Friday, January 23, 2009

Did a technology shock cause the subprime crisis?

Or the more widespread financial crisis? I was reminded of this by Robert Skidelsky. He overstates what RBC is (no unemployment) since the current crop of RBC or rather DSGE models are quite
In classic business-cycle theory, a boom is initiated by a clutch of inventions – power looms and spinning jennies in the 18th century, railways in the 19th century, automobiles in the 20th century. But competitive pressures and the long gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually profitable. Such over-investment produces an inevitable collapse. Banks magnify the boom by making credit too easily available, and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Dennis Robertson, an early 20th-century "real" business-cycle theorist, wrote: "I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial to the populations concerned." Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary "real" business-cycle theory builds a mountain of mathematics on top of these early models, the main effect being to minimise the "destructiveness" of the "creation". It manages to combine technology-driven cycles of booms and recessions with markets that always clear (ie there is no unemployment).How is this trick accomplished? When a positive technological "shock" raises real wages, people will work more, causing output to surge. In the face of a negative "shock", workers will increase their leisure, causing output to fall.

... Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern "real" successors smothered his insights in their obsession with "equilibrium" and "instant adjustments". For Schumpeter, there was something both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques of his mathematical progeny.

Update: Mankiw defends the equilibrium approach while Mark Thoma and Paul Krugman says that the approach is based more on theory than evidence.

Krugman: There’s no ambiguity in either case: both Fama and Cochrane are asserting that desired savings are automatically converted into investment spending, and that any government borrowing must come at the expense of investment — period.
What’s so mind-boggling about this is that it commits one of the most basic fallacies in economics — interpreting an accounting identity as a behavioral relationship.

Thoma: ... we can expect these economists to flail about defending the indefensible, they will be quite vicious at times, and in their panic to defend the work they have spent their lives on, they may not be very careful about the arguments they make.

Also, Robert Waldman explains the difference between equilibrium (fresh water) schools and everything else (salt water):
In the field of macroeconomics there is a much deeper division between macroeconomics as practiced at universities closer to the great lakes than to an Ocean (Fresh water economics) and that practiced at universities closer to Oceans (Salt water economics). [Disclaimer: I graduated from a Fresh water university.] ... It is a little difficult to explain the disagreement to non economists. Frankly, I think this is because non-economists have difficulty believing that any sane person would take fresh water economics seriously.

I think he overstates that everyone from a fresh water school believes that recessions are optimal.
Over near the Great Lakes there is considerable investigation of models in which the market outcome is Pareto efficient, that is, it is asserted that recessions are optimal and that, if they could be prevented, it would be a mistake to prevent them.
Although the responses to exogenous technological shocks are optimal and pareto efficient even within the fresh water schools there is some disbelief that technology shocks cause everything.

An Idealogical Turf War was an interesting read:
I was a little confused with this though (even though I agree with its tenor - by which I mean that the fresh water schools are sounding a little defensive):
What's different this time, and it's a difference I hope will bring about some humility, is that the wreckage is not from the Keynesian model crashing, this time it is the Classical formulation of the world that is being called into question. Once the proponents of these models are willing to concede that point, something they are currently resisting, maybe we can come together and get somewhere useful.

Which Classical formulation has failed?
1. The assumption that all agents are rational and like solving dynamic stochastic general equilibrium problems?
2. Markets are efficient (weak/strong form?) and clears at every point in time?
3. The idea of free markets/competion itself? I.e. More competition need not be good?
4. Dergulation? I guess this is tied into (3) because deregulation per se is usually not a feature of real business cycle models?

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