Real Business Cycle Theory Should Get Less Attention

Garrett Jones thinks we should talk more about real business cycle theory:

One of the major schools of thought in macroeconomics rarely makes it into mainstream discussions:Real Business Cycle Theory. RBC, as it is known, claims that a lot of year-to-year economic volatility is caused by changes to the supply side of the economy: perhaps tax and regulatory changes, bad weather in farm economies,spikes in oil prices, and above all, the mysterious force known as the “technology shock.”  Finn Kydland and Ed Prescott shared a Nobel, partly for creating RBC theory.

As with most discussions about what’s overrated and what’s underrated, there’s a question of how to specify the model here. Jones says RBC rarely makes it into mainstream discussions. I would say that mainstream discussions are absolutely dominated by a RBC-esque confusion of the sources of long-term prosperity with short-term business cycle issues. But one important reason why RBC shouldn’t make it into mainstream discussions is that it’s totally ridiculous. The above is a chart of the business cycle in the United States of America.

That is simply not a chart of technology shocks buffeting the economy. No way no how. If you think the rate of technological progress plummeted at a nearly unprecedented pace during the winter of 2008-2009 or that 1983-84 was a two-year span of technology progress unequaled in the rest of postwar American history then you’re badly confused.

Contemplation of RBC does, however, raise an important point about economists’ use of the word “technology.” In English, “technology” occurs when you invent new stuff and you assess the pace of technological innovation by looking at the quantity of new inventions. In growth economics, you do it backwards. You look at the extent to which the quantity of output increases, and then you subtract out the contribution of capital accumulation (more machines) and increased labor supply (more workers) and call the residual factor “technology.” If you get a better survey that can include the impact of greater education (i.e., “human capital”) rather than quantity of workers, the residual gets smaller and you still call it “technology.” And in this tautological sense, it becomes easy to prove that technology is the key to prosperity. You can also apply the method to short-term output fluctuations. Things like the weather clearly lead to output fluctuations, as do disasters like the earthquake Japan had recently. But then it turns out that a very large share of output fluctuations in modern economies (as opposed to farm-dominated ones) aren’t attributable to these identifiable shocks. By analogy with the long-term growth process, you can simply label the residual “technology” and thus illustrate the central importance of technology shocks to the business cycle. And then there’s reality….