Business Cycles: Are they really that mysterious?

Noah Smith had a funny series of posts in the last few weeks. In the most popular one, he showed John Cochrane to be a propagandist.

But Noah had two other posts which seem to be part of an intentional series. First, he wrote a post where he praised Roger Farmer for going after the real business cycle people for lowering the bar of success – and then not even clearing that bar.

Then, he also had a post titled “Should Theories be Testable”. This post was “college-freshman dorm” questions to him, but as he points out:

“But when you start making models that claim to be about some specific real thing (e.g. monetary policy), you’re implying that you think those models should be applied. And then, it seems important to me to have some connection to real data, to tell if the theory is a good one to use, or a crappy one to use. That’s testability.”

Noah knows the bullshit pedaled by John Cochrane is not without consequence. We try to help manage our economy on these ideas. Our long term growth is dependent on how much we can produce, and even minor changes in this growth rate have huge real world consequences.

Note: The same guy who wrote the post in the WSJ also wrote a paper worthy of investigating. Hmmm…

How does this tie in with the post on Farmer? We know what causes business cycles: Real estate. Ed Leamer – someone who is a professor of statistics and economic data – says it’s mostly real estate.

Here is Ed Leamer:

Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables. Housing did not give an early warning of the Department of Defense Downturn after the Korean Armistice in 1953 or the Internet Comeuppance in 2001, nor should it have. By virtue of its prominence in our recessions, it makes sense for housing to play a prominent role in the conduct of monetary policy. A modified Taylor Rule would depend on a long-term measure of inflation having little to do with the phase in the cycle, and, in place of Taylor’s output gap, housing starts and the change in housing starts, which together form the best forward-looking indicator of the cycle of which I am aware. This would create pre-emptive anti-inflation policy in the middle of the expansions when housing is not so sensitive to interest rates, making it less likely that anti-inflation policies would be needed near the ends of expansions when housing is very interest rate sensitive, thus making our recessions less frequent and/or less severe.

You should really read the entire paper from Leamer, and remember he also wrote a book called “Sturdy Econometrics” and written lots of papers on how badly many different econometric techniques perform. It is unlikely he is spouting bullshit on the real estate/business cycle relationship.

I point this out because the low bar that Roger Farmer discusses in his post is not really even cleared by the research program which developed to try and clear that low bar. We do not have a very good understanding of business cycles if you follow the Chicago School. It’s all a mystery – just throw your hands up and keep them away from the economy. They have lots of math and theory that does not match the data very well – so they threw out the idea of looking at the data.

But that does not mean everyone threw out the idea of looking at the data first and trying to understand what is happening. Leamer looked at the data – and it’s pretty clear Real Estate drives the business cycle.

 

 

 

 

 

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1 Comment on "Business Cycles: Are they really that mysterious?"

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Jens
2 years 5 months ago

Hi,

“… housing starts and the change in housing starts, which together form the best forward-looking indicator of the cycle of which I am aware”

I tried to make sense of professor Leamer’s comment, and found the following chart:
http://www.macrotrends.net/1314/housing-starts-historical-chart

Is this the chart professor Leamer is referring to, and if so, how one is supposed to make sense of it? How much of a drop is indicative of a change in a cycle? In terms of time, how forward looking is the indicator?

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