A Critical Analysis of the Main Theoretical and Methodological Tenets of Real Business Cycle Theory. Is It Suitable to Understand the Global Financial Crisis of 2007/08?

Table of Contents

Table of Figures

Table of Abbreviations

1. Introduction

2. Overview of RBCT

3. Analysis of strengths and weaknesses of RBCT

4. Explanation of the GFC

5. Comparison of RBCT with Marx’s crisis theory and Minsky’s FIH

6. Appropriateness of RBCT to deal with the GFC 2007/08

7. Conclusion

Bibliography

Table of Figures

Figure 1: S&P/Case-Shiller U.S. National Home Price Index

Table of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1.Introduction

“Why did nobody notice it?” asked Queen Elizabeth II. during a visit at London School of Economics (Pierce 2008). She referred to the Global Financial Crisis 2007/08 (GFC). Why did economists fail to advise politicians inasmuch as crises do not arise?

The Real Business Cycle theory (RBCT) was a common framework of analysing economics. Important representatives of RBCT are Edward C. Prescott and Finn E. Kydland. Both won the Nobel prize in economic sciences in 2004 inter alia for their contributions to understand driving forces behind business cycles (BCs) (The Nobel Prize 2018). This essay will analyse how useful RBCT and its policy prescriptions are in understanding and dealing with the GFC.

The thesis statement of this essay is that RBCT and its policy implications are not suitable to understand or deal with the GFC.

First of all, I will give an overview of RBCT. Subsequently, its strengths and weaknesses will be analysed. Then, the GFC will be explained. Afterwards, this essay will contain a comparison between RBCT and Marx’s crisis theory as well as Minsky’s financial instability hypothesis (FIH). Finally, the appropriateness of RBCT and its policy prescriptions to deal with the GFC will be discussed.

2. Overview of RBCT

The RBCT is generally based on the growth theory of Solow (Arnal 2016, 87). RBCT agrees with Solow insofar that internal mechanisms of market economies are stable. Technology shocks are the reason for cyclical fluctuations according to RBCT (Francisa and Ramey 2005, 1).

Kydland and Prescott (1982) provided a purely supply-side explanation of BCs. They presented a specific theory of BCs and a methodology for testing competing BC-theories (Kydland and Prescott 1982). The RBC methodology breaks down to two principles: The economy should always be modeled using dynamic general equilibrium models and a model’s aptness for describing reality should be assessed using calibration.

RBCT include the following assumptions: forward-looking rational expectations, stable preferences, perfectly competitive environment, complete information, optimising rational agents, no frictions and no adjustment or transaction costs. Furthermore, a representative agent framework is used where agents purpose to maximise their utility under resource constraints. Price flexibility guarantees continuous market clearing so that equilibrium always prevails. Exogenous shocks to technology are random, act as the impulse mechanism and have an impact on the supply side of the economy (Gill 1997, 79; Snowdon and Vane 2005, 307-308).

Different propagation mechanisms (for example intertemporal labour substitution) carry forward the impact of the original impulse. Intertemporal labour substitution means that the labour supply decision is grounded on the intertemporal trade-off between leisure and consumption between now and in the future. Changes in employment reflect voluntary changes in the number of hours people choose to work. When wages are low, people decide to work less and vice versa. Thus, work and leisure are highly substitutable over time. Moreover, the differentiation between the short run and the long run in the analysis of economic fluctuations and trends is abandoned. Monetary policy is irrelevant in RBC models (Snowdon and Vane 2005, 308).

BCs are real since they do not represent a failure of markets to clear. They are created by rational agents reacting optimally to real shocks. BCs reflect the most efficient procedure of the economy, given the structure of it (Gill 1997, 77).

RBC literature has broadened in the 1990s (Rotemberg and Woodford, 1997; Christiano and Eichenbaum, 1995). For the purpose of this discussion: When the essay mentions RBCT it does not include these extensions.

3. Analysis of strengths and weaknesses of RBCT

Lawrence H. Summers ([1986] 1994, 290) stated that there is no link between RBC models and BC- phenomena observed in any capitalist economy. He illustrated that values of parameters Prescott uses differ from economic reality (Eichenbaum et al. 1986; Summers [1986] 1994, 291).

Many studies contradict Prescott’s assumption of intertertemporal elasticity of labour substitution (Eichenbaum et al. 1986; Altonji 1982; Mankiw et al. 1985). Additionally, Hoover and Krugman doubted if the 25 percent unemployment rate during the Great Depresision was the result of a mass decision to take a vacation (Hoover, no date; Krugman 2009).

Summers ([1986] 1994, 292) also criticised that there is no proof for the existence of technological shocks. Regarding the supply shocks associated with the two OPEC oil price increases in 1970s, he claimed that energy shocks did not account for large movements in measured total factor productivity. Besides, he explained that bad theories can predict very well, thus predicting is not explaining (Summers [1986] 1994, 290).

Mankiw (1989, 88) and McCallum (1988, 30-31) animadverted the disregard towards monetary policy. Mankiw claimed that the economic effects of changes regarding monetary policy are well-observed. He (1989, 79) described RBCT as dangerous since it can be interpreted in a way that macroeconomic policies are needless.

Prescott’s (1986, 21) answer to the deviation of observation and theory is that measurement techniques have not yet progressed to the point where they completely affirm his theory. He claimed that the theory is ahead of BC-measurement.

Nelson and Plosser (1982) provided empirical evidence of real supply-side shocks. According to them, output variation cannot be explained through monetary disturbances (Nelson and Plosser 1982, 139).

