouse (1988, chs. 2 and 5).
6. Schumpeter refers to Mitchell and Spiethoff as disagreeing with him on this point.
64 THE BUSINESS CYCLE
7. See Mirowski (1985, pp. 201-213). The other sources of the crisis chronologies in ques-
tion are Bouniatian (1908), Ashton (1959), and Deane (1967). All authors agreed on two
dates, three agreed on six, and two agreed on ten (out of the 13 dates proposed by Ashton).
For 1700-1802, Ashton suggested a sequence of 16 "cycles," with durations averaging about
five years and concentrated mainly in the three-to-six-year range (Moore and Zarnowitz,
1986,pp.741-743).
8. The coverage of the annals is United States and England, 1790-1925; France, 1840-
1925; Germany, 1853-1925; Austria, 1867-1925; and 12 other countries on four continents
(various periods between 1890 and 1925).
9. This is certainly consistent with the recent evidence on the performance of business
outlook analysts, policy makers, and forecasters (see Fels and Hinshaw, 1968; Zarnowitz,
1967,1974).
10. Of course, many seemingly familiar facts or events are complex or controversial
enough to elude a tight formulation of meaning, say, in a definitional or legal sense. One is
reminded, for example, of Justice Potter Stewart's writing, in the 1964 case of Iacobellis vs.
Ohio, that obscenity was indeed difficult to define, but "1 know it when I see it."
11. For some detail on the historical statistics applied in the construction of the business
cycle chronology for the United States, see Zarnowitz (1981) and Moore and Zarnowitz
(1986), and references therein.
12. For a further analysis along these lines, see Zarnowitz (1985, 1992).
13. From the introduction by Burns to the posthumous book by Mitchell (1951, pp. VII-
VIII).
14. Something similar could be said as well about some earlier important influences,
notably that of Marx.
15. Early accelerator models made investment a function of changes in output (Aftalion,
1913; Clark, 1917). The more general and satisfactory formulation equates investment to some
fraction of the gap between the desired and actual capital stock.
16. This excludes the expansions during the Civil War and World War I periods, which
were longer than the average and different in some respects. Business contractions that
followed these expansions had shorter than average durations. But these distinctions are
blurred by the fact that some peacetime expansions were even longer and some peacetime
contractions were shorter. Compare lines 5 and 6 in table 1-1.
17. The rest of this section draws on material in Moore and Zarnowitz (1986, pp. 754-
758).
18. During the short but sharp and widespread 1920-1921 decline, Germany was insulated
by hyperinflation and the associated floating exchange rate (Friedman and Schwartz, 1963a,
p. 362). During the similarly diffuse and painful 1937-1938 contraction, Germany was no
longer a free market economy but a controlled economy under the Nazi dictatorship and
heavily engaged in arming for the war, annexing Austria, invading Czechoslovakia, and
threatening other neighboring countries.
19. The first of these is covered mainly by annual data (the duration measures are
expressed in monthly terms for comparability). Combining the two periods would add little to
the story.
20. This contraction is omitted from the chronology of Spiethoff (1955, vol. 1., p.147).
21. However, Friedman and Schwartz do not recognize the 1901 trough and the 1903 peak
included in the NBER chronology for Britain (1982, p. 74).
22. Thus, assuming that 1869-1870, 1887-1888, and 1899-1900 represented major slow-
downs rather than marginal recessions, the 1857-1918 period would contain 12 (not 15) busi-
ness cycles with an average length of 5 (not 4) years.
WHAT IS A BUSINESS CYCLE? 65
23. Indeed, using the latter would only strengthen the case, since the relative frequency of
expansions has been somewhat greater in the long upswings of prices, that of contractions in
the long downswings (Zarnowitz and Moore, 1986, p. 530).
24. The results of this combination include a sharp increase in real debt burdens; distress
selling of assets to payoff the debts; contraction of deposits; declines in production, trade, and
employment; depressed confidence; and lower nominal but higher real interest rates. When
the liquidation process and the debts and costs are reduced sufficiently in real terms, however,
confidence will gradually return, hoarding will give way to new buying and lending, and
reflation will pave the way to another recovery.
25. For more on the association between the price trends and the relative duration of
business cycle phases, see Zarnowitz and Moore (1986, pp. 530-531).
26. A hazard function shows the dependence of the termination or "failure" probability
on the duration of the process; in this case, the probability of a peak (trough) as a function of
the length-to-date of the preceding expansion (contraction). Let F(t) = Pr(T < t) be the prob-
ability that the duration random variable T is less than some value t; f(t) = dF(t)ldt be the
corresponding density function; and Set) = 1 - F(t) be the corresponding "survivor function."
Then the general form of the hazard function is A(t) = f(t)/S(t) (see Kiefer, 1988).
27. The following discussion draws in part on material from Zarnowitz (1985, 1987).
28. Consider the consequences of such natural disasters as cyclones and storm surges in
the Bay of Bengal (for India and Bangladesh) and hurricanes and shifts in ocean currents (for
fishing off the coast of Peru).
29. See Alt and Chrystal (1983). For some more positive appraisals and recent
contributions, see Willett (1988).
30. The measures are based on estimates by Balke and Gordon (1986, pp. 788-810) that
use the historical annual series by Gallman and Kuznets and more recent series of the Depart-
ment of Commerce. Persons' index of industrial production and trade (1875-1918) and the
Federal Reserve System index of industrial production (1919-46) were used as quarterly
interpolators.
31. Similarly, the index for Taiwan available since 1961 shows only one serious decline, of
9.1 %, in 12173-2175 (a minor decline of 1.3% occurred in 1190-8/90). Unlike Taiwan and
Japan, the economy of South Korea escaped a recession in 1973-1975 but had one in 1979-
1980. The Korean index declined by 10.3% in 3179-11180, its only lapse from growth since its
beginning in 1963.
32. Taking into account the divergences between the periods covered by the indexes does
not alter this conclusion.
33. For a description of the international indicators, see Moore and Moore (1985).
34. The Japanese series refers to the number of employees on payrolls in all non-
agricultural establishments (private and government-owned). The series for the United States,
Canada, France, and Italy cover nonfarm employment; for the United Kingdom, manu-
facturing, mining, construction, and public utilities; and for West Germany, mining and manu-
facturing.
35. The theories of hysteresis explain the persistence of high unemploymcnt by making
long-run equilibrium depend on history. Adverse shocks reduce demand for physical or
human capital or both as well as the demand for labor. Or "insider" workers keep real wages
high and "outsider" workers out of jobs (Blanchard and Summers, 1986).
36. This assumes that investment is predominantly productive in nature, well allocated by
market forces, and supported rather than hindered by government policies.
37. In this model, volatility is associated with productivity shocks, but I suspect that the
analysis of the Rameys has broader applicability.
66 THE BUSINESS CYCLE
38. See Klein and Moore (1985), Klein (1990), and Lahiri and Moore (1991).
39. This count does not include the 1990-1991 recessions in the United States, Canada,
and the United Kingdom or the concurrent slowdowns or possibly recessions in any of the
other three countries. Although the initial dates (peaks) of some of these movements have
been established, at least tentatively (see figure 1-3), their severity and duration cannot as yet
be known.
40. The listing uses broad labels and offers only selected types of theory. The theories are
in general not mutually exclusive and are often used in combinations, with varying emphases.
See Haberler ([1937]1964) and Zamowitz (1985) for surveys of the literature.
41. Still other, weaker effects accounted for in this model are those of changes in a fiscal
policy variable and in the price level. One should remember that a V AR model shows the
lead-lag interactions among all the selected variables, allowing also for the effects of their
own lagged values (for the serial correlations that are high in many important economic
aggregates).
42. On the monetary policy ineffectiveness in the new classical macroeconomics, see
Lucas (1972, 1973) and Sargent and Wallace (1975); on tests, see Barro (1978), Boschen and
Grossman (1982), and Mishkin (1983).
43. That is, prices clear markets, expectations are rational and adjust promptly, and all
opportunities for mutually beneficial transactions are used up.
44. Thus, the shift from production of goods to production of services made employment
much less cyclical, as already noted in section 2.7 (see also Zarnowitz and Moore, 1986,
pp. 536-538). But the 1990-1991 recession, although relatively mild, was unusually harsh in
causing a shrinkage of jobs in many service-producing industries. It is much too early to tell,
however, whether this constitutes a reversal of the trend previously observed, and if so to what
extent.
45. It can also be shown that the opposite change occurred for the lagging indicators,
where the lags have become shorter at peaks and longer at troughs (see Zarnowitz and
Moore, 1986, pp. 567-71). These changes are explained by the shift toward longer business
expansions and shorter recessions in the postwar era.
46. The two exceptions are the change in sensitive materials prices (line 14), where the
indicated k max timing is 0 (coincident), and the change in inventories (line 11), where it is a lag
of six months. This last result seems puzzling, since inventories tend to lag in levels but lead in
changes.
47. Only the average workweek, the diffusion index of slower deliveries (vendor perform-
ance), housing permits, and change in business and consumer credit-all series with little
trend-are used in level form (N) for the entries in columns 7-9.
48. The leads are particularly long in the case of inverted bond yields (line 32) or, which
amounts to much the same, indexes of corporate bond prices (Zamowitz, 1990). Note also
that the average duration of unemployment, like other series on unemployment, is naturally
taken in inverted form to match like turns in business activity. This indicator has a roughly
coincident timing at peaks but substantial and regular lags at troughs (line 25).
49. The big difference between seasonal and business cycles is that seasonal movements
are much more periodic (more truly "cyclical") and much more capable of being anticipated.
Over short spans within the year, seasonal fluctuations dominate the changes in many
variables, but over longer spans of several years it is the movements associated with business
cycles (the "specific cycles") that are predominant. The risk is that seasonal and cyclical
movements may interact so that their workable separation is impeded.
50. The cyclical (actually, trend-cycle) component is estimated as a weighted moving
average (Henderson curve) chosen on the basis of the relative amplitude of the irregular and
WHAT IS A BUSINESS CYCLE? 67
cyclical movements. Most series are smoothed with a 13-month device, but a nine-month
formula is used for relatively smooth and a 23-month formula for very volatile series. See
Zarnowitz and Boschan ([1975]1977, p. 173).
51. Any documentation would require more data, mainly in quarterly form.
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72 THE BUSINESS CYCLE
The argument that the U.S. economy has stabilized since World War II
has two parts: first, that the volatility of output (say, its standard deviation)
has decreased, and second, that postwar contractions are shorter, and ex-
pansions longer, than they were before the Depression. The first part of
this argument has come under serious attack by Romer (1986, 1989).
Her argument is that the prewar output figures were constructed using
inherently more volatile series: The available series cover more volatile
sectors of the economy. Although the particulars of her findings are still
debated, the case for stabilized postwar output is certainly much weaker than
previously thought. Zarnowitz lays out the evidence for the second part of the
argument. Drawing on previous careful analyses of the dating of certain
suspect prewar cycles, he concludes that, even if several prewar recessions
73
74 THE BUSINESS CYCLE
were deleted from the chronology, the empirical evidence remains that
postwar cycles have longer expansions and shorter contractions.
My purpose in this part of the discussion is to review some recent
research by Watson (1991) that questions this conclusion. As Moore and
Zarnowitz (1986) point out, different economic time series were used to
construct the NBER reference cycle chronology, depending on the histori-
cal period. This raises the possibility that systematic differences in the
series might induce an apparent shift in the properties of the reference
cycles. Watson addresses this possibility in two ways: first, by comparing
pre- and postwar phase durations for the same or comparable series and
second, by constructing an aggregate postwar index of industrial produc-
tion that has a similar coverage and definition to the available prewar
industrial production (IP) series. He concludes that specific cycles (cycles
based on individual series) appear not to have changed when they are
computed for series that are consistently defined prewar and postwar.
Selected evidence on this point is presented in table 1C-l. Panel A
presents average expansion and contraction lengths for the prewar and
postwar data based on the NBER chronology, and also based on the
NBER chronology as modified by Zamowitz by dropping some suspicious
early recessions. As Zamowitz emphasizes, postwar the recessions are
shorter and the expansions longer, whether the suspicious early recessions
are included or not.
Panel B presents evidence for specific cycles for series with comparable
definitions pre- and postwar. The specific cycle dates were computed using
the turning point identification algorithm developed by Bry and Boschan
(1973).1 For each series with comparable definitions, the differences in
prewar and postwar phase durations are modest or negligible. For example,
contractions in stock prices averaged 19 months prewar and 17 months
postwar. The most noteworthy results are for industrial production. Prewar
contractions and expansions, measured using the historical IP index
recently constructed by Miron and Romer (1990), averaged 16 and 22
months, respectively, both shorter but comparable to the average durations
based on the official NBER chronology in panel A. Similarly, the postwar
expansions and contractions based on the official IP series (produced by
the Federal Reserve Board) are essentially the same as those based on the
official NBER chronology. To examine the hypothesis that this difference
arises because of differences in the composition of series used to construct
the FRB and Miron-Romer IP indexes, Watson constructed a postwar
extension of the Miron-Romer series. His approach was to apply the
Miron-Romer weights to component series that were similar to those used
by Miron and Romer. As the results in the final rows of table 1C-1 indicate,
COMMENTARY 75
1854-1919 27 22 NBER
1854-1919 37 23 Modified NBER*
1945-1990 50 11 NBER
Source: Zamowitz (1992). E and t respectively denote average expansion and contraction
lengths, in months.
* Modified NBER: drop 1869-1870, 1887 -1888, and 1899-1900 recessions.
Series Period E (;
Source: Watson (1991). Peaks and troughs were dated using the Bry-Basehan (1973)
algorithm.
that one might think would have performed well during the summer of
1990---stock prices and oil prices-did not produce reliable forecasts when
these forecasts were made using the historically estimated forecasting
equation.
These observations suggest that the historical correlations between
these leading indicators and overall economic activity were not good
guides to this episode. More concretely, one can reasonably argue that dis-
inflationary monetary policy was an important proximate cause of the 1975,
1979, and 1981 recessions. The poor performance of the monetary
indicators in the 1990 recession suggest that restrictive monetary policy, or
an associated credit crunch, played at most a limited role in inducing the
sharp contractions of October and November.
The results instead are consistent with an alternative mechanism based
on unprecedented shifts in consumer expectations. The timing was right:
Expectations dropped precipitously in August; manufacturing and trade
sales fell sharply in September; and production, employee-hours, and
income all dropped in October. One interpretation is that the recession
transpired as a self-fulfilling prophecy. For example, the drop in consumer
expectations induced firms to restrict hiring and to expect lower sales; with
lower incomes, sales did in fact drop. Another interpretation is that
consumer expectations played only a passive role and reflected increased
uncertainty in the face of rising oil prices and the threat of war in the Gulf,
which together induced consumers to adopt more conservative spending
patterns. If these explanations are right, they illustrate Zarnowitz's point
that each cycle can have different sources: Over the previous 30 years,
consumer expectations had in fact been of only limited forecasting value. 3
Whether or not consumer expectations played a causal role in the contrac-
tion, the circumstances of the 1990 downturn differed from their recent
predecessors, in which indicators of monetary policy provided reasonably
reliable forecasts.
3 Conclusions
These observations only touch on the rich set of facts and theories
reviewed in Zarnowitz's chapter. In particular, his work on international
business cycles warrants careful reading and raises an interesting set of
research questions concerning international phase durations, cyclical stab-
ility, and cross-country patterns of growth. One of the implications of this
chapter, which I have attempted to illustrate and which I hope is taken
up by subsequent researchers, is that there are good reasons to study
Table 1C-3. Performance of Selected Leading Indicators as Forecasts of the XCI Coincident Index During the Onset of
the 1990 Recession (three-month-ahead forecast horizon)
Financial Indicators
S&P composite 4.30 2.61 4.72
RealMl 4.28 1.92 5.06
RealM2 4.08 2.02 3.57
Monetary base 4.51 1.68 6.40
Federal funds rate 4.09 1.39 5.67
lO-year T-bond rate, smoothed 4.36 2.18 5.47
Commercial paperrr-bill spread, six months 3.66 1.51 8.00
10-year T-bondll-year T-bond spread 4.12 1.38 6.63
Employment Indicators
New claims, unemployment insurance 4.46 1.83 5.34
Persons unemployed < five weeks 4.55 2.11 5.95
Index of help wanted ads, newspapers 4.05 2.52 3.07
Part-time work, economic reasons 4.35 2.03 5.38
Average weekly hours, manufacturing production workers 4.54 1.88 5.16
Inventories and Orders
Real unfilled orders, durable goods industries 4.48 2.01 5.31
Real manufacturing & trade inventories 4.55 2.37 6.21
Additional Indicators
Real retail sales 4.53 1.82 5.27
Building permits-private housing 4.15 1.56 4.13
Consumer expectations (University of Michigan) 4.27 2.01 3.00
PPI, crude petroleum 4.56 2.04 6.82
Weighted average of nominal exchange rates 4.42 2.10 7.83
Capacity utilization, manufacturing 4.55 1.86 5.08
Index of vendor performance 4.40 1.73 6.57
Notes: All results were computed using the data as revised through 91:02. RMSEs were computed for forecasts of x, = In(c'+3/c,) on
current values plus two lags of In(c/ct-J) and current values plus five lags of the (suitably transformed) individual leading indicator, where c, is
the Kalman smoother estimate of the Stock-Watson (1989) experimental coincident index (the XCI) computed on data revisions through
1991:2. The dates in the column headings are the months in which the three-month forecasts were made. Units are annual rate percent
growth rates.
