Understanding business cycles

In his book Recessions and Depressions: Understanding Business Cycles, Todd A. Knoop points out that a Rational Expectations perspective does not necessarily require that all segments of society are rational or use all available information:

Those who are rational will take advantage of the profit opportunities created by those who are consistently making mistakes.

In other words, the failure of some individuals to act on the future effects of policies  will create profit opportunities for people who do anticipate such effects.  This is an important observation because it highlights how public policies can be rendered ineffective without having to assume that all people are forward-looking, rational individuals.

The book also contains a useful observation about the effect of random shocks on business cycles:

It might seem strange that random shocks to productivity can create business cycle swings. Shouldn’t every negative shock be quickly offset by some positive shock? The answer is, no. Economists and statisticians have long known that if you flip a coin 20 times, cyclical patterns will emerge. There will be series of heads that follow each other just as there will be series of tails. If productivity is a random variable, then it is not surprising that economies exhibit cyclical patterns. Persistent business cycles can come about as a result of the luck that is inherent in any random process.

The existence of business cycles as such in unregulated economies does not necessarily constitute “market failure.”  In its most simplistic form, such a view of market failure would be akin to saying that free markets fail because they are not immune to meteorite attacks.

But at the end of his chapter on Rational Expectations Knoop states that

rational expectations in an imperfectly competitive model of the economy can have much different implications….It is not necessarily rational expectations but the Rational Expectations model of perfectly flexible markets that generates what many economists consider to be implausible results.

Any model that assumes competitive markets will lead to implausible results if it is used to predict how individuals behave in an economy where government policies adversely affect the operation of markets. This does not invalidate models of perfect competition but highlights the need for models that reconcile the postulate of rationality with imperfect markets, provided such models do not claim to be actual descriptions of laissez-faire economics.

One troubling implication of Rational Expectations is that government can only influence real variables in the economy if its policies are secret and unpredictable.  Even if one does not agree with the strong postulates of Rational Expectations, public stabilization policies that assume that people will repeatedly ignore their future tax burden or neglect profit opportunities that are generated by these policies, do not even pass the test of common sense. Government can, of course, respond in turn by preventing markets to refect these new realities, but this can only produce  a perpetual cycle to disturb the operation of the price mechanism.

Knoop’s book on understanding business cycles is a useful introduction to the subject although his chapter on Real Business Cycles Models could benefit from a more balanced perspective. The conjecture that business cycles could be the most efficient response to  exogenous changes given the structure of the economy is an important insight and reconciles microeconomics and macroeconomics.  Although the New Keynesian economists also provide microfoundations for their views, it is sometimes hard to tell whether these views are refinements of classical economics or departures from it. If New Keynesian Economics is just a “hodge podge of reasons for this or that market failure” it runs the risk of being able to explain any kind of empirical observations.

New Keynesian Economics seems to be less confident about public policy recommendations. It will be interesting to observe what the fate of this school of economics will be if recent work on the microfoundations of political failure will be given more attention in macroeconomics.