Managerial Economics

Managerial Economics Lecture Eight: Data on the cyclical economy Schumpeter’s model of cycles

Recap • “Keynesian-Neoclassical debate” conducted within framework of IS-LM & AS-AD models • Different perspectives (especially on labour market) but • Shared model essentially equilibrium in nature • But good empirical (Blinder) & theoretical (Schumpeter) reasons for believing economy in permanent disequilibrium • This week • statistics on structure of economic cycles • Schumpeter’s (verbal) model of the business cycle

A Noble Aim… • Kydland & Prescott (K&P) well-known and (especially Prescott) staunchly neoclassical economists • But purpose of 1990 paper was ‘detective work: “just the facts, ma’am!”’ • “reporting of facts—without assuming the data are generated by some probability model—is an important scientific activity. We see no reason for economics to be an exception.” (1) • Topic was the facts of the business cycle: • How much variables change • Which ones lead, which lag • Findings surprising (to neoclassical economists) and their candor about it admirable:

A Noble Aim… • “The growth facts are not the only interesting features of these aggregate time series. Also of interest are the more volatile changes that occur in these and other aggregates—that is, the cyclical behavior of the time series. These observations are interesting because they apparently conflict with basic competitive theory, in which outcomes reflect people's ability and willingness to substitute between consumption and leisure at a given point in time and between consumption at different points in time.” (2) • Used neoclassical economics to guide selection of variables to examine • Intended to use results to examine accuracy of neoclassical “New Growth” theory:

A Noble Aim… • "The purpose of this article is to present business cycle facts in light of established neoclassical growth theory… Do the corresponding statistics for the model economy display these patterns [found in the data]? We find these features interesting because the patterns they seem to display are inconsistent with the theory." (4) • Simple definition of cycle: “deviation from trend” • "We follow Lucas in defining business cycles as the deviations of aggregate real output from trend. We complete his definition by providing an explicit procedure for calculating a time series trend that successfully mimics the smooth curves most business cycle researchers would draw through plots of the data." (4)

Kydland and Prescott’s analysis • Their procedure: • Take a range of economic data • GDP, Employment, Capital stock • Consumption, Investment, Government spending • Labour income, Capital income • Monetary variables (MB, M1, M2), CPI • Take logs of these variables • change in the logarithm of a variable gives its percentage rate of change: Rate of change Divided by current value Yields % rate of change

Kydland and Prescott’s analysis • Find values for tt to minimise value of function: Emphasises long run trend Emphasises short run fit Value of variable Arbitrary weighting factor Est.trend rate of growth • Since each element of tt is variable, best fit to this bit would be tt=yt; • this bit penalises excessively close fit of tt to actual data

Kydland and Prescott’s analysis • Values of tt then give estimated trend rate of growth • Subtract these from actual values and you have the cyclical component for each variable • Compare these using regression analysis • Shift series backwards and forwards in time to discern lead/lag effects • A graphical exposition of their technique… • Take raw data… (example here is nominal GDP, not real)…

Kydland and Prescott’s analysis • Take the data…

Kydland and Prescott’s analysis • Take log of these numbers… Perfectly straight line would mean smooth growth Data clearly cyclical

Kydland and Prescott’s analysis • Derive sophisticated trend line (simplistic one shown)

Kydland and Prescott’s analysis • Subtract one from the other… • This gives you the cyclical component of variable

Kydland and Prescott’s analysis • Repeat process with another variable, say investment…

Kydland and Prescott’s analysis • Overlay two cyclical components and regress

Kydland and Prescott’s analysis • Data Analysis impeccable & admirable • But one piece of neoclassical flakiness in commentary • After simple neutral definition of cycle as “deviation from trend”, comment on theories that see cycles as causal (“boom causes slump causes boom”) rather than random: • "Theories with deterministic cyclical laws of motion may a priori have had considerable potential for accounting for business cycles; but in fact they have failed to do so. They have failed because cyclical laws of motion do not arise as equilibrium behaviour for economies with empirically reasonable preferences and technologies—that is, for economies with reasonable statements about people's ability and willingness to substitute." (5) • Notice the phrase “equilibrium behaviour”…

Kydland and Prescott’s analysis • Schumpeter, Minsky & other “Theories with deterministic cyclical laws of motion” are explicitly disequilibrium • K&P apply a priori belief in equilibrium to rule out disequilibrium theories • Yet data clearly contradicts predictions of equilibrium theory: “These observations … conflict with basic competitive theory, in which outcomes reflect people's ability and willingness to substitute between consumption and leisure at a given point in time and between consumption at different points in time” (2) • Schumpeter would not be amazed… real economies are in disequilibrium; data therefore necessarily conflicts with equilibrium theories (of any type!)… • Assumption of equilibrium at fault, not “boom causes slump causes boom” deterministic disequilibrium theories…