Source: Stock and Watson (1991).
82 THE BUSINESS CYCLE
Notes
References
Bernanke, B., and A. Blinder. Forthcoming. "The Federal Funds Rate and the
Channels of Monetary Transmission." American Economic Review.
Bry, G., and C. Boschan. 1973. Cyclical Analysis of Time Series: Selected Computer
Procedures and Computer Programs. New York: Columbia University Press.
Friedman, B.M., and K.N. Kuttner. 1989. "Another Look at the Evidence on
Money-Income Causality." Manuscript, Department of Economics, Harvard
University. Journal of Econometrics, forthcoming.
Gamer, C. Alan. 1991. "Forecasting Consumer Spending: Should Economists Pay
Attention to Consumer Confidence Surveys?" Economic Review of the Federal
Reserve Bank of Kansas City (May/June): 57-71.
Miron, J .A., and C.D. Romer. 1990. "A New Index of Industrial Production, 1884-
1940." Journal of Economic History 50: 321-337.
Moore, G.H., and V. Zarnowitz. 1986. "The Development and Role of the NBER's
Business Cycle Chronologies." In RJ. Gordon, ed., The American Business
Cycle: Continuity and Change. Chicago: University of Chicago Press.
COMMENTARY 83
85
86 TIlE BUSINESS CYCLE
dominant impulse (to borrow a phrase from Brunner and Meltzer, for
example, 1978) arises from shocks to the aggregate production function,
rather than to aggregate demand. Though it is true that monetary shocks
provide a genuine alternative to those hypothesized by Kydland and
Prescott, it is also the case that, except in the literature based on the twin
assumptions of (Walrasian) clearing markets and rational expectations,
monetary-impulse models have always been something of a minority taste.
In the literature of the 1950s and 1960s, and long before that, "real"
theories of the cycle predominated, though they were very different from
anything that currently carries that label.
Modem business cycle theory is based on Walrasian general equilibrium
analysis. In such a system, markets always clear and the distinction
between "demand" and "supply" shocks is not all that helpful: Say's law
holds, supply creates its own demand, and in general any shock will affect
both simultaneously. The demand-supply shock distinction does make
sense in a system in which the fact of monetary exchange permits aggregate
demand and supply to move independently of each other and in which,
therefore, a situation of general excess demand or supply can emerge.2 The
appropriate contrast, then, between Kydland and Prescott's work and that
of the 1950s and 1960s is not between "real" and "monetary" models; it is
between those that locate the shocks initiating the cycle in the economy's
production sector and in which both supply and demand behavior
interdependently respond, and those that locate them on the demand side
and treat production as passively adjusting to demand fluctuations whose
origins can be either real or monetary.
It is also worth noting that some advocates of "real business cycle
theory"-for example, Plosser (1991)-have lately taken to classifying
anything but a change in the monetary base, including a change in the
required reserve ratio, as a "real shock." They cannot be prevented from
using the word real this way, but they should make it clear to their readers
that it is then appropriate to use the adjective nominal rather than monetary
to characterize an alternative approach. This matter is important, because
every monetary theory of the cycle of which I am aware has paid careful
attention to, and indeed usually accorded prime importance to, endogenous
fluctuations in money multipliers (and in the case of 1937-1938 to changes
in reserve requirements as well) when confronting empirical evidence. No
one, to the best of my knowledge, ever advanced a purely nominal theory
of the cycle as a serious explanation of any actual historical experience.
None of this would matter very much if inability to cope with empirical
evidence was a characteristic of all demand side models of the cycle. But in
fact the models that found themselves in trouble from the mid-1960s onward
THE CYCLE BEFORE NEW-CLASSICAL ECONOMICS 87
were real (albeit demand-side) models, and these were already in difficulty
as a result of a re-examination of previous empirical evidence. The historical
studies of Friedman and Schwartz had, by the mid 1960s, established what
we would nowadays call the monetarist explanation of the cycle as some-
thing to be taken very seriously. Subsequent experience with inflation and
unemployment, which was so damaging to the orthodox Keynesian demand-
side macroeconomics of the time, did nothing to undermine monetarism.
Nor is the stylized fact that the price level has moved in a generally counter-
cyclical fashion in the postwar years, of which Kydland and Prescott (1990)
make so much, damaging to monetarist models of this vintage.
It is indeed true that assertions to the effect that the price level is a
procyclical variable are to be found in the literature. 3 It is also true, as
Kydland and Prescott (1990, p. 7) remark, that "if these perceptions are not
in fact the regularities, then certain lines of research are misguided," and
that, as they further suggest, the equilibrium monetary models of the 1970s
are vulnerable to such criticism. Monetarist models of the 1960s to early
1970s, however, were not constructed to predict any such fact. Nor, incid-
entally, did they rely on the postulate that "the money stock, whether
measured by the monetary base or by Ml, leads the cycle" (1990, p. 5).
Hence Kydland and Prescott's exposure of this postulate as yet another
"misperception" also leaves monetarist models unscathed.
In the following pages, I shall first give an account of how business cycle
theory fit into the macroeconomic consensus of the 1950s and early 1960s,
and then discuss monetarism's role in disturbing this aspect (along with
many others) of the consensus in question, paying particular attention to
the predictions of monetarist models about the cyclical behavior of money
and prices. I shall go on to argue that the main strength of later new-
classical economics, in the Lucas-Sargent-Wallace mode, was not so much
its explanatory power, as its conformity to particular a priori methodological
criteria, and that modem real business cycle theory also conforms to those
criteria, whose appeal is understandable in the light of those earlier
debates. I shall argue that the criteria in question are insufficient to estab-
lish the superiority of modem real business cycle theory and that it there-
fore remains open to empirical challenge from an alternative approach to
which the monetarist economics of the 1960s made a vital contribution.
Before the publication of The General Theory, the business cycle occupied
a central position in what we would nowadays call macroeconomics.
88 THE BUSINESS CYCLE
Though it shared the stage with inflation, the fact that many monetary
models of the cycle treated inflation as an integral characteristic of the
cycle's upswing meant that divisions here were not sharply marked. The
essentially comparative static analysis of The General Theory, and of the
IS-LM model that came to be regarded as embodying its central theoretical
contribution, shifted the focus of macroeconomics away from cycle theory,
but there was more to the "Keynesian Revolution" than that. 4
Whatever Keynes may have meant, Keynesian economics downgraded
the importance of monetary factors as an explanation of macroeconomic
phenomena. The empirical postulates that the demand for money was
highly interest elastic, and probably unstable too, and the belief that expen-
diture, again as an empirical matter, was insensitive to interest rates,
implied that the real side of the economy, as described by the IS curve,
must be the source of economic disturbances. An alleged empirically stable
marginal propensity to save underpinned a stable multiplier. Hence
fluctuations in investment came to be regarded as the main factor driving
movements in real income and employment, with variations in interest
rates playing at most a marginal and complicating role in the process.
Although, with the onset of the Keynesian revolution, models of the
cycle that located the impulses driving it in the monetary sector therefore
vanished from the mainstream of the literature, cycle theory continued to
flourish as an important component of the subdiscipline, requiring the
inclusion of a chapter or two in any intermediate textbook and the pro-
duction of supplementary textbooks and collections of readings for more
advanced students. The comparative statics of real income determina-
tion, embodied in IS-LM analysis, had to be grasped as ends in themselves,
but, for serious students, mastering them was also an essential preliminary
to coming to grips with "multiplier-accelerator" models, which treated the
cycle as the outcome of systematic rightward and leftward shifts of the IS
curve along an essentially horizontal LM curve. s
The pre-General Theory literature had contained a number of "real"
theories of the cycle. Jevons' speculations about the importance of fluctu-
ations in agricultural output stemming from sunspot activity continued to
attract attention well into the 1920s, operating, in the hands of Pigou, in com-
bination with the notion that business investment was subject to influence
from waves of optimism and pessimism. Schumpeter argued that invest-
ment fluctuated because of irregularities in the pace of innovation and that
the cycle was an integral component of the process of capitalist growth.
Though all of these approaches found a role for monetary factors, it was
a strictly supporting one; but viewed from the perspective of IS-LM analysis,
they were analytically uninteresting. In that framework they provided little
THE CYCLE BEFORE NEW-CLASSICAL ECONOMICS 89
Frisch's (1933) agenda for this area. First, the demise of the self-perpetuating
cycle models meant that the temporarily suspended search for exogenous
impulses had to be taken up again. Second, the study of propagation
mechanisms moved away from the analysis of low-order difference and
differential equation systems that had characterized multiplier-accelerator
theory into the domain of the large econometric models whose complex
distributed lag structures required numerical simulation exercises to reveal
their dynamic properties. 7 These two endeavors were not logically incom-
patible with one another, but, as a matter of fact, monetarism came to
dominate the first while an eclectic type of Keynesian economics was
perpetuated in the second.
anticipated, the economy's demand for real balances falls and also because
second and subsequent round influences on deposit-currency ratios will
affect the behavior of money growth relative to its ultimate equilibrium.
In new-classical analysis, a monetary surprise affects output because,
although the price level moves instantaneously to restore equilibrium be-
tween the supply and demand for nominal money, that movement is misper-
ceived by agents who react by increasing their supply of goods and services,
and its effects are spread out over time because of costs of adjusting
quantities supplied. In stark contrast, for Friedman and Schwartz, persistent
portfolio disequilibrium and its effects on flows of expenditure is of the
essence:
The central element in the transmission mechanism ... is the concept of cyclical
fluctuations as the outcome of balance sheet adjustments, as the effects of flows
on adjustments between desired and actual stocks. It is this interconnectedness
of stocks and flows that stretches the effect of shocks out in time, produces a
diffusion over different economic categories, and gives rise to cyclical reaction
mechanisms. The stocks serve as buffers or shock absorbers of initial changes in
rates of flow, by expanding or contracting from their "normal" or "natural" or
"desired" state, and then slowly alter other flows as holders try to regain that
state. [po 234]
Since among the stocks to which Friedman and Schwartz explicitly drew
attention were those of consumer durables and fixed capital, there was no
reason at all why their view of the monetary impulse could not have been
combined with a real propagation mechanism of the type, already referred
to, incorporating a flexible accelerator mechanism, to produce an eclectic
account of cyclical fluctuations. Matters did not at first develop in this way,
however. While the quantitative analysis of these real propagation mechan-
isms advanced in the context of work on large-scale econometric models,
a separate literature debated the monetarist view of the primacy of monet-
ary impulses.
The debate about the monetary origins of the cycle was untidy and
drawn out. It touched on general issues concerning the difficulty of deriving
conclusions about the direction of causation between variables from data
on timing, and about whether Friedman's (1959) view of the empirical
nature of the demand for money function as being essentially devoid of
significant interest rate effects had led him and his associates to pay
insufficient attention to the possibility that nonmonetary impulses might
sometimes be important. lO But when these issues had been settled in favor
of the critics-data on timing might indeed be misleading, and velocity was
after all interest-sensitive so money income could fluctuate even if money
did not-that still left the core of the monetarist case undamaged. It had
96 THE BUSINESS CYCLE
been advanced, not as a set of theorems that were true of logical necessity
under any conceivable circumstances, but as a collection of falsifiable
hypotheses about how real-world data had been generated. Much, though
not all, of the debate about these hypotheses concentrated upon a particu-
lar episode, namely, the Great Depression, and for a number of very good
reasons.
First, the episode in question had generated sufficiently large data
swings that it seemed likely that they might permit discriminating tests to
be carried out. Second, and closely related, Friedman and Schwartz had
used their interpretation of the Depression (and of one or two other rela-
tively major fluctuations) to establish an a priori presumption of the
importance of money for milder cycles, where the data made it much
harder to allocate cause and effect. Finally, and decisively, though the
actual history is a good deal more complicated, in the mythology of
the mainstream economics of the 1950s and 1960s, the Depression was the
episode that had given birth to the Keynesian revolution in economic
thought. To argue that the causes of the Great Depression were monetary,
then, was to mount a challenge to that mythology that could not be ignored
by Keynesians, in whose rhetoric it supplied the example par excellence of
the irrelevance of money in general, and the impotence of monetary policy
in particular.
But undermining Friedman and Schwartz's account of the Depression
proved to be hard indeed. They attributed some causative significance for
the initial downturn, which more or less coincided with the 1929 stock
market crash, to a preceding slowdown in the growth of the monetary base
and hence of the money supply. However, their key claim was that a sharp
recession turned into a major catastrophe because the Federal Reserve
failed to prevent a series of bank failures. The first round of these occurred
in 1930, precipitating large increases in reserve and currency deposit ratios,
which led to a collapse of money growth. In Friedman and Schwartz's view,
this collapse was the proximate cause of falling prices and output. From
1931 to 1933 this "great contraction" fed upon the further bank failures,
which a continued absence of lender of last resort action on the part of
the Federal Reserve permitted to occur. After 1933, the monetary base
continued to grow (as it had since late 1930) but was mainly absorbed into
bank reserves; and, according to Friedman and Schwartz, this showed not
that the Fed was "pushing on a string," but rather that surviving banks had
a well-developed, and easily justified, appetite for free reserves. This
hypothesis found support in the fact that, when reserve requirements were
increased in 1937 to absorb what the Fed believed to be excessive bank
liquidity, the banks responded by restoring their free reserve levels, in
THE CYCLE BEFORE NEW-CLASSICAL ECONOMICS 97
the process causing a money growth slowdown that brought on the 1938
contraction. I I
In short, endogenous, cumulative interaction between the quantity of
money and the cycle, which the authorities could have, but did not, offset,
rather than some mechanical one-way link between exogenous money and
endogenous income, was at the heart of Friedman and Schwartz's story.
And indeed, in their original exposition, they were careful not to identify
the mild monetary slowdown that began in 1928 as the only plausible ex-
planation for the initial onset of the contraction. Thus, though other
scholars could, and did, point to the Smoot-Hawley tariff, bank failures in
Europe, problems in the U.S. housing market, and so forth, as other
important contributing factors, such arguments left the core of the
monetarist case untouched. Only Peter Temin (1976) attempted to rebut
that core. He pointed out that, after the bank failures of 1930, real balances
continued to grow, and nominal interest rates to fall, and argued that these
facts were prima facie evidence that monetary contraction was a purely
passive response to a downturn whose fundamental cause was real, namely,
a downward shift of the consumption function.
There is not space here to survey the debate that Temin provoked.
Suffice it to note his arguments failed to convince the majority of his
colleagues, who wondered, for example, whether the supply of real
balances might not have expanded less than the demand for them between
1929 and 1931, or whether nominal rates of interest were a reliable sole
measure of the opportunity cost of holding money during a period of great
financial uncertainty and rapidly falling prices. Mayer (1978) showed that
Temin's postulated downward shift of the consumption function was very
sensitive to his choice of data. And this is not to mention the difficulty
involved in attempting to reinstate a Keynesian interpretation of the
Depression on the basis of instability of the consumption function, of all
relationships! All in all, the criticism their work provoked failed to under-
mine Friedman and Schwartz's reinstatement of the importance (though
not the sole importance) of monetary influences on the Great Depression.
