Business Cycle Theories and All That

Business cycle theory in economics is pretty complex stuff and I can’t say that it’s something I feel totally comfortable discussing because I haven’t formulated strong opinions about the specifics. So, it was pretty silly of me to write that post the other day pontificating about business cycles.  Thankfully, there are smart people around to set me straight when I go astray.

I poked around a bit more on the topic and talked to the brilliant David Andolfatto in more detail (if you don’t read his blog you should) about some of the things I wrote and I thought that he said what I was trying to say, except he said it in a way that was actually terminologically and logically consistent. Here are some key points:

• The idea of a business “cycle” could be misleading in that it implies a system with mean reverting tendencies. What Noah Smith was pointing out in his Bloomberg piece was that this idea could be totally wrong and in fact, economies could get shocked in such a way that they no longer have a tendency to revert to some historic “natural growth rate”.  That is, shocks can be permanent or transitory.
• Thinking of the economy in terms of low frequency cycles and high frequency cycles (as I was doing in my original post) might also be misleading.  It is probably better to think of the economy in terms of a multiple equilibrium system that doesn’t “cycle”, but simply fluctuates. It looks like it has a tendency to mean revert, but doesn’t in reality.

Now, this might not seem all that important, but it could be hugely important for economics as Noah stated because it means that many of the mainstream models, which assume a natural rate of growth, are based on false assumptions. More importantly, it forces us to think about the economy in terms of its cause and effect and whether these patterns of economic development are predictable and fixable. If the future path of the economy can be predicted or understood by looking at the way the system is constructed and why it operates in a certain way then that would mean that these fluctuations in the economy can be avoided in the future. In essence, discretionary intervention could result in a better future system.

As you can likely guess, I think there is strong evidence that the economy displays deterministic tendencies. That is, there are institutional and behavioral inputs that lead the economy to operate in certain ways. But these institutional and behavioral inputs can result in sub-optimal outcomes which, if better understood, could be improved. In other words, my sort of view of the economy rationalizes a discretionary approach to policy at times.

Anyhow, I’ll open this thread for comments in case someone has some good insights. Happy holidays everyone and sorry to ruin it for you with wonk talk.

Cullen Roche

Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.

He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.