Sunday, May 22, 2011

The Cyclicality of Economic Growth

Courtesy: NASA / Goddard Space Flight Center
A lot of my academic research has been predicated on the basis of cycles in growth.  I realize that we talk about the "business cycle" frequently in economics and yet hardly any economists use methodological tools that assume cyclicality.  This is, I hope, about to change.  Whether we like it or not, cycles in human behaviour are everywhere, and that is partly because we live on a planet that circles around a hot molten star.  And yet economists blithely go on talking about "shocks" as though everything would always be smooth sailing but, yes, damnit, "X" (insert your own reason) got in the way and knocked us off course.

The reason why I'm going on about this today is that I recently received a rejection letter from a journal which stated "because your (cyclically based) analysis succeeds mainly in describing and summarizing the data, and does not dig deeper to identify more fundamental factors or disturbances that drive the movements in those data, the Co-editor and I also feel that the paper’s contribution, though again certainly positive, would be better-suited for a journal that specializes to a greater extent in...."  - anyway I'm sure you get the idea!!  So what I want you to note here is the word "disturbances" - this is another way of what economists term as "shocks" - what economists assume drives cycles in growth.

A lot of this methodological baggage that economists carry around with them comes from physics and indeed astrophysics - and making an analogy with both of these subjects is extremely instructive if you think about it.  The earth travels in an orbit around the sun and there is a gravitational pull which makes this happen.  Of course if the sun weren't there, the Earth would travel in a straight line, but there again none of us would be here if that happened so we are thankful for the cycles that the sun creates. Now in the case of the sun, it is gravitational pull that causes the planets to keep orbiting in an elliptical fashion (hence the seasons) and in fact we should all live in fear of "shocks" to this orbital behaviour (see Hollywood movies such as Deep Impact and Armageddon) although luckily our atmosphere protects us from most of these problems.  The point is with the economy the "shocks" are not really shocks - they are repetitive events that although are caused by different factors are much more likely to relate to cycles in human behavior rather than anything else. The idea of "bubbles" in mass human behaviour is part of this fascinating type of human behaviour because it is clearly cyclical - but there are cycles in lots of economic variables - exchange rates, investment, consumption, technology, etc. and some of the cycles are not like bubbles - so causing large falls in prices when they burst - in some variables there just appears to be undulations that seem to continue through time.  Why this is we are not sure, but certainly research appears to confirm this.

When aggregated, all these different components of the economy will lead to complex interactions which in turn  drives our GDP growth.  Sure we can get knocked off track by external "shocks" but I don't believe that is really what drives what we see in the macroeconomic aggregates.  Just look at US GDP growth below:
The chart shows the growth of GDP over time - very different from the actual trajectory of GDP which no doubt inspired the original idea of "shocks" pushing the level of real GDP around.  But what is important to a macroeconomy?  I would suggest that it's growth in real GDP, not the absolute level of real GDP. 

Looking at the chart if there were no shocks then the growth would show a consistent direction if it was converging to a "natural" growth rate. So the only way you would get a pattern like we see in the above chart is because there are shocks happening at at least a 6-monthly frequency.  So that means that the cyclical approach still has legs in my view. 

Certainly if you buy into this, the chart suggests to me a variety of cycles going on at the same time - and right now given the recent data we appear to be in one of those shorter cycle downturns which suggests that the current "deceleration" in growth that many report as driving the stockmarkets right now is only temporary.  I also hear renewed talk of double dip recessions again - but given we know that the business cycle (that causes the severe downturns) operates at a frequency of 3 to 10 years, without some massive shock to the US economy, how could this be?  Clearly these "double dippers" are fringe, but the main point here is that we should not expect the recovery to be smooth.  Looking at GDP even in good times it is extremely volatile, so why should it not be in recovery periods as well? 

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