Kydland and Prescott’s analysis • K&P open with “tickler” of unexpected results: • “Equipped with our operational definition of cyclical deviations, we present what we see as the key business cycle facts for the United States economy in the post-Korean War period (1954-1989). Some of these facts are fairly well known; others, however, are likely to come as a surprise because they are counter to beliefs often stated in the literature.” • First 3: • Price level is not pro-cyclical but counter-cyclical • Inflation tends to fall during a boom, not rise • Real wage is not countercyclical but pro-cyclical • Real wage rises in a boom, fall in a slump • M1 does not lead the cycle • Changes in M1 & monetary base lag the cycle • Why are these surprises?…

GDP Labour Price level Marginal Product Labour GDP Counter-cyclical price level… • Neoclassical theory: Price level determined by diminishing marginal productivity • Price level should rise as output increases: • So boom should be associated with rising prices… • But it isn’t… Flip axes, x wage…

GDP Labour Marginal Product/Real Wage Labour Pro-cyclical real wage • Neoclassical theory: Real wage determined by diminishing marginal productivity • Real wage should fall as output increases: • So boom should be associated with falling real wages… • But it’s not… Physical Marginal RW1 Product RW2 E1 E2

M1 does not lead the cycle… • Neoclassical theory: “quantity theory of money” + “long run vertical Phillips curve” • “Money Stock x Velocity of circulation = Price level x Transactions” Price level Output Ratio derived from other 3 variables Stock of money • V assumed constant; T set by real factors • Vertical LR Phillips curve; • Increasing M simply increases price level • But may be short run effect of increasing T if M increased… • So increase in M1 should precede increase in T, P • But it doesn’t…

Kydland and Prescott’s analysis • “A number close to one indicates that a series is highly procyclical; a number close to one but of the opposite sign indicates that a series is countercyclical.” (7) • So x(t) column tells whether pro or anti cyclical • “if … the numbers … are positive but largest in column xt-i, where i > 0, then the numbers indicate that the series is procyclical but tends to peak about i quarters before real GNP… the series leads the cycle.” • “… a series that lags the cycle by j > 0 quarters would have the largest correlation coefficient in the column headed by xt+j.” • “For example, productivity is a series that leads the cycle, whereas the stock of inventories is one that lags the cycle.” (8)

Regression Analysis This column tells whether pro (+) or anti (-) cyclical Table 1: Inputs Pro-cyclical Bigger nos. here indicate lead Bigger nos. here indicate lag Anti-cyclical

Kydland and Prescott’s analysis • “the implicit real wage (the ratio of total real labor compensation to labor input) is even more procyclical than average hourly real compensation. (For the latter series, see Table 1.) This finding that the real wage behaves in a reasonably strong procyclical manner is counter to a widely held belief in the literature.” (11-12) • “Table 2 shows that both labor income and capital income are strongly procyclical and that capital income is highly volatile. Table 3 shows that, measured as shares of total income, labor income is countercyclical while capital income is procyclical.” (12)

Regression Analysis • Table 2: Output & Income components • Leading • All stronglypro-cyclical • Lagging

Regression Analysis • Table 2 (cont’d): Output & Income components • Lagging • Leading • All stronglypro-cyclical

Regression Analysis • Fall during boom • Rise during boom • Shares of GDP • Rise with lag after boom

Regression Analysis • Money base lags cycle • Monetary aggregates & prices • Credit leads it • Leading effect, non lagging • Prices strongly anti-cyclical

Kydland and Prescott’s analysis • “There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M 1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly. • The difference in the behavior of M l and M2 suggests that the difference of these aggregates (M2 minus M 1) should be considered. This component mainly consists of interest-bearing time deposits, including certificates of deposit under $100,000. It is approximately one-half of annual GNP, whereas M I is about one-sixth. The difference of M2 -M 1 leads the cycle by even more than M2, with the lead being about three quarters. • From Table 4 it is also apparent that money velocities are procyclical and quite volatile.” (15)

Kydland and Prescott’s analysis • We hope that the facts reported here will help guide the selection of model economies to study … any theory in which procyclical prices figure crucially in accounting for postwar business cycle fluctuations is doomed to failure. The facts we report indicate that the price level since the Korean War moves countercyclically. • The fact that the transaction component of real cash balances (MI) moves contemporaneously with the cycle while the much larger nontransaction component (M2) leads the cycle suggests that credit arrangements could play a significant role in future business cycle theory. Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

Graphical analysis • Charts obscure lead/lag to some extent, but emphasise comparative volatility • Investment: leading variable, far more volatile than GNP • Supports investment-led vision of economic growth • Consumer durables also highly volatile leading indicator…

Graphical analysis • Consumption procyclical & less volatile than GNP: • Government spending anti-cyclical and more volatile…

Graphical analysis • M1 less volatile than GDP and lags: • M2 more volatile & leads:

Graphical analysis • And the really big surprise for neoclassicals: price level clearly anti-cyclical: • Results surprising from neoclassical point of view; • How surprising are they from • empirical research (Blinder) • Disequilibrium theory (Schumpeter & shortly Minsky)? • Not at all!...

