Thursday, January 22, 2009

Back to Business Cycles

I solved my very first business cycle model today (paper here), so it feels like an auspicious time to continue the discussion from Nick Rowe's post the other day instead of booting up a video game for an hour before I head back across the river to start a micro assignment.

Firstly, it's worth pointing out that all economic statistics are unreliable to a degree, particularly macroeconomic ones, particularly ones trying to measure a concept like 'national output', i.e. GDP. Okay, there isn't a better alternative - people have proposed things like 'green GDP', I am personally more concerned about the value of leisure (and by extension, utility from work), but nothing has caught on.

Anyway, I can't say I know anything about Austrian economics, aside from a paper on endogenous growth and creative destruction I wrote years ago, but I do agree with the sentiment that it would be "unwise to estimate potential output by extrapolating from past actual output". Let me tell a story.

Suppose that one day a tree growing hundred-dollar bills sprouts in the backyard. Actually, this isn't a monetary story. Suppose a tree sprouts that grows cell phones. You think this is pretty awesome. With your new-found wealth, you even let your neighbours plant a few of your homegrown phones and soon enough more productive trees pop up in their backyards. The boom times roll into town as you and your colleagues sell cell phones to the world. The whole economy is growing on the strength of this additional production.

Six months later, you find out that these farmed cell phones kill their users within a year from a previously unknown disease. Farming abruptly stops, wiping out the investment in cell phone farms and techniques, taking the economy into a protracted recession.

This is basically how I imagine the financial crisis, with the cell phones being weird forms of debt and the disease being the unappreciated risk. Ex ante, before we know these phones cause cancer, we think we're doing well, i.e. we believe potential GDP is expanding rapidly from exploiting these new productive opportunities.

However, in retrospect, it wasn't at all. The transition from expansion to recession occured without anything 'real' actually happening, only the correction of misperception. However, an ideal index of welfare would actually increase when the news broke, because we now we won't all die from our phones.

If this is an accurate parable of what happened, then fiscal stimulus is pretty much useless - fiscal stimulus can only push GDP back to potential, not raise potential, unless you're way out there on the Keynesian side. But in my story, potential was low all the time and we were only managing to do as well as we were by fluke. This recession is bringing us back to reality; it's not something that can be fixed.

1 comment:

Gabriel said...

Off topics: that looks like something that could quickly be taken to the computer via Uhlig's toolkit.