Certainly, as Karl Brunner (1981, p. 316) remarked, "The story of a power-
less Central Bank acting valiantly but in vain in order to contain the eco-
nomic storm" was effectively disposed of by the controversies of the 1960s
and 1970s. The status of the monetary explanation of the cycle was thus
considerably enhanced, even though, as Brunner also noted, these contro-
versies stopped well short of establishing monetary shocks as the sole
impulse driving the cycle during the 1930s, let alone at other times.
Nor, by and large, did the econometric studies of the time convinc-
ingly establish money's dominance during the Depression. Friedman and
98 THE BUSINESS CYCLE
Friedman and Schwartz (1963b) were more precise about the way in which
monetary changes would affect the nominal demand for goods and services
than about how real income and prices would separately react to demand-
side shocks. In this their analysis was completely representative of its time.
The Keynesian economics of the postwar period was above all an econo-
mics of real income determination, and as we have seen the multiplier-
accelerator theory of the cycle that went along with it was a completely
real model. Though, in their work of the 1950s, Friedman and his associates
were far from the Keynesian mainstream in their attention to price level
behavior, this was in contexts in which ouput changes could be ignored. The
macroeconomics of the 1950s, that is to say, could deal with real output
fluctuations, or inflation, but not the two simultaneously and separately.
THE CYCLE BEFORE NEW-CLASSICAL ECONOMICS 99
say Barro's (1978) new-classical system. From the point of view of the
model's mechanics, there is no mystery about why this proved to be so.
First, and crucially different from any monetary new-classical model,
it incorporated the idea that in response to a monetary shock, ouput
changes preceded those in the inflation rate; second, the inclusion of a
geometrically declining weighted average of past values of the inflation
rate on the right-hand side of the Phillips curve guaranteed considerable
inertia to the predicted behavior of inflation. Since these are properties of
the data, the model could not help but fit them. 18
Two points about the type of model just described are worth stressing.
First, it can accommodate the idea that monetary changes are an important
cyclical impulse and can simultaneously predict the key stylized facts about
the business cycle that readers of Kydland and Prescott (1990) might think
disqualify a monetary explanation from serious consideration. Second, its
capacity to do so stems from its assuming price stickiness. This assumption
ensures that quantities begin to move before prices and that the inflation
rate displays inertia. But, of course, in the 1990s price stickiness is the hall-
mark of so-called "new-Keynesian economics." Monetarism seemed, two
decades ago, to provide a distinct approach to understanding the cycle.
Nowadays it looks more like a particular version of the very orthodoxy to
which it had at one time been diametrically opposed. This appearance is
not just a matter of the vantage point from which we now view the macro-
economics of the 1960s and early 1970s. Friedman's debate with his critics,
published in Gordon (1974), showed that most of their differences, though
deep and important, were nevertheless more quantitative than qualitative
and that further movement toward a synthesis of monetarist and Keynesian
views was in fact implicit in the debates described earlier in this chapter.
Those debates seemed to establish that monetary impulses had been far
more important in generating economic instability than the Keynesian
economics of the 1950s would have had it. They also seemed to establish
that a long-run inflation-unemployment tradeoff, which could be treated
as defining a policy menu, did not exist. Keynesian economics had to
absorb these lessons if it was to continue as an empirically viable and
policy-relevant body of doctrine-and it did so. But the story is not of the
universal triumph of monetarist ideas. To establish monetary instability as
an important source of cyclical impulse and propagation mechanisms does
not also establish its general dominance in either role. To begin with, any
THE CYCLE BEFORE NEW-CLASSICAL ECONOMICS 103
cycle theory has to address the fact of the relatively large amplitude of
variations in investment, and a purely monetary approach seems to have
little to say about the matter. Moreover, the debates that I have described
stopped far short of establishing the unimportance of nonmonetary cyclical
impulses. Anyone still in doubt about the lessons of the historical evidence
on this matter in the early 1970s was soon confronted with the effects of
OPEC's activities on the economy's behavior. Monetarists had to absorb
that lesson, as they did the evidence produced in the 1970s about the sensi-
tivity of the demand for money function to institutional change and its
implications for the effectiveness of a legislated money growth rule as a
built-in stabilizer.1 9
This is not to say that there would have been nothing to argue about by
the mid-1970s had new-classical economics not come upon the scene, but it
is to say that the differences between that body of theory and what had
gone before it were far more profound than any that still needed settling
between monetarists and Keynesians. The new-classical economists did not
advance an alternative set of empirical hypotheses formulated within an
already existing theoretical framework whose validity could be judged by
applying already accepted criteria. Rather they put forward an alternative
theoretical framework whose superiority they defended with recourse to
alternative methodological criteria. In their hands, cycle theory became an
application of general equilibrium analysis, and the approach was defended
with reference, not so much to superior empirical content, as to its con-
formity with the theoretical principles of eqUilibrium modeling.
Even so, empirical evidence did play a role, if only a subsidiary one, in
the literature of new-classical economics. Thus Lucas and Sargent (1978)
made much of the breakdown of the permanent inflation-unemployment
tradeoff in their premature obituary of Keynesian economics, arguing,
misleadingly, that only a model incorporating rational expectations could
cope with the evidence of the 1970s. I have already commented on this and
on Kydland and Prescott's more recent efforts to use stylized facts as a way
of distinguishing between various approaches to cycle theory. The acid test
of new-classical economics' methodological priorities arises, however, with
respect to its treatment of money wage and price stickiness. That many
money wages and prices are subject to contractual arrangements that render
them hard to change is beyond question, as it is that the incorporation
of such a fact into any macroeconomic model gives it distinctly Keynesian
characteristics. If we give priority to the facts in the selection of models, we
should let models that assume price stickiness stand or fall by their
predictions. But because we do not by any means fully understand the
nature of the underlying maximizing behavior that might lead to money
104 TIlE BUSINESS CYCLE
Acknowledgments
y*=_l_ A , (3)
l-s
the dynamics of income's deviation from this steady state, Y, are described
by
Y= (l-s + v)Y_ 1 + vY- z. (4)
In general, a difference equation of the form
x - a1x_1 + azx_z = 0
is stable if and only if
a1 - a2 -1 < 0 -a1 -az -1 < 0 and
and will display cyclical characteristics if and only if
at -4«z <0.
If v > 1 and s < 1, such a multiplier-accelerator system mayor may not
generate cycles, but it will be explosive. This is the system that forms the
starting point for Hicks' (1951) cycle model.
When m is the log of the nominal money supply, y the deviation of the log
of real income from its steady state value y*, p the log of the price level, and
Ape the expected inflation rate, we write the quantity theory equation as
Am = bAy + bAy* + Ap, (5)
the expectations-augmented Phillips curve as
Ap = gy-1 + Ap:'l> (6)
and the error-learning hypothesis as
Ape = dAp + (1 - d)Ap:'1. (7)
This model yields, as a reduced form for y,
106 THE BUSINESS CYCLE
Y = 1-
b
(il2m _ il2y*) + 2b - g y _ b - (1 - d)g y
b -1 b -2'
(8)
Application of the conditions for stability and cyclical behavior set out in
Appendix A will confirm that it is likely to be cycle prone, but that only if g
is "large" relative to b will this model fail to converge on its steady state.
The relationship between inflation and the cycle may be written as
il2p = gilY_1 + dgilY_2' (9)
With the rate of acceleration of prices thus a function of the rate of growth
of income's deviation from trend and the lagged value of this variable, the
price level clearly lags well behind income's deviation from trend, and
hence the "cycle."
This model is described in detail, and estimated, in Laidler (1973).
Notes
1. The quotation from Keynes comes from a New Statesman article of 1933. I have
borrowed it from Elizabeth Johnson (1978, p. 20). The reader's attention is drawn to the fact
that I do not here use the phrase "persuasive use of language" as synonymous with the word
"rhetoric." As readers of McCloskey (1983) will understand, there is much more to the way
in which economists converse with one another than their choice of words. This matter is,
however, sometimes important-indeed to someone like myself who clings to the rather old-
fashioned stance of attaching primary importance to the persuasive power of empirical
evidence, it is occasionally too important 1
2. Even "real demand side" models-of the multiplier-accelerator variety, for example
-require that the monetary system operate so as to prevent the rate of interest moving
to equilibrate savings and investment at full employment if they are to generate cyclical
fluctuations.
3. But, the data for the first half of this century do show prices to move procyclically. See
Haberler (1956, p. 133), Matthews (1959, p. 3), and indeed Lucas (1977, p. 3) for assertions
about this characteristic of the data. It is only in the postwar period that this has ceased to be
the case. The postwar reversal of the "loops" around the Phillips curve, discussed in note 15,
reflects this change in the stylized facts.
4. Haberler (1937) still provides the best available survey of interwar cycle theory. See
Patinkin (1990) for a persuasive defense of IS-LM as a valid, though simplifying, account of
the central theoretical content of The General Theory.
5. The American Economic Association produced two sets of readings in the area of
business cycles-Haberler (1944) and Gordon and Klein (1%5). A random inspection of old
intermediate macroeconomics textbooks confirms that those of Day (1957), Demberg and
McDougall (1960), and Brooman (1962) all contained chapters on the cycle. Matthews (1959)
was a widely used supplementary text of the same period. There is no reason to believe that
this small sample of what students might have been asked to read three decades ago is unrep-
resentative, and in each case the cycle theory presented was of the multiplier-accelerator
type.
THE CYCLE BEFORE NEW-CLASSICAL ECONOMICS 107
6. Harrod (1936) and Samuelson (1939) should be credited with pioneering the analysis of
multiplier-accelerator interaction as a key to cycle theory. Curious readers, whose training
has been recent enough to leave them unfamiliar with the general nature of this class of
models, are referred to Appendix A, where a simple generic example is briefly described.
7. The pioneering paper was surely that of Adelman and Adelman (1959).
8. The relevant papers of Friedman are reprinted as chapters 9-12 in his 1969 collection,
The Optimum Quantity of Money. See also R.I. Gordon (1974).
9. Though it is convenient to cite and quote Friedman and Schwartz's account of the trans-
mission mechanism here, the reader should not be misled into believing that their account was
in any way unique. Johnson (1962) noted that a variety of essentially similar accounts of the
mechanism were emerging in the literature at that time, as much from Keynesians as from
quantity theorists (as monetarists were then called). He quoted a lengthy section from
Brunner (1961) to illustrate its properties.
10. In particular, Friedman's downplaying of the importance of the interest sensitivity
of velocity, most notable in (1959) but also apparent in Friedman and Schwartz (1963b),
attracted much comment before being finally laid to rest as an issue by Laidler (1966) and
Friedman himself (1966). The question of interpreting the timing of data was most notably
debated by Tobin and Friedman in their 1970 exchange in the Quarterly Journal of
Economics.
11. Even so, this 1933-1937 episode still seems to me to be the most difficult one for a
monetary explanation of the 1930s to cope with. That surviving banks might want to build up
free reserves in the wake of the bank failures of 1930-1933 is not surprising, but that they
should do so slowly over a four-year period is much harder to understand. Morrison's (1966)
explanation of the phenomenon is cast in terms of backward-looking expectations and would
be well worth some new analysis. The reader's attention is drawn to the fact that the em-
phasis of monetarist analysis of the 1930s is on the behavior of the money supply. Other
commentators (e.g., Bernanke, 1983), while focusing on events in the banking system, stress
the destruction of the information-processing and decision-coordinating capacity of the
financial sector, rather than the mere contraction of the money supply, as an important
element in the propagation of the Great Depression.
12. And, as Johnson (1962) noted at the time, a Keynesian could take considerable
comfort from the fact that a theory designed to explain fluctuations in income during periods
of chronic unemployment seemed capable of doing just that.
13. This is the view of Brunner and Meltzer (1987).
14. Two points are worth making about Phillips' contribution. First, the major finding
of his research on stabilization policy, which utilized his engineer's knowledge of control
mechanisms, was that feedback rules had to be extremely carefully designed and implemented
if they were not to be actively destabilizing; so Phillips himself was very nearly as skeptical as
Friedman about the feasibility of "fine-tuning." Second, according to Conrad Blyth (1987),
the Phillips curve itself began life as an attempt to meet Sir Dennis Robertson's criticism that
Phillips' earliest work concentrated too exclusively on real variables. That the analytical
centerpiece of the Keynesian econometric models that were later to be so confidently used to
design stabilization policies should have such a pedigree is ironic, to say the least.
15. But it should be noted that Phillips' original empirical results still need to be
explained. They show procyclical behavior of the inflation rate, rather than the price level, but
the presence of counterclockwise loops around the relationship in earlier years (they are
clockwise in postwar data) tends to make inflation lead the cycle, and hence to make the price
level itself procyclical, thus reflecting the stylized facts referred to in note 3. Presumably the
relatively constant inflation expectations existing in Britain under the gold standard, and
108 THE BUSINESS CYCLE
under the Bretton Woods system, go a long way toward explaining the appearance of a stable
inflation-unemployment tradeoff before 1914 and during the 1950s. The interwar years never
did generate so well-defined a relationship. During the 1960s, and with considerable percep-
tiveness, G.c. Archibald referred to this phenomenon in conversations as "the econometric
consequences of Mr. Churchill." And, of course, the disappearance of the Phillips curve in the
1970s came immediately after the breakdown of the Bretton Woods system.
16. This is not the place to rehearse well-known arguments about the appropriateness of
assuming price stickiness in the absence of a widely accepted microeconomic explanation of
the phenomenon. The argument that the behavior of prices ought to be explained as the
outcome of maximizing behavior is unexceptional but does not suffice to defend new-
classical analysis, since, in a competitive model, it is well known that all endogenous agents
are price-takers and that such a model cannot explain how prices are set. Since I know of
no well-articulated microeconomic explanation of money price flexibility, and since stickiness
of many money prices does seem to be a well-documented fact, I agree wholeheartedly with
Brunner (1989) on the appropriateness of making the assumption in question.
17. The reader interested in the formal properties of this type of model is referred to
Appendix B, where these are briefly described. The most complete extension of this line of
research into a rnacroeconometric model is surely to be found in the publications of Peter
Jonson and his associates at the Reserve Bank of Australia (see Jonson, Moses, and Wymer,
1976, and Jonson and Trevor, 1980). These models were differentiated from contemporary
Keynesian models by their relatively small size « 30 behavior equations), their emphasis on
the importance of monetary impulses, and their lack of a long-run inflation-unemployment
tradeoff. With hindsight, their similarities to Keynesian models, which stem from the assump-
tion that wages and prices adjust slowly to market disequilibrium over real time, are more
striking than their differences. It is worth noting that these models are not simply systems of
independently estimated equations, but incorporate the cross-equation restrictions implied
by the theoretical analysis of stock-flow interaction that lies at the heart of the monetarist
analysis of the transmission mechanism. It is also worth noting that they represent a product
of the research agenda begun by Phillips (1954) and continued by Rex Bergstrom and
Clifford Wymer (1974). Finally, it should be pointed out that small empirical models were
not a complete monetarist monopoly. Benjamin Friedman (1977), for example, presents a five-
equation model of a very Keynesian type.
18. For a small model of the U.S. economy with these characteristics, and results that are
directly comparable (and are compared) to those obtained by Barro (1978), see Laidler and
Bentley (1983).
19. The relevant literature as far as the United States is concerned was ably surveyed by
Judd and Scadding (1982). My own views on the significance of the evidence on the instability
of the demand for money function that emerged in the 1970s have most recently been set out
in Laidler (1990b).
20. And given that, from the 1880s onward, money wage stickiness was the explanation of
cyclical unemployment accepted by those whom we would nowadays classify as "classical"
economists-for example, Alfred Marshall and A.C. Pigou among others-and that, in Chap-
ter 19 of The General Theory, Keynes made it quite clear that he did not believe that his own
explanation of the phenomenon depended on such stickiness, the inappropriateness of the
current usage of the adjectives "new-classical" and "new-Keynesian" could not be more total.
It is, however, far too late to do anything about it.
THE CYCLE BEFORE NEW·CLASSICAL ECONOMICS 109
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Barro, RJ.1978. "Unanticipated Money, Output, and the Price Level in the United
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Bergstrom, Rand C.R Wymer. 1974. "A Model of Disequilibrium Neo-Classical
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Brooman, F.1962. Macroeconomics. London: George Allen and Unwin.
Brunner, K. 1961. "The Report ofthe Commission on Money and Credit." Journal
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Brunner, K., and AH. Meltzer, eds. 1978. The Problem of Inflation. Carnegie
Rochester Conference Series, vol. 8. Amsterdam: North-Holland.
