Noah Smith writes: U.S. economy’s current expansion past its sell-by date? Will we soon go back to the employment levels we had before 2008, or did the recession do lasting damage? Macroeconomists wrestle with these questions, but usually without much success. To understand why it’s so hard to predict business cycles, you need to realize that nobody really knows if a business cycle actually exists.
The word “cycle” conjures up images of waves and seasons, but the business cycle isn’t a regular cycle.
There’s an obvious upward trend to this line. But take a look at the recessions (the gray areas on the graph). Do you see temporary bumps, followed by the return to a trend? Or shifts in the trend itself? Or both? As hard as it is to make that call using the naked eye, it’s equally hard to do using mathematical tools.
One traditional method, pioneered by the Nobel-winning macroeconomist Ed Prescott, is called the Hodrick-Prescott Filter, or H-P Filter. Basically, an economist just picks a time horizon — say, three months, or five years, or 20 years — that he thinks represents the business cycle, and the H-P Filter will separate the squiggly line into a cycle and a trend.
But there are some big problems with this method. Roger Farmer, a macroeconomist at the University of California, Los Angeles, expresses his frustrations.
[Prescott] proposed that we should evaluate our economic theories of business cycles by how well they explain…the wiggles. When his theory failed to clear the 8ft hurdle of the Olympic high jump, he lowered the bar to 5ft and persuaded us all that leaping over this high school bar was a success…
Keynesian economics is not about the wiggles. It is about permanent long-run shifts in the equilibrium.
In other words, modern macroeconomic theories all assume that recessions are temporary — that they don’t permanently damage the economy’s productive potential. If that assumption is wrong, then most modern macroeconomic theories are barking up the wrong tree. It might mean that government needs to engineer a boom to undo the effect of a slump.
Some macroeconomists, such as Greg Mankiw and John Campbell of Harvard, have been presenting evidence to this effect since the 1980s.
In fact, the evidence is now piling up that the 2008 recession did have lasting effects. Researchers at the Federal Reserve have crunched the numbers and have tentatively concluded that economies don’t usually bounce back on their own. They write:
The finding that recessions tend to depress the long-run level of output may imply that demand shocks have permanent effects. The sustained deviation of the level of output from pre-crisis trend points to flaws in the way the economics profession models the recovery of output to economic shocks and raises further doubts about the reliance on measures of output gaps to determine economic slack. For policymakers, the results also point to the cost of recessions, especially deep and long ones, and provide a rationale for strong and rapid policy responses to economic downturns.
In general, this is bad news — it means that it may be decades before an extraordinary boom undoes the damage of the Great Recession. But there’s a silver lining, because it also means that the current economic expansion probably isn’t about to die of old age. It may simply be time to stop thinking of the business cycle as a cycle.
