Friday, December 22, 2006

A Chanukkah Present for Max

by Ken Houghton

I have been, as one might guess, dealing with multiple issues for the past several weeks: work (budget season), household duties, and school. (The latter suffered severely [see here and here], and it is only now that the former two resemble normalcy.)

Our Holiday Cards say "Happy New Year"; when I asked why, Shira noted that they won't be mailed until tomorrow at best.

So it is that now, as the Eighth and Final Day of Chanukkah approaches, that I give the one present I planned to deliver before this post went to his archives page. Max said:
My question about real business cycles goes to something basic. The idea in question is that "shocks" that cannot be anticipated push the employment level up, down and around. There isn't much role for government. It looks to me that these shocks are only recognized ex post as a deviation from trend. Then they are redefined as trend. Everything that transpires is preordained, although no RBC genius can ordain it. All they can do is rationalize after the fact. They can only predict the past. Color me unimpressed. Perhaps I am misinformed.

It is left to me to clear up this misinformation. Accordingly, a touch of economics history.

Lo, in the dark ages (1958, back when U.S. productivity was still high, before Viet Nam, oil shocks, and Reagan budgeting), there was an economist named Phillips who created the Phillips Curve, a theoretical trade off between inflation and unemployment that seemed to track with the U.K. economy. And in the early 1960s, the Phillips Curve also tracked well with the U.S. economy.

Edmund Phelps (along with Dr. Miltie) pointed out that this made no sense—or, more accurately, that the tracking must depend on the expectations of inflation matching the reality. (I know it seems mythical to some, but for a very long time, there was low, steady inflation in the United States without a major fooforah being made about its "Maestro.")

Emboldened by this success, Phelps went on to argue that there is a Real Business Cycle, in which people anticipate what will happen in the economy. But there is imperfect information, so sometimes, well, they guess WRONG. They overproduce, and they have to balance this by later underproducing. This is a "real business cycle" (RBC); as the result of imperfect information, businesses overproduce and then underproduce, the latter causing what we mortals call A Recession.

The cool thing about the phrase "imperfect information" is that it explains why a range of things are not going to help. In the case of RBC theory, this is the claim that monetary policy cannot prevent or shorten a recession.

Note, then, the two things Phelps has said:
  1. With regard to the Phillips Curve, the "error" is that anticipation matched expectations (pi = , as it were), leaving a zero (0) term that Phillips neglected.
  2. With respect to RBC
    1. an unanticipated change by the Fed will have no effect and
    2. doing nothing—which would be unexpected in the face of a slowdown—would not be unexpected either

To lesser mortals, such as Max, this may seem an internal contradiction. Surely, given Phelps's analysis of the Phillips Curve, one would expect that he would have a course of action to propose, some unexpected piece of shock and awe.

But to do so would be to forget the context. The reference above to isn't an idle one, as even RBC proponents acknowledge that is a factor in the real demand for money, which leads to the LM curve.

The level of output (and therefore employment) in the United States is therefore determined, per Macroeconomic Theory, as the intersection of the IS (Investment/Savings) and LM (Money Demand [L] / Money Supply [M]) curves. All of this, again, should be review for Max.

What is missing to make all clear is the context. As Charlie Cook notes, this was the mid- and late 1960s. The presidential cri de coeur of the day was:
yearning for the fabled "one-armed economist" that President Lyndon Johnson once desired as he tired of hearing the phrases, "On the one hand ..., but on the other hand..."

RBC Theory—which excludes the money portion of the problem from being part of the solution—was purely and simply an attempt to make President Johnson happy.

I hope this helps, Max.
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