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Raffaele Mattioli Lectures, Carnegie-Mellon University (mimeo).
Burns, AF., and W.e. Mitchell. 1946. Measuring Business Cycles. New York:
NBER
Cagan, P. 1965. Determinants and Effects of Changes in the Stock of Money 1870-
1960. New York: Columbia University Press for the NBER
Culbertson, J.M. 1961. "Friedman on the Lag in Effect of Monetary Policy."
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Day, AC.L. 1957. Outline of Monetary Economics. Oxford: Clarendon Press.
DePrano, M., and T. Mayer. 1965. "Tests of the Relative Importance of Auto-
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Dernberg, T.F., and D.M. McDougall. 1960. Macroeconomics. New York:
McGraw-Hill.
Domar, E. 1947. "Expansion and Employment." American Economic Review 37:
34-55.
Friedman, B.M. 1977. "The Inefficiency of Short-Run Monetary Targets for
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Johnson, H.G. 1962. "Monetary Theory and Policy." American Economic Review
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Jonson, P.D., E.R. Moses, and e.R. Wymer. 1976. "A Minimal Model of the
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Jorgenson, D.W. 1963. "Capital Theory and Investment Behavior." American
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Commentary
by Ben S. Bernanke
113
114 THE BUSINESS CYCLE
Ray Fair's chapter goes into more detail about the empirical
shortcomings of the RBC approach. Here I would like to focus
on the question of methodology. What exactly is distinctive and appeal-
ing about the RBC methodology, enough so to bring the approach a
considerable following even in the absence of convincing empirical
successes?
Let me start by listing some features of RBC models that are often
pointed to but are not, in my view, the defining aspects of those models.
First, although much has been made of the productivity or supply shock
aspect of early RBC models, the focus on supply shocks is not essential to
that approach. Witness, for example, the recent work on fiscal and monet-
ary shocks in an RBC context. Nor is the emphasis on the representative
agent, the attempt to base behavior on rigorous microfoundations, or even
the assumption of instantaneous market-clearing essential. It is not difficult
to find recent examples of RBC-style research missing each of these
characteristics.
Rather, what is distinctive and attractive about the RBC methodology is
its emphasis on general equilibrium modeling as the right way to do macro-
economics. The strict adherence to general equilibrium modeling has a
number of advantages. Greatest among these is logical coherence-the
116 THE BUSINESS CYCLE
general equilibrium approach helps us see how the various aspects of the
economy fit together. For example, in his chapter Ben Friedman correctly
points out the difficulty of isolating "pure" demand or supply shocks to
the macroeconomy. Rather than being an argument against the RBC
approach, however, Friedman's observation is an argument in favor of it: It
is precisely a general equilibrium approach that is needed to work out both
the demand and supply implications of, for example, a rise in the price of
imported oil.
In principle, the general equilibrium approach also has important
empirical advantages. At a minimum, the general equilibrium approach
eliminates the spectacle of independent research teams working on the
different equations of the macro model, each with its own set of mutually
inconsistent identifying assumptions. More positively, the full-information
estimation of a general equilibrium model increases our ability to identify
parameters or test specifications, since each paramenter value or specifica-
tion choice has implications for the behavior of the entire model, not just
its "own" equation.
Given these advantages, why hasn't the RBC approach produced more
solid empirical results? The main problem, it seems to me, is the com-
putational complexity associated with solving general equilibrium models
that embody even modest degrees of realism. At this point the cost and
technical difficulty of working with these models are too great for them to
be the workhorses of quantitative macroeconomic analysis that their
proponents would like them to be. This may change in the future, of
course, as we learn more about how to work with these models and as
computing costs continue to decline.
This brief discussion helps clarify, I hope, the difference between the
monetarist and RBC attacks on the Keynesian paradigm-the old cycle and
the new cycle. While the monetarist approach involved a methodological
component, its main contributions-the empirical relevance of money
to the business cycle, the natural rate hypothesis, and the case for non-
activism-are straightforward propositions about how the world works. In
contrast, the RBC innovation is to introduce an appealing but-at
this point-not fully developed methodology for systematically studying
macroeconomic questions. This methodology has not delivered very much
so far, it is true; but would we rule out further investigation of supercon-
ductivity (for example) because of its limited practical value thus far?
I think a fair evaluation of the RBC approach will have to wait a few
more years. In the meantime, the practical knowledge delivered by the
Keynesian-monetarist synthesis will continue to be of great value in practi-
cal debates about the economy and economic policy.
COMMENTARY 117
Note
1. However, these authors do not necessarily equate tight monetary policy with slow
money growth per se. Romer and Romer use the minutes of FOMe meetings to try to
measure policy intentions, while Bernanke and Blinder use interest rate indicators of monet-
ary policy.
References
Bernanke, Ben, and Alan Blinder. Forthcoming. "The Federal Funds Rate and the
Channels of Monetary Transmission." American Economic Review.
Bernanke, Ben, and Harold James. 1991. "The Gold Standard, Deflation, and
Financial Crisis in the Great Depression: An International Comparison." In
R. Glenn Hubbard, ed., Financial Markets and Financial Crises. Chicago:
University of Chicago Press for NBER.
Eichengreen, Barry, and Jeffrey Sachs. 1985. "Exchange Rates and Economic
Recovery in the 1930s." Journal of Economic History 45: 925-946.
Friedman, Milton, and Anna J. Schwartz. 1963. A Monetary History of the United
States, 1867-1960. Princeton, N.J.: Princeton University Press for NBER.
Hamilton, James. 1987. "Monetary Factors in the Great Depression." Journal of
Monetary Economics 19: 145-169.
Romer, C. and Romer, D. 1989. "Does Monetary Policy Matter? A New Test in the
Spirit of Friedman and Schwartz." NBER Macroeconomics Annual 1989.
Cambridge, MA: MIT Press, pp. 121-170.
Temin, Peter. 1989. Lessons from the Great Depression. Cambridge, MA: MIT
Press.
SESSION II
3 FOR A RETURN TO
PRAGMATISM
Olivier Jean Blanchard
For the last 20 years, mainstream macroeconomics has been facing a strong
challenge. For a while, it looked as though it would not survive, as though
it would be reconstructed along drastically new lines. As the challenge is
now clearly fading, it is a good time to assess what has been done and
where to go from here. This is what this chapter does. The message is not
one of self-congratulation. There has been progress but also much time
wasted. Put simply, to capitalize on what we have done, we need to return
to pragmatism.
121
122 THE BUSINESS CYCLE
Policy could in principle reduce their effects and their duration. But given
the realities of the political process, and the lags in the transmission pro-
cess, whether fiscal and monetary policies were likely to actually improve
things was very much a matter of debate.
This common view of structure and basic mechanisms allowed for
division of labor, with work on the parts proceeding in parallel with work
on an integrated structure. Work on the pieces-consumption, invest-
ment, and so on-was proceeding through the simultaneous development
and interaction of theoretical models, construction of the appropriate
aggregates, and estimation of aggregate relations. Those making the theor-
etical breakthroughs-Modigliani, Friedman, Jorgenson and Hall-were
often those making empirical progress as well. But the empirical speci-
fications were inspired from, rather than dictated by, theoretical work.
The belief was that aggregation problems were such that individual
microoptimizing relations should serve as a guide, not as a corset to the
estimation of aggregate relations.
Work on an integrated structure was proceeding in parallel. Small
analytical models, with an IS-LM backbone, but paying attention to a
particular aspect of general equilibrium, were used to identify channels and
strengthen the intuition. The strength of the best ones, those built by the
likes of Tobin and Mundell, came from the smart shortcuts they used to
deliver a high ratio of relevant insights to machinery. At the same time,
larger empirical models such as the MPS provided, by integrating the
different estimated components, a much richer dynamic structure. They
gave a sense of the time dimension of the relevant dynamics, something
small analytical structures could not do. When simulated, they would often
reveal unexpected dynamics; if those dynamics appeared implausible,
research would identify their source and possibly modify the models. The
models could be used to study medium-run issues, which were hard to
handle analytically. Most importantly, they provided a common practical
and mental structure in which the implications of new contributions could
be assessed, alternative formalizations compared, and so on.
Not everything was perfect. There were two main problems. The first
would trigger the crisis and the new-classical challenge. The second would
become obvious only in retrospect.
While optimization was heavily used to think about the behavior of con-
sumers and firms, from consumption to investment to portfolio decisions,
this reliance on optimization did not carry over to the explanation of price
and wage determination. This was not based on the belief that markets
could be thought of as perfectly competitive, so that there was no need to
think about who was setting prices and how. Indeed, a central aspect of the
FOR A RETURN TO PRAGMATISM 123
adjustment to shocks was the small and slow adjustment of nominal prices
and wages. And the belief was that goods markets were largely oligo-
polis tic, that complex bargaining was taking place in the labor market, and
that credit rationing was a pervasive feature of credit markets. Neverthe-
less, descriptions of price and wage evolutions were mostly data deter-
mined, and theories were used rather casually to justify the presence of a
variable in an equation. For example, imperfect competition was used to
justify markup over standard cost in the "price equation." Labor markets
were in effect treated as a black box, with Phillips curve relations providing
an empirical, atheoretical "wage equation."
The second problem was that the basic model, and U.S. macroeconomic
thinking in general, was very much that of a closed economy. While
perhaps a decent approximation for the U.S. economy at that time, this
was already a serious problem in thinking about fluctuations in other
countries. More importantly, these models were very much "one-sector,"
"one-country" models, leaving U.S. macroeconomists with little training
in thinking about "two-sector/two-country models" and thus about such
issues as changes in the prices of imported raw materials, changes in compet-
itiveness, and the like, issues that were to dominate the macroeconomic
scene for the following 20 years.
The first phase, in the late 1970s and early 1980s, was based on the
realization that supply shocks and rational expectations could be fruitfully
124 THE BUSINESS CYCLE
These developments were important. But they were the easy part. The
hard part was to understand the structure of markets, to understand how
prices and wages were set. This is where most of the work in U.S. main-
stream macroeconomics has taken place for the last ten years. Much prog-
ress has been made.
We have shown how small individual delays in changing prices or wages
can be individually rational yet lead to substantial aggregate price inertia
and lasting effects of demand on output. In the process, we have learned
about the trickiness of aggregation issues, about how, for example, indi-
vidual price inertia can disappear or instead be amplified in the process of
aggregation from individual prices to the price level. We have learned about
the effects of inflation on the distribution and the information content of
prices and clarified the allocation costs of inflation. I feel that this part of
the research agenda has largely been fulfilled and that decreasing returns
are setting in. But there is no longer any doubt that slow adjustment of
the price level could be given and has been given solid foundations.
We have explored alternative theories of wage setting, with the primary
purpose of explaining how fluctuations in labor demand lead to fluctua-
tions in unemployment rather than in wages. We have explored various
structures of individual and collective bargaining, asking what role the
~nemployed play in the process and how they affect the outcome. Follow-
ipg up on work that had started with the Phelps volume, we have explored
rhode Is of "efficiency wages," models in which firms use wages to elicit
FOR A RETURN TO PRAGMATISM 125
effort, motivate workers, or recruit better workers. All these models can
explain the presence of unemployed workers who would rather be work-
ing at the prevailing wage. I do not believe that they yet provide very con-
vincing reasons why fluctuations in labor demand translate mostly in
employment variations rather than in wages. I return to this later.
We have explored alternative theories of imperfect competition and
price setting in the goods markets, with the aim of explaining why firms are
willing to satisfy changes in demand at roughly constant markups over
wages. We have examined the most natural explanation, that marginal cost
is fiat, and concluded it probably is not. Following again lines first drawn in
the Phelps volume, we have explored the idea that firms concerned about
customers may decide not to increase their prices in response to an increase
in demand. Using developments from industrial organization and game
theory, we have examined whether oligopolists are also likely to smooth
prices relative to marginal cost. On these issues, I believe, we still have a
long way to go; I also return to this later.
We have explored the role of asymmetric information, moral hazard,
and adverse selection in credit markets, with the purpose of understanding
the interactions among money, credit, and activity. We have looked at the
role of banks and made progress in thinking about credit rationing. We
have studied the role of internal finance and thus the role of current cash
flow in investment decisions. In other financial markets, Shiller nearly
single-handedly has forced us to think about deviations from arbitrage and
the efficient market hypothesis. This has led to work on how interactions of
speculators and noise traders in asset markets can generate large deviations
from fundamentals, which can in turn feed back on consumption and
investment decisions.
they can explain the large set of cyclical facts that characterize labor
markets. The point goes beyond labor markets. We have developed a large
collection of theories or, more often, sketches of theories; we have not
explored whether and how they add up to a macro theory. This failure
can be traced to two causes. The first has been our "back to basics" mode.
The second has been our too frequent adoption of the wrong methodology.
Going "hack to basics" meant going away from complex issues and
returning to the study of the basic elements of our models. It also meant
keeping an open mind and exploring whatever new directions the models
we were developing to shore up foundations would lead us. Thus con-
frontation with broad sets of facts and integration were clearly not
at the top of the list of priorities. What was a healthy intellectual attitude at
the beginning has now become a disease. And part of the reason we never
proceeded to the next step-namely, systematic empirical explora-
tion and integration-is that along the way we got stuck with the wrong
methodology.
While we were rejecting the new-classical view of the world, we have too
often adopted one of its methodological ukases, namely, the quasi-religious
insistence on micro foundations and the derivation of results from "tastes
and technology." (This point echoes a theme developed by Larry Summers
a few years back, in which he denounced the dangers of "scientific illusion"
in macroeconomics.) In doing so, we have constructed too many monsters,
too many heavy models with few interesting results. But, worse than that,
those rules have de facto prevented both systematic empirical exploration
and integration. Exploring how a theory of the labor market can explain
not the time series behavior of one or two specific time series but rather the
broad set of facts about the cyclical behavior of the structure of wages, the
composition of unemployment, and so on, just cannot be done when one
plays by such rules: The taste and technology machine that would
be required would be monstrous, if it could be built at all. Exploring how
various theories of labor, goods, and asset markets combine into a macro
theory also requires shortcuts, the ability to capture the essence and ignore
the details of the various theories. Deciding what is of the essence is neither
easy nor uncontroversial, but this is precisely what shortcuts are about.
Absent the willingness to take them, systematic empirical explorations and
integration have simply not happened.
What we have seen instead of smart new Tobin-Mundell-like machines
has been an explosion of "fully articulated" one-explanation-models of
"the business cycle." The premium has too often been on intellectual
excitement per se, on epater les bourgeois rather than on relating a model
to the facts and to the existing body of knowledge. Think of the typical
FOR A RETURN TO PRAGMATISM 127
dominated by the relative demand for the particular basket of goods they
produce. European countries are, for the moment, much less specialized
than U.S. regions, but Europe 1992 is likely to lead to higher specialization.
The United States as an economy is still much less specialized, so that
shocks to domestic demand still dominate. But even the United States
is becoming increasingly specialized. Like most OECD countries, it is
specializing in products using skilled labor while consuming products which
we both skilled and unskilled labor.
The natures of these two shocks are quite different. While consumer
confidence, for example, can swiftly reverse direction, consumers who shift
their demand from one product to another are unlikely to make a quick
turnaround. And the adjustment mechanisms are also quite different. With
respect to shifts in aggregate demand, the basic stabilizing mechanism
involves the effects of changes in employment on nominal prices and wages
and in turn on real money balances. Of central importance in the process
are "nominal rigidities," to which we have devoted so much work. But for
employment to return to normal in the face of shifts in relative demand,
relative prices, and thus real consumption wages must adjust, or over a
longer horizon, factors must move, or the basket of goods produced must
change. "Real rigidities," in particular the speed and strength of the effect
of unemployment on real wages, are central to that process; even absent
nominal rigidities, changes in relative demand can generate sustained
fluctuations in unemployment. And, indeed, in a number of European
countries, nominal rigidities appear to play only a small role in generating
fluctuations in unemployment. In a rather ironic twist, what we are observ-
ing are increasingly "real business cycles," or, following my semantic edict,
"real fluctuations."
3. One aspect of those fluctuations is the set of interactions among
recessions, technological change, and unemployment. I am struck at how
these issues keep coming up and how primitive our thinking about them is.
