Economics Grapples What Causes Recessions

(Bloomberg) -- Most of economics is pretty healthy as a discipline. But one branch has really been thrown for a loop — business cycle theory. The financial crisis of 2008 and Great Recession taught macroeconomists that they didn't really understand the sources of recessions. The long, grinding stagnation that followed demonstrated that economies sometimes don't bounce back as quickly or automatically as most models had assumed:

Meanwhile, evidence continues to emerge that some of the basic building blocks of modern business-cycle theories — such as the assumed relationship between consumption and interest rates — are faulty.

How should business-cycle theorists respond to this approach? One idea would be to abandon the so-called microfoundations project. That project, which became popular in the 1980s, refers to the idea of constructing theories of the macroeconomy from theories about the behavior of individual agents like consumers and companies. Because the math of microfoundations turns out to be pretty difficult, most business-cycle theories fudged a bit, using models of human and corporate behavior that weren't very realistic. But even with this oversimplification, modern business-cycle models proved so opaque that central bankers had difficulty using them for guidance during the worst days of the crisis.

Despite these shortcomings, the vast majority of business-cycle theorists haven't abandoned the hope of modeling the macroeconomy as the sum of individual decisions. Instead, they're doing the hard work of trying to make those assumptions more realistic. Some are trying to model the whole spectrum of wealth and income inequality, instead of assuming that all consumers have equal amounts of money. Others are trying to model the process by which unemployed people look for jobs and bargain over wages.

But increasingly, macroeconomists are venturing into an area that previously had been considered a bit taboo — behavioral economics. The unwritten rule that macroeconomists should assume perfect rationality on the part of economic agents like consumers and businesses is falling by the wayside.

Some macroeconomists, like Roger Farmer of the University of California – Los Angeles, have been experimenting with behavioral models for years. But recently, a number of high-profile stars in the field have shifted in a behavioral direction. Michael Woodford, a leading business-cycle theorist, used a behavioral explanation to fend off a challenge from a group of critics known as the Neo-Fisherians, who believe that low interest rates encourage deflation. Xavier Gabaix, a highly respected mathematical economist, came out with a behavioral model of business cycles based on short-term thinking. And top macroeconomists Emmanuel Farhi and Ivan Werning produced their own based on bounded rationality, an idea promoted by early behaviorists like Herb Simon and Daniel Kahneman.

When the profession's big guns began playing around with behaviorism, it seemed to open a floodgate. More and more macro papers started appearing with a distinctly behavioral feel.

At the 2018 American Economic Association meeting in Philadelphia, behavioral macro papers were very common. At a session called “Behavioral Macroeconomics,” Woodford gave a presentation about how monetary policy should change to deal with economic agents who don't plan for the long term. Columbia University's Hassan Afrouzi presented a paper about inattention, in which he actually went out and surveyed companies about their inflation expectations. Asking consumers or businesses directly about expectations used to be something macroeconomists shied away from doing, but is becoming more common.

Behavioral theories popped up in a variety of other sessions at the conference as well. George-Marios Angeletos and Chen Lian of Massachusetts Institute of Technology showed how under bounded rationality, a small recession can mushroom into a large, long-lasting one. Andrei Levchenko and Nitya Pandalai-Nayar argued that fluctuations in sentiment — essentially, random mistakes that economic agents make — can cause recessions to spread from one country to another. A similar study by Stephane Dées and Srečko Zimic labeled these random mistakes “animal spirits,” borrowing a term from the legendary macroeconomist John Maynard Keynes.

Sushant Acharya, Jess Benhabib and Zhen Huo also took a page from Keynes, modeling “beauty contest” effects in which economic agents all try to predict what the others will do. They show that changes in beliefs can become self-fulfilling, causing recessions that aren't driven by fundamental economic factors. Cosmin Ilut and Rosen Valchev created a model of bounded rationality in which aggregate economic effects can display a variety of weird, unintuitive behavior. European macroeconomists Cars Hommes, Domenico Massaro and Matthias Weber presented a model of behavioral decision-making in which government recession-fighting efforts also lead to stabilization of inflation — directly contradicting the conventional wisdom that there's a trade-off between the two.

So behavioral economics is no longer an outcast in the world of macroeconomic theory. Expect the boom in behavioral theories to continue, focusing on ideas like bounded rationality, inattention, short-term thinking and expectation errors.

But don't count on the behavioral boom to offer clear answers to the big questions anytime soon. If there's one thing that the proliferation of theories has shown, it's that once business-cycle models stop being simplistic, almost anything can happen. That's a valuable insight, since it shows the fundamental difficulty of tackling business-cycle theory. But given the limited data that macroeconomists have to work with, it will be very hard to figure out which of these theories (if any) are useful, and which are flights of fancy. Progress in macroeconomics will be painstakingly slow, and there will be many more recessions before the economists of the future figure out how business cycles actually work.

To contact the author of this story: Noah Smith at nsmith150@bloomberg.net.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.

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