Chatterjee (2000) indicated that RBCT had remarkable success in explaining cyclical fluctuations.

To name just one example, the faster-than average growth of U.S. economy between 1995 and 2000 is explainable through RBCT. Moreover, Plosser (1989) showed that the values foreseen by RBCT are close to real values of key macroeconomic variables.

4. Explanation of the GFC

The consequences of the GFC were far-reaching. The increase of the suicide rate in 2009 in Europe and America was higher than expected if earlier trends had continued (Chang et al. 2013). The GFC cost the U.S economy at least 40 to 90 percent of one year’s total goods and services (Atkinsion et al. 2013, 19). The world GDP decreased from 2008 to 2009 about 5,19 % (World Bank 2018a).

The Federal Reserve (FED) lowered its funds rate from 5,24 % (July 2006) to 1,98% (May 2008) (FRED 2018a) to boost the economy. Consequently, more US-citizens were able to raise a mortgage and did so. Banks accepted real estates as a collateral because home prices increased since the beginning of the 1990’s (figure 1). A lot of mortgages were granted to people with small repayment ability. These were commonly referred to as subprime mortgages (Acharya and Richardson 2009, 196-198).

Figure 1: S&P/Case-Shiller U.S. National Home Price Index

Abbildung in dieser Leseprobe nicht enthalten

Source: Own Diagram. Data: FRED 2018b.

Banks securitised the mortages which were rated. Securitised mortgages with different ratings were mixed together and bundled up in collateralised debt obligations (CDOs). Many of these CDOs which include a large variety of different mortgages were rated by a rating agency with “AAA”.

In fact, the realistic rating of a lot of these CDO’s were worse (Cominskey and Madhogarhia 2009, 271- 272). In spite of this, they got a triple A rating since there have been modeling failures and conflicts of interest since rating agencies got paid by their principals (Acharya and Richardson 2009, 196). Furthermore, it is questionable if rating agencies understood the complex CDOs (Cominskey and Madhogarhia 2009, 272).

Banks sold top rated CDOs to different investors (institutional investors, hedge funds etc.) globally, especially to US and European investors. Doing so, they also passed the credit default risk. Instalments of the borrowers were then flowing to the buyer of the CDO. CDOs seemed to be highly profitable for banks and investors. Consequently, the demand rose (Ibid., 271-272).

The demand for mortgages was saturated after some time, while the demand for CDOs continued to rise. Therefore, banks begun to lower their credit approval standards even more by giving mortgages to people with very low creditworthiness. The number of borrowers who defaulted increased (Ibid.). Consequently, they had to endorse their houses to banks. Additionally, the demand for real estates decreased since a considerable part of the housing demand was already covered. Meanwhile, banks recognised being too lax and insisted of a more thorough documentation of income and assets which reduced the number of house-buyers (Baker 2008, 80). Besides, the FED tried to prevent inflation from rising by raising interest rates from mid-2004 to mid-2006. The rates of adjustable-rate mortgages rose, so many subprime borrowers could no longer make their mortgage payments. Following foreclosures depressed housing prices even more (Ibid., 272).

The more the value of real estates decreased, the bigger became the loss for owners of CDOs. Thus, they tried to sell them – without success. At this point, several financial institutions (FIs) already owned loss generating CDOs. Accordingly, FIs began to distrust each other and banks reduced their extension of credit (Earle 2009, 788). FIs were dependent on these credits, especially after their losses through CDOs. Several FIs did not have enough equity deposits to countervail these losses. Hence, they went bankrupt like Lehman Brothers or were nationalised like AIG (Mishkin 2011, 52-53).

5. Comparison of RBCT with Marx’s crisis theory and Minsky’s FIH

Within Marx’s theoretical framework, a capitalist employs machinery to enhance producitvity. Therefore, fewer workers are necessary for production and unemployment rises. Moreover, wages are decreasing as goods become cheaper. Because of the competition, the entrepreneur is forced to invest constantly one part of the profits to new machinery. Consequently, the rate of profit and the wage of the entrepreneur falls. While the supply of goods rises, is the demand shrinking. An overproduction crisis arises (Marx and Engels 2008, 276).

Marx’s tendency of the rate of profit to fall assumes that the rate of profit decreases, although the productivity, through using machines, increases. The surplus value rate is not high enough to compensate the costs of the machinery (Sinn 1975, 656-666). This approach lacks empirical evidence (Li 2018).

Marx claims that a capitalist system is intrinsically prone to crisis: The crisis will occur in a never-ending circle. This leads to an inevitability of a communist revolution. Capitalism produces its own gravedigger (Henning 2017, 73-75).

Contrary to Marx, Minsky’s FIH was largely ignored until the GFC. The collapse of the subprime market was branded as “Minsky moment” (Palley 2009, 2).

He distinguishes between three different “income-debt relations for economic units”. “Hedge financing units” can pay their contractual obligations through their cash flows. “Speculative finance units” can only pay the interest of their debt. The redemption of the principal is only possible through refinancing. The cash generated by “Ponzi units” are not enough to repay the principle or the interest. Therefore, agents have to sell assets or raise new loans. A financial system is stable as long as hedge financing units dominate (Minsky 1992, 6-7).

In times of economic prosperity speculative finance units and Ponzi units rise because economic agents assume that the value of their assets keep increasing. The system becomes unstable (Minsky 1992, 8).

If an overindebted agent defaults, it has to sell its assets. The level of indebtedness has to be revalued; this moment is the “Minsky moment” (Lahart 2007).

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