Do recessions trigger or hinder technological progress and the introduction
of new products? Do they leave permanent scars on the labor force? Or do
they instead lead to cleansing, to the elimination of weak firms, to the elim-
ination of fat in others? From the work on the apparent disenfranchising of
the long-term unemployed in Europe to the work on the cyclical behavior
of job creation and destruction in the United States, we have tantalizing
hints of the presence of both sets of effects. Will the politics of austerity
followed by many governments in Western Europe make or break their
economies, will they lead to rationalization and improved competitiveness,
or will they lead instead to inefficient bankruptcies and prolonged unem-
ployment? Closely related issues are also at the center of discussions in
130 lHE BUSINESS CYCLE
1970, was not perfect. But it had solid foundations and was basically right.
Because of that, it has survived the new-classical challenge. Much progress
has been made; much of it, however, is still latent. Realizing that progress
will require more systematic confrontation with the data and more system-
atic integration. This task is far from impossible. But it will require a return
to more pragmatic, data-oriented research than we have relied on for the
past decade.
Acknowledgments
I have been given the daunting task of discussing how the debate among
the various schools of business cycle theorists might be resolved. People
obviously differ in how they think the macroeconomy works. Will there
ever be a winner? I am optimistic enough to think so, although I view the
last two decades as making only modest progress in this direction. One
problem is that there is too little testing of alternative models. There has
been no systematic attempt to find the model that best approximates the
macroeconomy. As disturbing, however, is the fact that macroeconomic
research appears to be moving away from its traditional empirical em-
phasis. I will elaborate on both points in this chapter.
From Tinbergen's (1939) model building in the late 1930s through the
1960s, the dominant methodology of macroeconomics was what I will call
the "Cowles Commission" approach.l Structural econometric models were
specified, estimated, and then analyzed and tested in various ways. One of
the major macroeconometric efforts of the 1960s, building on the earlier
work of Klein (1950) and Klein and Goldberger (1955), was the Brookings
model (Duesenberry et aI., 1965, 1969). This model was a joint effort
of many individuals, peaking at nearly 400 equations. Although much was
133
134 TIlE BUSINESS CYCLE
learned from this exercise, the model never achieved the success initially
expected and was laid to rest around 1972.
Two important events in the 1970s contributed to the decline in popu-
larity of the Cowles Commission approach. pte first was the commer-
cialization of macroeconometric models. 2 'J1his changed the focus of
research on the models. Basic research gave wj1y to the day-to-day needs of
updating the models, of subjectively adjustiq,g the forecasts to make them
"reasonable," and of meeting the special ineeds of clients. The second
event was Lucas's (1976) critique, which argued that the models are not
likely to be useful for policy purposes.
The Lucas critique led to a line of research that has cumulated in the
real business cycle (RBC) theories. This in tum has generated a counter
response in the form of new-Keynesian economics. I will argue that neither
the RBC approach nor new-Keynesian economics is in the spirit of the
Cowles Commission approach and that this is a step backward. The Cowles
Commission approach is discussed in section 1; the RBC approach, in
section 2; and new-Keynesian economics, in section 3. Suggestions for the
future are then presented.
1. 1 Specification
Some of the early macroeconometric models were linear, but this soon
gave way to the specification of nonlinear models. Consequently, only the
nonlinear case will be considered here. The model will be written as
(i=1, ... ,n) (t = 1, ... , T), (1)
where Yt is an n-dimensional vector of endogenous variables, X t is a vector
of predetermined variables (including lagged endogenous variables), (Xi is a
vector of unknown coefficients, and Uit is the error term for equation i for
period t. For equations that are identities, Uit is identically zero for all t.
Specification consists of choosing (1) the variables that appear in each
equation with nonzero coefficients, (2) the functional form of each
equation, and (3) the probability structure for Uit. (In modem times one has
to make sufficient stationarity assumptions about the variables to make
the time series econometricians happy. The assumption, either explicit or
implicit, of most macro econometric model building work is that the vari-
ables are trend stationary.) Economic theory is used to guide the choice
of variables. In most cases there is an obvious left-side variable for the
THE COWLES COMMISSION APPROACH 135
equation, where the normalization used is to set the coefficient of this vari-
able equal to one. This is the variable considered to be "explained" by the
equation.
It will be useful to consider an example of how theory is used to specify
an equation. Consider the following maximization problem for a represen-
tative household. Maximize
(2)
subject to
St = W t (H - L t) + rtA t- l - PtCt (3)
At = At-l + St
AT=A.,
where C is consumption, L is leisure, S is saving, W is the wage rate, H is the
total number of hours in the period, r is the one-period interest rate, A is
the level of assets, P is the price level, A is the terminal value of assets, and
t = 1, ... ,T. Eo is the expectations operator conditional on information
available through time o. Given Ao and the conditional distributions
of the future values of W, P, and r, it is possible in principle to solve for
the optimal values of C and L for period 1, denoted Ci and Li- In
general, however, this problem is not analytically tractable. In other words,
it is not generally possible to find analytic expressions for Ci and Li.
The approach that I am calling the Cowles Commission approach can be
thought of as specifying and estimating approximations of the decision
equations. In the context of the present example, this approach is as
follows. First, the random variables, WI' Pt , and 't, t =1, ... , T, are replaced
by their expected values, EoWt, EoPt , and Eorl' t = 1, ... , T. Given this
replacement, one can write the expressions for Ci and Li as
Ci= gl(Ao,A., EOW1,·· ., EoWT' EoP1> . .. , EoP T, E or1> . .. ,Earn~) (4)
Ll* = gz(Ao,A,
- EoWj, . .. , EOWT' EoP!> .. . ,EoP!> E O'1> . .. , EorT' ~), (5)
where f3 is the vector of parameters of the utility function. Equations (4)
and (5) simply state that the optimal values for the first period are a func-
tion of (1) the initial and terminal values of assets; (2) the expected future
values of the wage rate, the price level, and the interest rate; and (3) the
parameters of the utility function. 3 The functional forms of equations (4)
and (5) are not in general known. The aim of the empirical work is to try
to estimate equations that are approximations of equations (4) and (5).
Experimentation consists in trying different functional forms and in trying
different assumptions about how expectations are formed. Because of the
136 THE BUSINESS CYCLE
large number of expected values in equations (4) and (5), the expectational
assumptions usually restrict the number of free parameters to be estimated.
For example, the parameters for EOWb . .. ,EOWT might be assumed to lie
on a low-order polynomial or to be geometrically declining. The error
terms are usually assumed to be additive, as specified in equation (1), and
they can be interpreted as approximation errors.
It is often the case when equations like (4) and (5) are estimated that
lagged dependent variables are used as explanatory variables. Since Co and
Lo do not appear in equations (4) and (5), how can one justify the use of
lagged dependent variables? A common procedure is to assume that C! in
equation (4) and Li in equation (5) are long-run "desired" values. It is then
assumed that because of adjustment costs, there is only a partial adjust-
ment of actual to desired values. The usual adjustment equation for
consumption would be
0< A < 1, (6)
which adds Co to the estimated equation. This procedure is ad hoc in the
sense that the adjustment equation is not explicitly derived from utility
maximization. One can, however, assume that there are utility costs to
large changes in consumption and leisure and thus put terms like (Cl - CO)2,
(C2 - C l )2, (Ll - Lo)2, (L 2 - Ll)2, ... in the utility function, equation (2).
This would add the variables Co and Lo to the right-hand side of equations
(4) and (5), which would justify the use of lagged dependent variables in
the empirical approximating equations for (4) and (5).
This setup can handle the assumption of rational expectations in the
following sense. Let E 1_l Y21+l denote the expected value of Y21+1o where the
expectation is based on information through period t - 1, and assume that
Et-lY2I+l appears as an explanatory variable in equation (1). (Equation 1
might be the equation explaining consumption, and Y2 might be the wage
rate.) If expectations are assumed to be rational, equation (1) can be
estimated by either a limited information or a full information technique.
In the limited information case E t- 1Y21+1 is replaced by Y21+b and the
equation is estimated by Hansen's (1982) generalized method of moments
(GMM) procedure. In the full information case the entire model is
estimated at the same time by full information maximum likelihood, where
the restriction is imposed that the expectations of future values of variables
are equal to the model's predictions of the future values. 4 Again, the
parameters of the expected future values might be restricted to lessen the
number of free parameters to be estimated.
The specification just outlined does not allow the estimation of "deep
structural parameters," such as the parameters of utility functions, even
THE COWLES COMMISSION APPROACH 137
1.2 Estimation
1.3 Testing
Laidler (1992) has written an interesting and useful chapter on the history
of monetarism. From the perspective of the Cowles Commission approach,
I have no complaints about this chapter. The Laidler and Bentley (1983)
140 THE BUSINESS CYCLE
In discussing the RBC approach, it will be useful to begin with the utility
maximization model already considered. The RBC approach to this model
would be to specify a particular functional form for the utility function
in equation (2). The parameters of this function would then be either
estimated or simply chosen ("calibrated") to be in line with parameters
estimated in the literature.
Although there is some parameter estimation in the RBC literature,
most of the studies calibrate rather than estimate, in the spirit of the semi-
nal article by Kydland and Prescott (1982). If the parameters are estimated,
they are estimated from the first-order conditions. A recent example is
Christiano and Eichenbaum (1990), where the parameters of their model
are estimated using Hansen's (1982) GMM procedure. Altug (1989)
estimates the parameters of her model using a likelihood procedure. Chow
(1991) and Canova, Finn, and Pagan (1991) contain interesting discussions
of the estimation of RBC models. There is also a slightly earlier literature
in which the parameters of a utility function, as in equation (2), were
estimated from the first-order conditions-see, for example, Hall (1978),
Hansen and Singleton (1982), and Mankiw, Rotemberg, and Summers
(1985).
The RBC approach meets the Lucas critique; deep structural para-
meters are being estimated (or calibrated). It is hard to overestimate the
appeal this has to many people. Anyone who doubts this appeal should
read Lucas's 1985 lahnsson lectures (Lucas, 1987), which is an elegant
argument for dynamic economic theory. The tone of these lectures is an
exciting sense of progress in macroeconomics and hope that in the end
THE COWLES COMMISSION APPROACH 141
parameters. Why waste one's time in working with models whose co-
efficients change over time as policy rules and other things change? The
logic of the Lucas critique is certainly correct, but the key question for
empirical work is the quantitative importance of this critique. Even the
best econometric model is only an approximation of how the economy
works. Another potential source of coefficient change is the use of aggre-
gate data. As the age and income distributions of the population change,
the coefficients in aggregate equations are likely to change, and this is
a source of error in the estimated equations. This problem may be
quantitatively much more important than the problem raised by Lucas.
Put another way, the representative agent model that is used so much in
macroeconomics has serious problems of its own, which may completely
swamp the problem of coefficients changing when policy rules change. The
RBC literature has focused so much on solving one problem that it is likely
in the process to have exacerbated the effects of a number of others.
There are a number of reasons the RBC models probably do not fit the
data well. The RBC approach requires that a particular functional form
for, say, the utility function be chosen, and errors made in this choice may
lead to large prediction errors. Remember that this function represents the
average of the utility functions of all the households in the economy, and
it is unlikely that one is going to get this quite right. The advantage of
estimating approximations of the decision equations, as discussed in section
1, is that it allows more flexibility in estimating functional forms. The data
are allowed more play, if you will. Using the approach of estimating approx-
imations of decision equations, one trades off estimating deep structural
parameters for less sensitivity to functional-form errors and the like.
When deep structural parameters have been estimated from the first-
order conditions, the results have not always been very good even when
judged by themselves. The results in Mankiw, Rotemberg, and Summers
(1985) for the utility parameters are not supportive of the approach. In a
completely different literature-the estimation of production-smoothing
equations-Krane and Braun (1989), whose study is based on quite good
data, report that their attempts to estimate first-order conditions was
unsuccessfuL It may be that one is asking too much of the aggregate data to
force them into estimating what one thinks are parameters from some
postulated function.
Finally, one encouraging feature regarding the Lucas critique is that
it can be tested. Assume that for an equation or set of equations the
parameters change considerably when a given policy variable changes.
Assume also that the policy variable changes frequently. In this case the
model is obviously misspecified, and so methods like that discussed in
THE COWLES COMMISSION APPROACH 143
I should hasten to add that I do not mean by these criticisms that there is
no interesting empirical work going on in macroeconomics. For example,
the literature on production smoothing, which is largely empirical, has
produced some important results and insights. It is simply that literature of
this type is not generally classified as new-Keynesian. Even if one wanted
to be generous and put some of this empirical work in the new-Keynesian
literature, it is surely not the essence of new-Keynesian economics.
One might argue that new-Keynesian economics is just getting started
and that the big picture (model) will eventually emerge to rival existing
models of the economy. This is probably an excessively generous inter-
pretation, given the focus of this literature on small theoretical models,
but unless the literature does move in a more econometric and larger-
model direction, it is not likely to have much long-run impact.
4 Looking Ahead
So I see the RBC and new-Keynesian literatures passing each other like
two runners in the night, both having left the original path laid out by the
Cowles Commission and its predecessors. To answer the question posed to
me at the conference, I see no way to resolve the debates between these
two literatures. The RBC literature is only interested in testing in a very
limited way, and the new-Keynesian literature is not econometric enough
to even talk about serious testing.
But I argue there is hope. Models can be tested, and there are
procedures for weeding out inferior models. The RBC literature should
entertain the possibility of testing models based on estimating deep struc-
tural parameters against models based on estimating approximations
of decision equations. Also, the tests should be more than just observing
whether a computed path mimics the actual path in a few ways. The new-
Keynesian literature should entertain the possibility of putting its various
ideas together to specify, estimate, and test structural macroeconometric
models.
Finally, both literatures ought to consider bigger models. I have always
thought it ironic that one of the consequences of the Lucas critique was to
narrow the number of endogenous variables in a model from many (say a
hundred or more) to generally no more than three or four. If one is worried
about coefficients in structural equations changing, it seems unlikely that
getting rid of the structural detail in large-scale models is going to get one
closer to deep structural parameters.
THE COWLES COMMISSION APPROACH 145
Acknowledgments
Notes
1. See Arrow (1991) and Malinvaud (1991) for interesting historical discussions of eco-
nometric research at the Cowles Commission (later Cowles Foundation) and its antecedents.
2. It should be noted that the commercialization of models has been less of a problem in
the United Kingdom than in the United States. In 1983 the Macroeconomic Modeling Bureau
of the Economic and Social Research Council was established at the University of Warwick
under the direction of Kenneth F. Wallis. Various u.K. models and their associated databases
are made available to academic researchers through the bureau.
3. If information for period 1 is available at the time the decisions are made, then EoW!,
EaPl' and EOrl should be replaced by the actual values in equations (4) and (5).
4. Sec Fair and Taylor (1983) for a description of this procedure. This procedure is based
on the assumption of certainty equivalence, which is only an approximation for nonlinear
models.
5. This is assuming that one does not search by (1) estimating a model up to a certain
point, (2) solving the model for a period beyond this point, and (3) choosing the version that
best fits the period beyond the point. If this were done, then one would have to wait for more
observations to provide a good test of the model. Even if this type of searching is not formally
done, it may be that information beyond the estimation period has been implicitly used in
specifying a model. This might then lead to a better-fitting model beyond the estimation
period than is warranted. In this case, one would also have to wait for more observations to
see how accurate the model in fact is.
6. One might argue nine. Okun's article, "Inflation: Its Mechanics and Welfare Costs,"
which I did not count in the eight. presents and briefly discusses data in one figure.
7. By Olivier Blanchard.
References
148
COMMENTARY 149
Perhaps the most depressing aspect of Fair's chapter is that after all
these years of research on the business cycle, we still do not have a depend-
able, thoroughly tested model that explains the past well, predicts
satisfactorily, and is useful for policy purposes. He recognizes this fact but
is still optimistic, as am I. However, I believe that what is missing is an
honest admission of our ignorance in important areas. Let's be frank and
admit that we don't know enough to formulate the n nonlinear equa-
tions in Fair's equation (1) with much confidence. The forms of consump-
tion equations, investment equations, production functions, and many other
equations are highly uncertain. Further, it is not at all clear that the
parameter vectors, the a/s, are constant for reasons given by Fair-namely,
Lucas effects and aggregation effects-and, I add, adaptive optimization
on the part of firms, consumers, and policy makers, changes in production
techniques induced by large-factor price changes, wars, oil crises, and
consumer changes in tastes. It is shocking that the underlying deep struc-
tural parameters may be variable. Further, who knows how to prove that
this n-equation nonlinear system has a unique solution and what its global
dynamic properties are? With a large n, there is a substantial probability
that equations, error term properties, restrictions, and the like are
incorrectly formulated. And with all of these problems, who knows how
to estimate parameters well and test hypotheses with confidence? Frank
answers to these questions are not reassuring. And indeed, simulation
experiments reported by the Adelmans (1959), Hickman (1972), Zellner
and Peck (1973), and others have revealed important, unusual properties
of existent models unknown to the model builders and users. Further,
various forecasting tests of Christ (1951), Cooper (1972), Nelson (1972),
Litterman (1986), and McNees (1986) reveal that Cowles Commission-
type model forecasts have not been satisfactory. Results such as these and
the poor performance of these models led McNees (1986, p. 15) to state in
the last paragraph of his paper that "macroeconometric models may have
been 'oversold' in the 1960s and early 1970s, leading to disappointment and
rejection in the late 1970s and 1980s."
