Why Economies Boom

One of the major schools of thought in macroeconomics rarely makes it into mainstream discussions: Real Business Cycle Theory.

This article was originally published in The Atlantic

One of the major schools of thought in macroeconomics rarely makes it into mainstream discussions: Real Business Cycle Theory. 

RBC, as it is known, claims that a lot of year-to-year economic volatility is caused by changes to the supply side of the economy: perhaps tax and regulatory changes, bad weather in farm economies, spikes in oil prices, and above all, the mysterious force known as the "technology shock."  Finn Kydland and Ed Prescottshared a Nobel, partly for creating RBC theory.

Let me tell the basic story of RBC and technology shocks using a story famously ridiculed by Larry Summers: Robinson Crusoe is on his island, toiling away alone.  He spends some effort on catching fish to eat (consuming) and some time making nets (investing, building capital).  When a storm hits, what does he do?  Well, it's a bad time to catch fish and a bad time to make nets.  But a person's got to eat, so what little time he does spend working he spends catching fish. 

 If you watched Crusoe from a distance for a few years, what would you see? You'd see boom times, when the weather is good: High output, high consumption, lots of work, high investment in nets. And during stormy weather, the opposite: Low output, low consumption, low work, low investment. 

Comovement reigns on the island, and it's all driven by Crusoe's rational reaction to changing weather.  That's just what we see in actual business cycles: People don't switch from consuming to investing in a boom, they do more of everything.

So you can see where I'm going: A change in the weather really is a technology shock.  But can this possibly be relevant for explaining the boom-bust cycle in real-world economies?  Not always, for sure, but I'm no monocauser: Monetary policy seems to matter a lot, as Friedman/Schwartz and Romer/Romer  argued; and other business cycle stories abound. 

 But I'd like to know whether good ideas come in clusters and whether these waves of innovation (positive technology shocks) are big enough to move the whole economy: And when these waves do come along, do they usually boost output, hours of work, and investment?  When the waves go away, do hours fall?  And are the effects big enough to matter, or do they just become background noise in an economy as big as the US?

Michelle Alexopoulous looked into this in two papers (one coauthored), one of which appeared in the prestigious American Economic Review.  She looked at technical books: When a lot of new books are published in a promising technical field, does that predict a boom?  And what about reverse causation: Even if books predict booms, is that just because people publish technical books when the economy is already doing well?

She found that books really do predict booms. In her paper looking at new books from 1955-1997, she found that new technical books predicted between 1/6 and 1/5 of all medium-term changes in business capital investment.  Total GDP and (to a more modest extent) hours of work moved together with new tech books, usually with a lag of a couple of years. 

Further, she found that a good economy didn't predict more tech books, and a bad economy didn't predict fewer.  So reverse causation isn't the story. 

Finally, as a placebo, she checked to see whether years when lots of history books were published tended to precede economic booms. They didn't. Alexopoulos made a good effort of kicking the tires on this hypothesis.  And remember: She only looked at technical books: There are surely a lot of other new ideas in fields like management, biotech, and accounting that matter for business productivity, and they also seem to come in waves.  

What does this mean for rich-country economies?  It means that real-world technology waves are big enough to shift the whole economy within a few years: Investment, hours, GDP, all moving together. Technology shocks can create real Real Business Cycles.  

Normally, macroeconomists assume that technological change matters for the long run--big ideas diffuse over a generation, too slowly to matter for the boom-bust cycle.  But a glance at the business media will demonstrate that executives and managers are constantly in the hunt for new ideas, the next big thing.  Key players always want that first-mover advantage. The race to be first--so obvious from the rise of the Internet economy -- pushes up the demand for excellent labor and new capital when a promising idea arises.  

And the downside is grim as well. Innovation droughts usually mean stagnation, great or small.  Less work, less investment, less output. 

If I taught a class on technological progress, I'd surely assign a Vonnegut novel, perhaps Cat's Cradle. Here's Vonnegut, putting words into the mouth of an executive at a private research lab:

"Nothing is generous. New knowledge is a valuable commodity." 

RBC takes Vonnegut's idea and uses it to explain some of the big shifts we see in real-world economies.  It's usually hard to fit RBC into partisan political narratives, which helps explain why we don't hear about it much.  But as long as big ideas come in waves, as long as energy supplies depend on the vagaries of global politics, and as long as politicians enact policies that weaken confidence in the health of a nation's economic institutions, RBC will matter.