K&P and Blinder’s empirical findings • Counter-cyclical prices • Firms adjust prices slowly: 50 % of firms adjust once/year • Response to cost pressures likely to be strongly lagged • 90% of firms have constant or falling marginal cost • Majority have large fixed costs • Boom likely to mean increase in capacity utilisation • Variable costs will fall • Larger output amortised over fixed costs • Possibility for prices to fall during boom

K&P and Blinder’s empirical findings • Aside: one reason why economists are poor forecasters may be because they impose their beliefs on data rather than either • Simply relying on observed statistical patterns; or • Truly understanding dynamics of market economy • E.g., current worry about link between capacity utilisation and inflation… • Manager would do better to apply K&P analysis & findings than simply accept economic forecasts… • Back to K&P & Blinder…

K&P and Blinder’s empirical findings • Blinder’s reasoning based on survey results • “one basic reason for expecting prices to rise in booms and fall in slumps is the presumption that demand curves are shifting in and out along upward-sloping supply curves… If the supply prices of cyclically sensitive goods are more commonly downward-sloping, then we would expect their relative prices to move counter-cyclically instead. Then, if nominal marginal costs rise in booms, nominal prices might not show much cyclicality at all.” (102-104) • Reasoning makes sense of K&P’s empirical finding

K&P and Blinder’s empirical findings • Pro-cyclical wages • No diminishing marginal productivity: no need for real wage to fall for more workers to be employed • Real wage rise may reflect increased bargaining power of workers during boom • Fall in wages share & rise in profit share may reflect greater profitability of cost-plus pricing firms as boom reduces unit costs • Lagged rise in wages share may reflects lagged impact of increased wage bargaining power, decline in profit late in boom… • Business cycle data thus contradicts neoclassical theory • But supports cycle theory of Schumpeter…

K&P’s findings, Schumpeter & disequilibrium • Schumpeter: boom caused by • New innovation(s): discontinuous drop in cost of production (hence part of price effect) • Another factor in K&P finding of counter-cyclical prices • Boost to credit to finance new ventures • Generalisation of sectoral boom to whole economy • Explains K&P finding that credit growth precedes boom • K&P’s findings • Reinforce Blinder’s survey results • Support disequilibrium explanation of macro economy over either “Keynesian” or neoclassical equilibrium explanations… • And are relevant to Australia too (with one exception)

Relevance to Australia? • Similar results found for Australia: Lance Fisher, Glenn Otto & Graham Voss 1996, “Australian business cycle facts”, Australian Economic Papers pp. 300-320 • With one exception: • “For most of the period since 1974, the real wage is strongly counter-cyclical whereas for these societies [USA, UK, New Zealand] it is pro-cyclical.” (320) • May reflect Australia’s centralised wage setting system and less than 100% CPI-adjustments that dominated post-1974 decisions

Schumpeter and cycles • “I explain the phenomenon of business fluctuations … solely by an objective chain of causation which runs its course automatically, that is by the effect of the appearance of new enterprises upon the conditions of the existing ones.” (Schumpeter 213) • Necessarily non-equilibrium because discontinuous: • “does this … proceed in unbroken continuity, is it similar to the gradual organic growth of a tree? Experience answers in the negative. It is a fact that the economic system does not move along continually and smoothly. Counter-movements, setbacks, incidents of the most various kinds, occur which obstruct the path of development; there are breakdowns in the economic value system which interrupt it.” (216)

Schumpeter and cycles • Breakdowns could be randomly distributed through time • There would then be no “trade cycle”, only “deviations from trend” • But Schumpeter argues that “new combinations are not, as one would expect according to general principles of probability, evenly distributed through time—in such a way that equal intervals of time could be chosen, in each of which the carrying out of one new combination would fall—but appear, if at all, discontinuously in groups or swarms.” (223) • This discontinuous appearance is necessary for a true cycle to emerge, since…