Let's admit that the economic theory underlying the equations and over-
all structure of macroeconometric models, be they RBC or NK models, is
at best tentative and probably inadequate. Fair's chapter gives a reasonable
overview of how economic theory has been employed in model building.
Let me add a few critical remarks to indicate how shaky this theoretical
structure may be. First, with respect to equation (2), there is an expec-
tation operator E in the equation with no remarks on the underlying prob-
ability measure. Knight might say, in view of the near ignorance of experts,
that consumers face uncertainty, not risk, and the difficulty in formulating
150 THE BUSINESS CYCLE
with their peculiar assumptions about seasonal, cyclical, trend, and noise
components. All of these problems, which are swept under the rug in most
econometric studies, not only can vitally affect statistical estimation,
testing, and predictive procedures but also undermine the economic ration-
ale underlying statistical tests. Yet they are rarely mentioned. Perhaps
engineers' state space models involving measurement equations, reflecting
both systematic and random measurement errors and state equations with
state equation errors, are worth considering. Also, when error-ridden,
current preliminary estimates of GNP and other variables are employed,
who knows what results?
Abstracting from these serious measurement error and seasonal adjust-
ment problems, what are we to make of a model with n uncertain nonlinear
equations to be implemented with one set of data? There are issues of
parameter identification, testing overidentifying restrictions, estimation,
diagnostic checking, and prediction. In all of these areas there are serious
problems as I discussed years ago (Zellner, 1979). I shall just remark here
that there are, as yet, no secure and tested statistical methods for
formulating an n-equation nonlinear model from a single set of data.
Formulation of such a model is still an art. In the process, the data is often
used over and over again in tests of alternative variants of equations, and
thus subsequent estimates are afflicted with pretest biases and standard
errors are hardly satisfactory. Also, there is the well-known problem of
data mining, overfitting, and the like. For example in testing a valid null
hypothesis at the 10% level in independent trials, the probability of
accepting the null on one try is .9; on two, .81; on three, .73; and so on.
Thus after just three tests, the probability is .27 of rejecting the true null
hypothesis. Effects like this are well known to be present when a single
set of data is employed to screen many hypotheses-for a discussion of
how to correct for such "selection" effects in a simple case, see Jeffreys
(1967, p. 253). Also, the discussion in Friedman and Schwartz (1991) is
relevant. When many alternative hypotheses are considered with a single
set of data, conclusive results are hard to obtain, a fact that is probably well
known. Getting more data is helpful in such situations as is out-of-sample
predictive testing, as Fair indicates.
Fair remarks, perhaps in jest, "In modern times one has to make
sufficient stationarity assumptions about the variables to make time series
econometricians happy." With the presence of Lucas effects, regime
changes, aggregation effects, adaptive optimization, and so on, it is prob-
ably the case that the stationarity assumptions, which can be tested, under-
lying most macroeconometric analyses are violated. These include spectral
and cross-spectral analyses, impulse response function analyses, method of
COMMENTARY 153
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1947." In Conference on Business Cycles. New York: National Bureau of
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Cooper, R.L. 1972. "The Predictive Performance of Quarterly Econometric
Models of the United States." In B.G. Hickman, ed., Econometric Models of
Cyclical Behavior. New York: Columbia University Press, pp. 813-926.
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Veloce, W., and A Zellner. 1984. "Modeling a Competitive Industry with Entry."
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- - - . 1985. "Entry and Empirical Demand and Supply Analysis for Competitive
Industries." Journal of Econometrics 30: 459-471.
Zellner, A. 1971. An Introduction to Bayesian Inference in Econometrics. New
York: John Wiley and Sons, reprinted by Krieger Publishing Co., 1987.
- - - . 1979. "Statistical Analysis of Econometric Models." Journal of the
American Statistical Association 74: 628-65l.
Zellner, A, L. Bauwens, and H.K. van Dijk. 1988. "Bayesian Specification Analysis
and Estimation of Simultaneous Equation Models Using Monte Carlo
Methods. " Journal of Econometrics 38: 39- 72.
Zellner, A, C. Hong, and C. Min. 1991. "Forecasting Turning Points in Inter-
national Output Growth Rates Using Bayesian Exponentially Weighted
Autoregression, Time-Varying Parameter, and Pooling Techniques." Joumal of
Econometrics 49: 275- 304.
Zellner, A., and F.e. Palm. 1974. "Time Series Analysis and Simultaneous
Equation Econometric Models." Journal of Econometrics 2: 17-54.
- - - . 1975. "Time Series Analysis of Structural Monetary Models of the U.S.
Economy." Sankhya 37 (Series C): 12-56.
Zellner, A., and S. Peck. 1973. "Simulation Experiments with a Quarterly
Macroeconometric Model of the U.S. Economy." In A.A. Powell and R.A.
Williams, eds., Econometric Studies of Macro and Monetary Relations.
Amsterdam: North-Holland, pp. 149-168; reprinted in A. Zellner. Basic Issues
in Econometrics. Chicago: University of Chicago Press, 1984.
SESSION III
5 HOW DOES IT MATTER?
Benjamin M. Friedman
161
162 THE BUSINESS CYCLE
hardship, were, in the first instance, what the subj ect was all about. Although
the aggregate-level fluctuations observed in the world's advanced industri-
alized economies in the post-Depression era have been both less severe
and less distressing, in human as well as political terms, the same questions
have largely framed this line of study ever since.
Modem research on business cycles revolves around several important
distinctions, distinctions that appear to correspond to policy prescriptions
no less than to positive economics. The line of research that grew most
directly out of the Depression experience, and that dominated the first
quarter-century of thought on the subject following World War II,
emphasized fluctuations in the public's demand for goods and services. The
implicit assumption behind this focus on demand was either that the eco-
nomy's ability to produce goods and services was highly elastic or that that
ability, if less elastic, at least did not experience sharp movements over
business cycle horizons. The remaining question was then why the demand
for goods and services fluctuated, including fluctuations that at times
carried demand in the aggregate below what the available resources could
readily supply. The main distinction this line of research came to em-
phasize was that between "monetary" disturbances, which disrupted the
equilibrium between the public's desire to hold cash balances and the
banks' ability to create those balances, and such nonmonetary factors
as changes in government spending and revenues or "autonomous"
shifts in households' desire to consume or in firms' desire to invest. (See
chapter 2.)
The economic events of the 1960s and 1970s, however, undermined
confidence in the assumptions behind this exclusive focus on disturbances
to the demand for goods and services as the source of business fluctuations.
First, the emergence of rapid price inflation, as a by-product of the effort in
many countries to stimulate demand so as to achieve ever higher levels of
employment, made the corresponding supply appear less elastic than policy
makers in those countries had hoped. Then the quadrupling of petroleum
prices by the OPEC cartel (and subsequent redoubling, several years later)
showed that aggregate supply could be not only inelastic but also subject to
disturbances just as abrupt, and apparently just as important for business
fluctuations, as those highlighted in the earlier demand-oriented research.
The emergence of a new set of business cycle theories primarily em-
phasizing disturbances to aggregate supply, in contrast to either strand of
the earlier demand-based theories, framed yet another important distinc-
tion from which continuing research drew normative as well as positive
conclusions. Over time, the ensuing "real business cycle" approach came
to encompass not merely disturbances to aggregate supply but also those
164 THE BUSINESS CYCLE
In analysis along the lines of the earlier postwar business cycle literature, in
which the focus is on aggregate demand and the question at issue amounts
to whether the chief disturbances to that demand are monetary or
nonmonetary, the analysis nearly always points to at least the potential
usefulness of one or another kind of corrective policy intervention. If
increased concerns about the risks embodied in nonmoney assets lead
investors to want to hold a larger share of their portfolios in money
balances, the central bank in a fractional reserve banking system should
expand the quantity of bank reserves, so that banks can accommodate
the larger demand for deposit creation. If a decline in stock prices leads
households to want to cut back on their consumption spending, the fiscal
HOW DOES IT MATTER? 165
policy has in fact hinged on the uncertainty issue, more so than on any
disagreement over such behavioral questions as whether money might be
neutral.
Given the assumption that macroeconomic policy actions can stimulate
or retard aggregate demand with at least some modicum of reliability on
average over time, the guiding presumption of the demand-oriented busi-
ness cycle literature is that policy actions should do so in such a manner as
to even out, insofar as possible, disturbances affecting aggregate demand.
The rationale underlying this presumption is simply that in the best of
all worlds-which by the economist's standard assumption is, of course,
a world free of all impediments to market-clearing equilibrium, so that
all relevant marginal tbis's always equaled the appropriate marginal that's
-disturbances to aggregate demand would not affect real economic out-
comes anyway. In that world the allocation of all economic resources would
depend solely on considerations associated with aggregate supply (and
on more fundamental aspects of demand, like the prevailing economy-wide
rate of time preference, which are unlikely to vary much over business cycle
horizons). In an actual economy not blessedly free of all such imper-
fections, the role of macroeconomic policy is therefore to nullify the impact
of disturbances to aggregate demand whenever possible and thus to restore
real economic activity to its pristine supply-determined equilibrium.
Against the background of this general philosophy of the demand-
oriented approach to business fluctuations, the realization that aggregate
supply also might be subject to sudden disturbances naturally created the
appearance of a sharp analytical contrast. Unusually good or bad harvests,
new technologies that increase productivity, or changes in an open eco-
nomy's terms of international trade, all imply changes in just the mar-
ginal this's and that's that are ideally supposed to determine how the
society deploys its resources. When supply considerations shift, therefore,
the standard presumption is not to offset their impact on real activity
but instead to interpret that impact as the requisite movement to a fresh
supply-determined equilibrium. This new equilibrium may be either
superior or inferior to the one that preceded it, depending on whether the
disturbance that brought about the change was favorable or adverse, but in
either case it is superior to any other allocation available in the new post-
disturbance environment.
Hence the chief policy implication of the view that the business cycles
actually observed in modern industrialized economies are "real business
cycles," in the sense of movements driven by disturbances to aggregate
supply (or, less likely for short-run fluctuations, disturbances to the fun-
damental underpinnings of aggregate demand), is that no macroeconomic
HOW DOES IT MAITER? 167
mechanism and that the tax system embodies a set of penalties and
subsidies sufficient to internalize all relevant externalities. By contrast, if
wages and prices are not perfectly flexible, or if markets are subject to
frictions, or if the tax system leaves some externalities uncorrected, then
there is room for macroeconomic policy to respond to even the purest of
"supply" shocks.
For example, consider the circumstances ("imagine" might be more
appropriate in this case) if OPEC's leaders had been sincere in their pro-
testations throughout the 1970s that they were merely using a higher price
to encourage the world to economize on a scarce nonrenewable resource,
and thus had compensated each oil-importing country by remitting the
extra revenue that the cartel received, to be distributed on a lump-sum
basis to that country's popUlation. At least in conventional analyses-that
is, abstracting from the prior discussion of inherent interrelationships
among such aspects of behavior as labor supply and consumption demand
-this situation would strictly correspond to an adverse supply disturbance.
The higher price of a key imported input would reduce the economy's
overall ability to produce goods and services, but the lump-sum distribution
of remitted proceeds would restore the demand for goods and services (in
aggregate) to its prior level. In the face of a decline in productivity, the
economy's new equilibrium would presumably call for a lower real wage.
As long as labor supply exhibits at least some positive elasticity, this new
equilibrium would therefore involve lower levels of both output and
employment.
But can an economy characterized by sticky nominal wages reach that
new equilibrium without some assist from macroeconomic policy? Suppose
that in this circumstance the central bank simply kept the supply of bank
reserves fixed and that no further disturbance affected either the public's
demand for money balances or banks' willingness to create them from a
given reserve base. The adverse aggregate supply shift would involve both
reduced output and higher prices. The higher prices in turn would imply
lower real wages. So far, so good. But in general there is no reason why the
reduction of real wages brought about by the price rise needed to clear the
market for goods and services would be proportional to the reduction of
real wages required to clear the labor market. A plausible role for mone-
tary policy in that case would be to deliver either a greater or a smaller price
rise than would occur otherwise, so as to achieve whatever decline in real
wages were necessary to reach the new equilibrium despite the rigidity of
nominal wages.
The fact that monetary policy can play such a role, of course, does not
mean that it actually should do so. The implications of uncertainty, as
HOW DOES IT MAITER? 171
A large part of what distinguishes the modern world from the primitive is
its incredible richness of texture. Individuals differ along an infinity of
dimensions, of which many probably do not bear on economic behavior
but many probably do. People have not only different preferences for
this good or that, or for working more or less, but also whole different
approaches to organizing their existence in this world. People also differ in
what they bring to the economic table in ways that go far beyond such
familiar distinctions as who has had how much formal education or on-the-
job training or who owns what tradable assets. Institutions, to the extent
that they take on an organic aspect and therefore reflect more than just the
collective attributes of the individuals associated with them, likewise
exhibit enormous differences among one another.
Standard theories of the business cycle, be they of the aggregate demand
or real business cycle type, mostly ignore this heterogeneity. Most familiar
models at best distinguish the "representative household" from the "repre-
sentative firm," although some demand-oriented models also distinguish
those households that face liquidity constraints from those that do not.
Financial intennediaries usually exist in these models only in the fonn
of banks, which except for a stochastic element, unrelated to anything else
in the analysis, amount to no more than an extension of the central bank.
Much of the demand-oriented literature simply proceeds from mathemat-
ical statements describing the behavior of economywide aggregates, with
no explicit representation of either households or finns.
Simplification and categorization are both essential, of course, to fruitful
study of complex phenomena. Nevertheless, they also bear costs. From
the perspective of macroeconomic policy, one of the costs of the level of
abstraction at which the standard theories analyze business cycles is the
blurring, if not total elimination, of distinctions that experience suggests
matter importantly for actual policy decisions.
A hypothetical example can illustrate this point. In 1991, the govern-
ment of Japan made a $9 billion cash payment to the U.S. government in
consideration for the American role in the Persian Gulf War. (For
purposes of this discussion it is irrelevant whether one construes this trans-
action as a cost-sharing contribution in a joint endeavor or as a simple fee
paid for services rendered.) It is widely reported that this payment aroused
substantial political antipathy among Japanese voters. Suppose, therefore,
that instead of remitting $9 billion in cash, the government of Japan had
delivered 1 million Japanese-made automobiles, suggesting that the U.S.
government then sell them at an average price of $9,000 each.
HOW DOES IT MATTER? 173
government would decline the gift. The point is not merely that the govern-
ment would prefer the cash to the cars. If the cash were simply not in the
picture, and the only choice were to take the cars or receive nothing from
the Japanese in consideration of the American war effort, the U.S. govern-
ment would still decline the gift of the cars.
The reason why the actual policy choice would no doubt be to reject a
gift that would make the "representative agent" in the American economy
better off sheds light on two shortcomings of standard macroeconomic
analysis. To begin, the models used do not adequately distinguish between
income and output. In the hypothetical case under discussion, the heart of
the matter is that aggregate income should rise while aggregate output
should decline. If everyone in the economy were a "representative agent,"
with an equal share in aggregate income and aggregate output alike, there
would be no reason to focus macroeconomic policy on maintaining output
as distinct from income. Income is what would matter. (In fact, there are
good reasons why output matters along with income, but they arise from
dynamic considerations of international competition rather than economic
fluctuations in the ordinary sense.) But in an economy made up of
heterogeneous elements, many people's ability to earn income depends
directly on their opportunity to contribute to output. If output falls, their
income falls too, even if aggregate income rises.
Moreover-and from a practical perspective, more importantly-many
people's ability to earn income depends on their opportunity to contribute
to the output of a specific good or service. In the hypothetical example of
the Japanese gift cars, even if macroeconomic policy managed to maintain
aggregate u.s. output unchanged (so that aggregate U.S. spending rose
by the value of the million cars), the output of the American automobile
industry would be smaller and the output of many if not most other
American industries would be greater. This shift, even within a given level
of aggregate output, would leave some people worse off even if the
"representative agent" were better off.
To the extent that macroeconomic models address such issues at all,
as opposed to burying them under the abstraction of the "representative
agent," they typically do so in two ways. One is to assume that factors of
production, including labor as well as capital, are mobile among alternative
uses. The other is to assume that appropriate redistributions from those
individuals initially made better off by any change to those initially made
worse off can, in the end, leave everyone better off as long as the change is
welfare-improving in the aggregate. Both of these responses fall short, at
least in terms of what is relevant to macroeconomic policy in a business
cycle context.
It is readily apparent that both labor and capital are far from fully
HOW DOES IT MATIER? 175
mobile, even over horizons longer than any standard business cycle.
Individuals possess both industry-specific and employer-specific human
capital. Machines and buildings have limited functional adaptability or
geographical mobility. Institutions, including conventional businesses as
well as many in the "not for profit" sector, likewise acquire vested interests
in the continuation or expansion of quite specific economic activities. Even
people with no direct participation in a company or industry may acquire
analogous interests, in that the elimination of a business (or, for the same
reasons, a military base) would reduce the demand for their own services
or the market value of their nearby property. The costs of adjustment that
induce people and institutions to strive so hard to continue in their eco-
nomic activity rather than move to deployment elsewhere-witness the
1991 Washington "summit" meeting of some one hundred American
corporations to coordinate lobbying strategies to prevent the downscaling
or possible elimination of the B2 bomber project, for which each was a
supplier-are clearly great enough to preclude the immediate and full
transfer of resources in the wake of some kind of supply disturbance.
The absence of transfers by which the "winners" can so compensate
the "losers" as to leave everyone better off after a change that would be
welfare-improving in the aggregate also involves, conceptually, a kind of
transactions or adjustment cost. Here, however, the costs precluding what
the standard theory simply assumes will take place are not economic
but political. For all their virtues, the democratic political institutions
that govern the world's advanced industrialized economies have not been
very successful at compensating those individuals or businesses, or other
institutions, that are adversely affected by changes that benefit many
others. The economist's notion of a Pareto improvement (a change that
leaves at least some people better off and no one worse off) therefore loses
its practical relevance. Given the combination of enormous heterogeneity
and limited mobility that characterizes the modern economy, few changes
are likely to be Pareto-improving on initial impact. And given the inability
of the prevailing political institutions to achieve the requisite transfers, the
winners cannot compensate the losers so as to turn a change that is merely
welfare-improving in the aggregate into a Pareto improvement. Hence
"policy," including macroeconomic policy, becomes a matter of "politics"
in the classic sense.
A different example may further sharpen the point. Unlike the hypo-
thetical receipt of gift cars from Japan, the currently proposed free trade
agreement between the United States and Mexico would, if instituted, alter
considerations bearing on production in ways that properly constitute a
"supply shock." Most obviously, the agreement would expand opportu-
nities to produce goods, for sale in U.S. markets, from American capital
176 THE BUSINESS CYCLE
and Mexican labor. Like a rise or fall in oil prices, these changes in supply
considerations would persist over time. But also like a rise or fall in oil
prices, they would have a short-run impact that bears analysis in a business
cycle context.
That analysis suggests that the new equilibrium would-as in the case
of the gift cars-involve higher aggregate U.S. income and spending and
lower aggregate U.S. output and value added. For just the reasons already
discussed, this change would be welfare-improving in the aggregate. (That
is why economists typically favor free trade.) But here again, heterogeneity
importantly enters the story. The reason why U.S. income would be higher
despite lower U.S. output is that the additional income earned on
American-owned capital deployed in Mexico would outweigh the loss of
income earned at home by American workers. In this case, therefore, the
relevant distinction is not who works (or owns stock) in the automobile
industry and who works elsewhere, but who earns income from selling
labor and who earns income from owning capital.
The fact that the free trade agreement would be welfare-improving in
the aggregate for the United States means that owners of capital could, in
principle, compensate workers so as to render everyone better off. But
because there is little prospect that those transfers will occur, organizations
representing U.S. labor strongly oppose the free trade agreement. If the
agreement is enacted, the same groups will no doubt seek macroeconomic
policy action to offset the loss of U.S. employment. (The more than
10% unemployment that developed in Canada following the implemen-
tation of a parallel U.S.-Canadian free trade agreement elicited wide-
spread calls for monetary and fiscal expansion there.) Explaining that what
has happened constitutes a straightforward supply shock-and a favorable
one, at that-and that conventional business cycle theories therefore
mandate simply allowing the economy to go to its new (in the aggregate,
preferred) equilibrium, would be of little practical import.
The point of all this is that, for reasons wholly apart from the questions
of rigidities and market imperfections discussed earlier on, standard busi-
ness cycle theories fail to address issues that importantly bear on the
making of macroeconomic policy in a business cycle context. The upshot is,
again, to blunt the force of whatever policy implications these models have
to offer.
4 Concluding Thoughts
The main line of argument in this chapter has been that recent
developments in business cycle theory-specifically, the emergence of
HOW DOES IT MATTER? 177
Acknowledgments
One of the few advantages of reaching a certain age is the ability to put
things into the perspective of the history and breadth of one's science.
Obviously, I envy Ben Friedman's assignment to do just that, and I will
embroider my own license along the same lines.
I want to leave aside the issues of appropriate research agendas-we all
make our views clear in the agendas we pursue. Instead I want to focus on
the policy debate. Ben has challenged the now almost conventional wisdom
that the monetary authority's central goal should be price-level stability
and that it should eschew both contracyclical policy and unintentional
destabilization policy. He also challenges the view that fiscal policy is
pretty much hopeless. Finally, he proposes an agenda for future research
needed to better choose the correct set of policy instruments to address
particular business cycle phenomena. It is my intention to defend the
conventional views-a personally novel experience but perhaps that too
comes with middle age. Although I must differ with Ben on the desirability
of contracyclical policy, I applaud the clarity and vigor of his argument in
its favor.
Until living through the recent recession in a policy-making position in
Washington, I believed that, by and large, the economics profession had
outgrown its fascination with contra cyclical policy and fine-tuning eco-
nomic growth. Obviously I was wrong, and Ben is far from alone in arguing
for an activist approach to macroeconomic policy. Nonetheless, after
having seen the theory and practice of contracyclical policy thoroughly
tested in the 1960s and 1970s, the bulk of the academic segment of the
profession has-in my opinion-come to share the view that fine-tuning
the economy is beyond our collective wisdom and institutional capacity.
Still the urge to do good is strong; so I plan to devote the main portion of
my comments to explaining why that urge should properly be resisted.
These remarks will differ sharply from Ben's chapter in that I shall
not assume this shift or that shift as necessary to illustrate a particular
quandary-instead I shall try to present a bare-bones framework for look-
ing at policy strategies in the face of an economy in which macroeconomic
shocks occur randomly and with no clear, timely indication of their size and
direction. I shall concentrate on shocks to aggregate demand. The real
179
180 THE BUSINESS CYCLE
the labor force. These policies have long-run rather than contracyclical
aims. Deviations from equilibrium real income due to demand shocks
-which I shall term cyclical income-would be zero if any autonomous
disturbance to the system were offset by a policy disturbance of equal
magnitude and opposite sign.
In the absence of stabilization policy, the variance in cyclical income is
equal to the variance of the autonomous disturbance. But, if we implement
stabilization policy, the variance of cyclical income equals the sum of the
variances of autonomous and policy shocks plus twice their covariance.
Thus a reduction in the variance of cyclical income is possible only if a
negative covariance between autonomous disturbances and policy dis-
turbances can be achieved. This means that when autonomous disturb-
ances are moving cyclical income in one direction, policy disturbances
on average are moving cyclical income in the opposite direction.
Where a negative covariance in the values of autonomous and policy
disturbances can be demonstrated, contracyclical policy may indeed be
stabilizing. There is no certainty, however, that this will be the case. The
assumed negative covariance has two components: First, a negative corre-
lation reflects the average ability of policy makers to move in an offsetting
direction. Second, a scale factor indicates the magnitude or forcefulness of
the policy moves taken. At the optimal scale factor, the variance of cyclical
income is reduced by the square of the correlation coefficient. For
example, if the correlation between autonomous and policy shocks were
-0.2, then at best the variance of cyclical income could be reduced by 0.04,
or 4%. If the scale of policy shocks supplied by government were too small,
the reduction in variance of cyclical income would be less than this amount.
If the policy shocks were too large, the result would be either a smaller
decrease or an actual increase in the variance of cyclical income.
We are now at the heart of the policy problem. If stabilization policy is
to be effective, policy makers must be able to determine the appropriate
direction, magnitude, and timing for the required policy shock. If direction
and timing can be determined so as to achieve a negative correlation,
restraint on the scale of policy is necessary for the policy to be stabilizing
rather than destabilizing. Conversely, a correlation of zero would indicate
that any active policy can only increase the variance of cyclical income and
hence destabilize the economy.
A few decades ago, when the debate was limited to Keynesians and
monetarists--aren't the terms quaint to today's ears-I believed that
framing the debate in terms of slopes of IS and LM curves was completely
misleading. Here I have proposed a framework first presented by Milton
Friedman (1953) some four decades ago and hope that you will find it more
to the point.
Now let me summarize the points of view in terms of correlation and
scale: On correlation, Keynesians believe that they are able to recognize
autonomous shocks and take offsetting actions rapidly enough to achieve
a substantial negative correlation. New-classicals, at the other extreme,
believe that systematic actions are ineffective and therefore that only
random policy shocks uncorrelated with the state of the economy are poss-
ible. Monetarists fall in between, allowing for some effects of systematic
policy but emphasizing lags of recognition, decision, and effect so that the
correlation between autonomous and policy shocks is necessarily small
in absolute magnitude. On scale, Keynesians tend not to worry about find-
ing the right setting as well as direction, monetarists fear that political
pressures will lead to an overzealous and hence destabilizing scale of policy
actions, while any scale of random actions is destabilizing for the new-
classicals.
So what has happened to contracyclical policy? First, Keynesian
optimism has not fared at all well in the academic community and little
better in the practical world. By and large the 1960s and 1970s have been
read as demonstrating that the Keynesian policy means well but is badly
destabilizing. I must say that the theoretical arguments against contra-
cyclical policy, which Ben challenges, may be used to explain why it didn't
work, but have not been per se fatal to the Keynesian agenda. Second, and
perhaps as importantly, neither monetary nor fiscal policy has really been
available for attempting sophisticated contracyclical fine-tuning. Fiscal
policy has been dominated by longer-term clashes over the scale of taxes
and spending while the monetary authorities were facing a daunting task
just to avoid doing harm.
2 Monetary Policy
3 Fiscal Policy
4 Conclusion
Stabilization policy was tried in the 1960s and 1970s. It failed. I believe that
it is that failure, and not any literal belief in the assumptions to which Ben
points, that explains its current disrepute. That does not mean that the
Federal Reserve's move since 1988 toward price stability did not affect the
real economy. Rather, those effects were viewed as a temporary side effect
of a long-run shift to a better equilibrium. While clearly there have been
internal and external differences of opinion about the speed with which the
Fed has moved toward price stability, those debates have not been in the
context of contracyclical policy.
I believe that the passing of contracyclical policy as a strategy is a good
thing for economists as a group. First, we are no longer promising a cure
that in actuality makes things worse. Second, as concentration shifts to
medium- and longer-term strategies, the systematic forces that economists
understand become more important relative to the random shocks that
elude us. It is perhaps inevitable that during what appears to be the early
stages of recovery from a recession, the siren song of contracyclical policy
might sound good. But nostalgia for a past which wasn't must not blind us
to the present reality. While I applaud the Fed's efforts to get M2 growing
again, that falls under eschewing procyclical policy or automatic destab-
ilizers. That, I think, we can all agree is a good idea.
References
Darby, Michael R., Angelo R. Mascaro, and Michael L. Marlow. 1989. "The
Empirical Reliability of Monetary Aggregates as Indicators: 1983-1987." Eco-
nomic Inquiry 27: 555-585.
Friedman, Milton. 1953. "The Effects of a Full-Employment Policy on Economic
Stability: A Formal Analysis." In Essays in Positive Economics. Chicago:
University of Chicago Press.
CONFERENCE OVERVIEW
Commentary: Deja Vu All Over Again
by Alan S. Blinder
Often, conferences acquire nicknames. I suggest we name this one either
the Michael 1. Fox conference or the Yogi Berra conference, for it has
provided the most reminiscences since my high school reunion. The
analogy is an apt one because the way David Laidler and Olivier Blanchard
review the two "debates"-a polite word for cockfights-reminds me of
puberty: It isn't much fun when you are going through it, but you look back
at it fondly-though inaccurately-as "the good old days."
Permit me a brief biographical detour. I received my undergraduate and
graduate educations in economics between 1963 and 1971, just the years
when the Keynesian-monetarist debate was in full swing, and began my
career as a macroeconomist on the eve of the new-classical counter-
revolution. In 1971, when I joined the cadre of practicing macroeconomists
-thereby Granger-causing the subsequent arrival of both Olivier Blanchard
and Bob King-I believed myself to be joining a process of Kuhnian
"normal science." Those of us trained in the 1960s knew there were
problems with both the empirics and, especially, the theoretical foun-
dations of the standard consumption, investment, and money-demand
functions-not to mention the wobbly Phillips curve. We also knew that
the treatment of inflationary expectations was a major problem for the
latter. But progress was being made. The macroeconomics of 1971 was
noticeably better than the macroeconomics of 1961 and 1951. And we had
every reason to think that the macroeconomics of 1981 would be better yet.
But those expectations were far from rational. What has happened since
has been neither normal nor science. Who would say that the macro-
economics of 1991 is demonstrably better than the macroeconomics of 1972?1
Not I, nor, I surmise, Blanchard. It turned out that we macroeconomists
spent the better part of two decades arguing-often from behind ideologi-
cal barricades (a point the authors in this volume delicately ignore)
-whether wages and prices move instantly to clear all markets. Not why
they do not, which is a good question, but whether they do. That, in retro-
spect, and probably even in prospect, was ridiculous.
189
190 THE BUSINESS CYCLE
energy arguing about theoretical basics (Blanchard) and that it is high time
we got back to empirics (Laidler, Fair).
Blanchard writes (p. 127) that "by being in the 'back to basics' mode,
the field has developed mostly according to its own internal logic, and we
have shunned external stimulus too much."
Laidler observes (p. 103) that "the new-classical economists did not
advance an alternative set of empirical hypotheses .... Rather they put
forward an alternative theoretical framework whose superiority they
defended ... with reference, not so much to superior empirical content, as
to its conformity with the theoretical principles of equilibrium modeling."
There is no point in providing a similar quotation from Fair, for Ray's
entire chapter carries this message. Let me just state, instead, that I agree
entirely.
However, those who endorse the pre-eminence of empirical evidence
over theory, as I do, must reckon with the Phillips curve episode of the
1960s. Laidler described it exactly correctly. The position of mainstream
Keynesian economists in, say, 1969 was that the Friedman-Phelps argu-
ments for a vertical long-run Phillips curve were theoretically correct but
that the empirical evidence said otherwise-and we should stick with the
empirical evidence until it was proven wrong. We did; and it was. So those
who placed their bets on a priori theorizing over empirics won that round.
Advocates of real business cycle theory maintain that its eventual triumph
will be a second case in point. Blanchard, Laidler, Fair, and I implicitly
take the other side of this bet. (In fact, I'll give odds.) But we should re-
member that it's a bet and duly note that our side was wrong once before.
There is another aspect of these debates-in addition to and related to
the ideological component-that should be brought out; but none of the
chapters have done so. Once a few positive issues (like the interest elas-
ticity of money demand) were resolved, the Keynesian-monetarist debate
was largely over normative, policy-related issues. Should the authorities
pursue an activist stabilization policy or follow nonreactive rules? Should
monetary or fiscal policy be the chief instrument of demand management?