Schumpeter and cycles • “If the new enterprises in our sense were to appear independently of one another, there would be no boom and no depression as special, distinguishable, striking, regularly recurring phenomena. For their appearance would then be, in general, continuous.” (224) • Three reasons for the “clumped” nature of new innovations & associated booms: • Frequently, “new combinations will not grow out of the old firms or immediately take their place, but appear side by side, and compete, with them.” (226) • Credit extended to new entrepreneurs causes “a very substantial increase in purchasing power all over the business sphere. This starts a secondary boom, which spreads over the whole economic system and is the vehicle of the phenomenon of general prosperity…”

Schumpeter and cycles • This general prosperity allows everyone to profit, not just entrepreneurs: • “Only because new purchasing power goes in bulk from the hands of entrepreneurs to the owners of material means of production, to all producers of goods for "reproductive consumption", and to the workers, and then oozes into every economic channel, are all existing consumption goods finally sold at ever-rising prices. Retailers thereupon place bigger orders, manufacturers extend operations, and for this purpose increasingly more unfavorable and often already abandoned means of production come into use again. And only on this account do production and trade everywhere temporarily yield a profit, just as in a period of inflation…” (226)

Schumpeter and cycles • The combination of these factors • notable innovations in production • new credit-financed demand as they are brought into existence • general prosperity from the extended credit • Means that other entrepreneurs (good and bad!) find it easier to also get funding: • “Why do entrepreneurs appear, not continuously, that is singly in every appropriately chosen interval, but in clusters?Exclusively because the appearance of one or a few entrepreneurs facilitates the appearance of others, and these the appearance of more, in ever-increasing numbers.” (228) • With danger that success of good entrepreneurs helps bad ones to get funding…

Schumpeter and cycles • “Every normal boom starts in one or a few branches of industry (railway building, electrical, and chemical industries, and so forth), and … derives its character from the innovations in the industry where it begins. But the pioneers remove the obstacles for the others not only in the branch of production in which they first appear, but, owing to the nature of these obstacles, ipso facto in other branches too. Many things may be copied by the latter; the example as such also acts upon them; and many achievements directly serve other branches too, … , quite apart from the circumstances of secondary importance which soon appear—rising prices and so on. Hence the first leaders are effective beyond their immediate sphere of action and so the group of entrepreneurs increases still further and the economic system is drawn more rapidly and more completely than would otherwise be the case into the process of technological and commercial reorganisation which constitutes the meaning of periods of boom.” (229)

Schumpeter and cycles • “the swarm-like appearance of new combinations easily and necessarily explains the fundamental features of periods of boom. It explains why increasing capital investment is the very first symptom of the coming boom, why industries producing means of production are the first to show supernormal stimulation… It explains the appearance of new purchasing power in bulk, thereby the characteristic rise in prices during booms, which obviously no reference to increased need or increased costs alone can explain. Further, it explains the decline of unemployment and the rise of wages, the rise in the interest rate, the increase in freight, the increasing strain on bank balances and bank reserves, and so forth, and, as we have said, the release of secondary waves—the spread of prosperity over the whole economic system.” (230)

Schumpeter and cycles • So a boom is a positive feedback process: • Financing of one invention makes it easier for other inventions to be financed • One success in one industry sector makes it easier for others in the same sector to succeed • Spillover of finance into rest of economy makes new businesses and old ones profitable • Conventional economics dominated by presumption of negative feedback: • Increase in price reduces demand • Rise of profits encourages new entrants who reduce profits…, etc. • In fact many real-world processes involve positive feedback, with one other essential real-world feature:

Schumpeter and cycles Nonlinear relations • Positive feedback process sets of further process that later strengthens negative feedbacks… • Interaction over time of +ive & -ive feedbacks produces continuous cycle: system never settles down to equilibrium • Schumpeter’s cycle not ended by convergence to equilibrium but by build-up of negative feedback forces…

Schumpeter and cycles • “the new entrepreneur's demand for means of production, which is based upon new purchasing power—the well known "race for means of production" in a period of prosperity—drives up the prices of these.” (232) • “the new products come on the market after a few years or sooner and compete with the old… • “At the beginning of the boom costs rise in the old businesses; later their receipts are reduced, first in those businesses with which the innovation competes, but then in all old businesses, in so far as consumers' demand changes in favor of the innovation…”

Schumpeter and cycles • “The average time which must elapse before the new products appear—though of course actually dependent upon many other elements—fundamentally explains the length of the boom. This appearance of the new products causes the fall in prices, which on its part terminates the boom, may lead to a crisis, must lead to a depression, and starts all the rest…” (233) • “the appearance of the results of the new enterprises leads to a credit deflation, because entrepreneurs are now in the position—and have every incentive—to pay off their debts; and since no other borrowers step into their place this leads to a disappearance of the recently created purchasing power just when its complement in goods emerges…” (233)

Managerial Economics