Should policy makers (and their advisers) worry most about the short-run
unemployment problem or the long-run inflation problem?2 It is almost a
foregone conclusion that questions that begin with the word should can
never be given a definitive answer by research results alone. At minimum,
value judgments and political considerations enter. So these questions con-
tinue to be debated. That fact is no condemnation of economics as a science.
The new-classical debate was, in stark contrast, largely over positive
issues. Do all markets clear (approximately) instantly? Is anticipated
money neutral? Do shocks to aggregate demand principally move real
DEJA VU ALL OVER AGAIN 191
output or the price level in the short run? Are economic fluctuations
dominated by mainly demand or mainly supply shocks?3 This second list
of questions is not about what policy makers should do but about how
the economy works. Such questions ought to be resolvable by economic
research-by the process of normal science-and perhaps by now have
been. The fact that such issues remained controversial for so long is a
strong condemnation of our profession.
One final important point has not been brought out in the discussion but
should be. So-called new-Keynesianism has come in for a great deal of
criticism, but little praise, at the conference so far. One main reason is
its starkly nonempirical flavor. It is difficult even to imagine taking most
of these models to the data; and few (but not no) new-Keynesians seem
so inclined. But I think this criticism is unfair, for it entirely ignores
the historical context. New-classical counter-revolutionaries sacked the
Keynesian temple not because its empirical content was found wanting,
though some falsely argued that point,4 but because its theoretical
underbelly was so soft. The challengers did not offer superior empirical
predictions, but rather models that were smaller, cuter, and more consist-
ent with maximizing behavior. It was therefore rational for younger
economists seeking to defend the Keynesian tradition to work on strength-
ening the theory, not the empirics-which is precisely what they did.
Were they misguided? Consider this metaphor. You are the commander
of Fort Keynes, which guards the intellectual frontier from dangers
believed to lurk principally on the empirical east side. Though your fortress
is far from beautiful, it is functional-and functioning. You are aware of
both homely aspects and structural weaknesses in the consumption, invest-
ment, and money-demand towers arrayed along the east side, where most
of the fortifications have been built. And you are working hard to repair
them. In the meantime, you have allowed yourself to live with meager
defenses on the theoretical west side, believing that there is little danger of
attack from that quarter. Then events prove you wrong. Enemies from the
theoretical west mount an attack whose ferocity was previously unimagin-
able. Soon they are scaling the walls. You suffer heavy losses for a while,
but then fresh troops arrive. My question is simple: Where do you send
them? That, I believe, is the story behind new-Keynesian economics. It
both explains and rationalizes its nonempirical flavor.
Let me now try to illustrate the main message of the conference by turning
to the achievements, or rather lack thereof, of what is here being called the
192 THE BUSINESS CYCLE
them erratic. Both fiscal and monetary shocks are taken to contribute
significantly to the variability of aggregate demand. The aggregate supply
curve is usually taken to be quite flat in the short run, an exception being
when the economy is pressing up against capacity constraints. Supply
shocks, we learned in the 1970s, can on occasion be extraordinarily large
and disruptive. 8 But, for normal quarter-to-quarter economic fluctuations,
the contemporary consensus is that supply shocks are quite small.
And then there is the Phillips curve, which, despite much bad-mouthing,
has proven to be a remarkably sturdy empirical regularity once supply
shocks are appended. The contemporary consensus is that IX = 1 and A is
small, just as in the second column, and that expectations are probably
rational. I use the qualifying adverb because, while most economists
nowadays accept the rational-expectations hypothesis, the empirical
evidence in its favor is at best weak and at worst damning. In fact, my
personal assessment is that the weight of the evidence is against it. 9
In conclusion, I invite you to compare the last column to the first two
in table C-1-thereby skipping over both versions of equilibrium macro-
economics. Other than recognizing the potential importance of supply
shocks-which was forced on us by events, not by the new-classical revol-
ution-and the wholesale adoption of rational expectations, perhaps for
unsound reasons, the "new" consensus is the same as the "old" consensus
that had been reached in 1972. Was that progress?
Well, that's the past. What of the future? Can macroeconomists,
equipped with this new/old consensus, get back to doing normal science?
Five and a half years ago, when I wrote an evaluation of the "second
debate," I thought the answer was no; we were not ready yet.lO Now I think
the answer may be yes. If we can break the habit of shouting "Lucas
critique" or "rational expectations" or "unexploited profit opportunities"
in a crowded theater, then workaday macroeconomists may be able to
return to the task that was so unfortunately abandoned in 1972.
Notes
1. I pick 1972 over 1971 advisedly. By 1972 the "vertical-in-the-long-run" view of the
Phillips curve had won the day.
2. It will be noted that this last question presupposes the existence of a short-run tradeoff.
Keynesians and monetarists did not and do not dispute this.
196 THE BUSINESS CYCLE
References
Important changes in the agenda for research into the business cycle in
modern industrial countries have occurred over the past two decades.
These changes have included the end of the single-minded concern of
researchers with the determination and management of aggregate demand
and a new emphasis instead on the cyclical implications of shocks to avail-
able resource endowments and on cyclical aspects of regional and sectoral
economic development.
Prior to the mid-1970s, conditioned by the cyclical experience of the
preceding hundred years and especially by the experience of the Great
Depression, we took it for granted that in modern industrial economies,
cycles in the economic activity reflect fluctuations in the utilization rate of
existing endowments of labor and capital and that these fluctuations in the
utilization rate are proximately the consequence of fluctuations in nominal
aggregate demand. It seemed obvious then that, with the exception of the
damage associated with major wars, the possibility of sharp changes in
existing resource endowments was not something worth worrying about, at
least not in the context of modern industrialized economies, which had
conquered the old problems of famine and pestilence. In addition, although
we were concerned with problems of economically depressed regions and
industries, we regarded these problems as involving secular issues of econ-
omic growth and stagnation and as distinct from the agenda of business
cycle research. In sum, we believed that, if we were able to understand
fluctuations in nominal aggregate demand, then we would have understood
economic fluctuations, and that, if we were able to prescribe how to
stabilize nominal aggregate demand and, thereby, to stabilize aggregate
economic activity at the national level, then we would have largely solved
the problem of economic fluctuations.
Accordingly, the business cycle research agenda prior to the mid-1970s
focused on the determination of nominal aggregate demand, on the
relation between nominal aggregate demand and real aggregate demand,
and on the management of economic policy to stabilize nominal aggregate
demand. This research agenda generated a variety of distinct, but related,
controversies. One controversy concerned the source of fluctuations in
nominal aggregate demand-specifically, the importance of disturbances to
197
198 THE BUSINESS CYCLE
aggregate demand through the rest of the decade. Only the mildest of
recessions as measured at the national level, probably resulting mainly
from a contractionary fiscal impulse, interrupted this expansion. And the
Fed seems sufficiently cautious in its reaction to this last recession that
we have little reason to fear an unsustainably fast expansion of nominal
aggregate demand that would lead to a major new cycle of inflation and
recession at the national level.
But a single observation does not provide a powerful test of an hypoth-
esis. Were the 1980s merely a lucky drawing from an unchanged economic
and political structure? Or are we actually living in a new era in which we
have no need to worry about major cyclical fluctuations in nominal aggre-
gate demand at the national level? To try to answer this question, we can
begin by trying to account for the two events that I have emphasized-the
policy reversal of the late 1970s and its apparent consequence, the macro-
economic stability of the 1980s. Two explanations, which are potentially
complementary, occur to me as good candidates for such an accounting.
The first explanation emphasizes the effects of the accumulation of new
knowledge about the economy during the 1970s. This new knowledge
included both new theories-especially the natural-rate hypothesis, and
also the rational-expectations hypothesis-as well as new empirical
evidence-especially, evidence that the natural rate of unemployment is
not a constant and, in particular, that by the late 1970s the natural rate of
unemployment was much higher than in the 1950s and 1960s. According to
this explanation, policy makers, who by the 1960s were confident of their
ability to manage nominal aggregate demand, learned during the 1970s the
limitations on the ability of aggregate-demand management to deliver high
levels of economic activity. The inflationary surges of the late 1960s, mid-
1970s, and late 1970s were all plausibly part of this learning experience.
The second explanation emphasizes that since the late 1970s the major
industrial countries have seen no exogenous economic or political disturb-
ances of the type that have led to inflationary monetary policies in the past.
Most obviously, there have been no adverse disturbances like the oil price
shocks of the 1970s. In addition, the large increase in military spending in
the 1980s, in contrast to spending for the war in Vietnam, had wide political
support, support that precluded the need to risk an inflationary surge to
finance it. The more recent easing of international tensions has reduced
further the strain on resources that potentially would generate political
pressures for inflation.
But, we have no guarantee that the future will not bring less favorable
developments. Most basically, there has been no obvious change in the
structure of preferences and political constraints underlying economic
BUSINESS CYCLE DEVELOPMENTS 201
policy, and especially monetary policy. It is one thing for policy makers to
know how to manage aggregate demand to mitigate fluctuations in aggre-
gate economic activity. It is another thing for them to give priority to this
objective. Even if policy makers have learned the dangers of under-
estimating the natural rate of unemployment and of trying to exploit the
short-run Phillips curve to drive unemployment below its natural rate,
without a change in preferences and political constraints we cannot
preclude the possibility that some future economic or political develop-
ment will cause policy makers knowingly to risk producing a possibly
unsustainable expansion of nominal aggregate demand and a consequent
cycle of inflation and recession. For example, can we be sure that the large
and growing fiscal obligations implied by current budget deficits and other
currently legislated spending commitments will not undermine future
monetary discipline?
Returning to the current agenda for business cycle research, it seems to
me that we still have to be concerned about fluctuations in nominal aggre-
gate demand. But the present priority does not seem to be to refine further
our knowledge either of the determination of nominal aggregate demand,
or of the relation between nominal aggregate demand and real aggregate
demand, despite the fundamental importance of this issue for economic
modeling, or of how to manage economic policy to stabilize aggregate
demand. Rather the experiences of the past two decades suggest that the
present priority, in addition to studying the cyclical implications of shocks
to available resource endowments and the cyclical aspects of regional and
sectoral economic development, should be to improve our understanding
of the political-economic structure underlying monetary and fiscal policy. I
leave a discussion of the directions for such a research agenda for another
occasion.
Acknowledgments
202
WHERE DO WE STAND? 203
with a horizontal LM curve as well, the aggregate demand curve (the equi-
librium locus in price-output space) was vertical, so the entire apparatus
was irrelevant. All one needed to determine aggregate economic activity
was the 45-degree cross model of the consumption function and auto-
nomous expenditure.
Arnold Zellner has recalled that in the early 1960s while a member of
President Kennedy's Council of Economic Advisers, James Tobin was
asked whether he used large-scale econometric models to form his advice
to the President. 2 Tobin responded that he did not. Instead he used an
envelope on which he drew the 45-degree cross model to generate his
multiplier results. Remarked Tobin, "I don't believe the results but at least
I know what I am doing." The only difference between the 45-year-old
Tobin and the 25-year-old Parkin was that I did believe the results and
didn't know what I was doing!
Many of us left the traditional Keynesian track sometime in the 1960s.
For me the departure was dramatic. It was in the fall of 1967. I had just
arrived at the University of Essex, where I met David Laidler, fresh from
Chicago and Berkeley. He was as fast on his feet, well read, and well
equipped to do verbal battle as anyone I had ever met. After one or, at
most, two sessions in which I resoundingly lost all the arguments-because
I was ignorant of some crucial, by then well-known, pieces of empirical
evidence, especially Laidler's own work on the demand for money function
and Jorgenson's work on investment demand-I quickly recognized that
the IS curve indeed was not vertical and that the LM curve was not hori-
zontal. The IS- LM apparatus was not only elegant but useful.
Given this view of the IS-LM curves, the aggregate demand curve
sloped downward and to determine eqUilibrium output we needed an
aggregate supply curve. Thus I was ready to buy into the IS-LM, AD-AS
Phillips curve mainstream. Actually, accepting the Phillips curve part of
the story was really easy because I had already been convinced (on the
basis of the same ignorance that led me to my earlier conclusions on the IS
and LM curves) that the Phillips curve was the most robust of the empirical
relationships available!
As the mainstream flowed and the expectations augmentation of
the Phillips curve was absorbed into it, a great deal of constructive work
was done. Though the mainstream flowed strongly, it did not flow up
the mountain. (Karl Brunner was fond of reminding us-usually when
putting down some absurd statement based on factual error-that water
does not flow up hill, not even in Switzerland.) As the mainstream flows
it fills in the cracks and sorts out the details. That's what was happening in
the late 1960s.
204 THE BUSINESS CYCLE
economists have been accustomed to think. Indeed, the idea of even proposing
and "testing," in the above sense, a purely Walrasian model of the cycle has
generated heated objections, sometimes aggravated by the misguided claim that
these initial attempts conclusively demonstrated that business cycle phenomena
were nothing more than the optimal reaction of rational agents to exogenous
productivity shocks.
My final quotation from the Danthine-Donaldson paper is one that
shows how they view the enterprise and what they see as the possibility of
progress:
In reality, RBC methodology is by nature ideologically neutral in the sense that
it prefers the model or set of models that is (are) best able to replicate the
stylized facts independent of the hypotheses underlying it (them). The best RBC
model may thus ultimately be a demand-driven money model with substantial
non-Walrasian features. [My italic.] Such a convergence will ultimately occur,
however, not on the basis of prior views but as the outcome of a process of build-
ing increasingly richer models and confronting them with an increasingly richer
set of stylized facts .
. . . It is ... premature ... to claim victory of one model paradigm over
another given the modest set of facts which current models are able to repli-
cate .... However, a clear achievement of the RBC literature has been to free us
to reconsider what we know about the business cycle.
I believe the foregoing statements by Danthine and Donaldson
represent the point of view of the vast majority of young macroeconomists
working the field today. They certainly represent the views of my
colleagues who work in this area and of all the young macroeconomists
with whom I have discussed the subject in the past several years. Olivier
Blanchard's (1991) characterization of the research program on which
these young economists are embarked is severely at odds with the picture
that I have painted and, I think, is wrong.
The approach has already led to the development of models with enor-
mous diversity. There are papers that explore a variety of alternative types
of technology shocks,S international aspects of the business cycle,6 alterna-
tive interpretations of the Solow residual-seeking to understand the poss-
ible deeper sources of shocks7-and non-competitive market structures. 8
This new method of quantitative theory joins the other research methods
in macroeconomics-the Cowles method, qualitative models, and case
or episode studies-the outstanding example of which is Friedman and
Schwartz (1963) but a modern example of which is Romer and Romer
(1990).
If the new method of macroeconomics is doctrinally neutral, what has
become of the new-classical and new-Keynesian labels that are at the
WHERE DO WE STAND? 207
a process, not an event"l1 and there is, therefore, no need to operate in the
time domain, or because other methods have superseded quantitative
theory.
Finally, what about policy itself? What does the current state of know-
ledge imply for policy choice? First, there does not exist a feasible commit-
ment technology that permits us to establish policy rules. All policy is
inevitably discretionary. In this I agree with Ben Friedman's assessment.
Second, given where we stand, policy can do no better than use the tradi-
tional econometric models rationalized through the aggregate demand-
aggregate supply-expectations augmented Phillips curve view of the world,
in its attempt to steer a course between recession on the one side and
inflation on the other. Third, given the political and institutional con-
straints on policy making, it is all but certain that policy actions will be
imperfect and will from time to time exacerbate the very cycles they seek
to smooth.
The more interesting and important policy questions, it seems to me, are
not those concerning the details about which instrument to assign to which
target, with what intensities and timing, but those concerning the way in
which policy makers react to the evolving economy and the ways in which
alternative institutional arrangements- central bank law and operating
procedures-operate to stabilize the economy. I recommend strongly to
our hosts and organizers that they consider this topic as a suitable one for a
future St. Louis conference.
Acknowledgments
Notes
1. Attributed to Einstein in a letter by Oliver Sacks to The Listener 88, No. 2279, 30
November 1972, p. 756. (I have not been able to track down the original Einstein quotation.)
2. A remark made at the Sixteenth Annual Economic Policy Conference, Federal Reserve
Bank of St. Louis, October 17 -18,1991.
3. See Kydland and Prescott (1982).
4. The reader is referred to Olivier Blanchard (1991), not the revised version of his paper
published in this volume.
WHERE DO WE STAND? 209
References