Impulses and propagatIon mechanIsms In equIlIbrIum busIness cycles theorIes: From Interwar debates to dsge “consensus”Documents de travail GREDEG GREDEG Working Papers Series

Muriel Dal Pont LegrandHarald Hagemann

GREDEG WP No. 2019-01https://ideas.repec.org/s/gre/wpaper.html

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ImpulsesandPropagationMechanismsinEquilibriumBusinessCycles

Theories:FrominterwardebatestoDSGE“consensus”1

MurielDalPontLegrand*

HaraldHagemann**

GREDEGWorkingPaperNo.2019-01

Abstract. It is tempting to understand the DSGE (Dynamic Stochastic General Equilibrium)approachasarefinementofearliercontributions,namelySlutsky(1927)andFrisch(1933),andtoalesserextentHayek,Hicks,andLutz.Byanalyzingthedebatesintheseperiods,wetrytoshow that themodern tools fromwhich our theories benefit, far frombeing neutral, havedeeply changed the nature of business cycles theories. We identify the reduced role ofpropagationmechanisms inDSGEmodels and their consequences for current debates. Theoveremphasisonthecapacityofmodelstomimiccyclicalfluctuationsontheoneside,andtheclearincapacityofthesemodelstoexplain(eventomimic)largescalecrisesontheother,aredistinctbutconvergentelementswhichrevealadeepchangeintherelationshipbetweentheempirical findings (data, stylized facts) and the theory. These elements are deservingmoreattentionfromhistoriansofeconomicthought.

Keywords: equilibrium business cycles theories, dynamics, impulse, shocks, propagationmechanism(s),empiricalvalidation,calibration,crisis.

*UniversitéCôted’Azur,CNRS,GREDEG:muriel.dal-pont-legrand@univ-cotedazur.fr**UniversityofHohenheim,Stuttgart:harald.hagemann@uni-hohenheim.de

1TheauthorsthankMicheldeVroey,RogerBackhouse,andHans-MichaelTrautweinfortheircommentsonanearlierdraft.

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1. Introduction

There is no doubt thatDSGE (Dynamic StochasticGeneral Equilibrium)modelswhichwere

considered benchmark models during the Great Moderation period, were challenged

enormously when the global financial crisis developed. As business cycles models, their

capacity to provide insights into the origins and mechanisms of propagation failed in the

contextofthecrisis.Thisquestionstheirvalidityalsoasabasisforeconomicpolicyadvice.As

a consequence, many economists are pleading for new benchmarks or for a deep

reconsiderationofboththetheoreticalandempiricalsidesof thearguments.2 Althoughno

newconsensushasyetemergedonpossible“solutions”toorreorientationsoftheresearch

program in this field, many economists are trying to understand Where modern

macroeconomicswentwrong3.Ashistoriansofeconomicthought,weproposetoretracethe

evolutionofbusinesscyclestheoryandofitsempiricalpracticesinordertobetterunderstand

thewaythisliteraturetodayaddressesmacroeconomicvolatilityandeventuallycrises.

Although endogenous and exogenous explanations of business cycleswere for a long time

considered to be competing views, today it is clear that the impulse/propagation scheme

dominates. Under the combination of various influences, in the 1980s, a consensus had

emerged about the need for “sound” microeconomic foundations4 of models based on

equilibrium, alongside empirical studies and computational tools to allow a better

understandingof thenatureof shocks (DuarteandHoover, 2012) andhow theyaffect the

economy.Thefactthatpioneeringcontributionswithintheimpulse/propagationtraditionare

rootedintheinterwarperiod,producedatemptationtointerprettheDSGEapproachaspurely

arefinementofthecontributionsprovidedbySlutsky(1927)andFrisch(1933),andtoalesser

extentHayek,HicksandLutz,andbenefitingmorerecentlyfromthetechnicalimprovements

providedbytheNewClassicalSchool5.

2SeetheSpecialIssueoftheOxfordReviewofEconomicPolicy,Vol.34,Nos.1-2,SpringandSummer2018.3ThisisthetitleofoneofJosephStiglitz’scontributionsintheSpecialIssueoftheOxfordReviewofEconomicPolicy.4SeeKing(2012)forasurveyanalyzingthevarietyofprogramsonmicrofoundations.5ThismeansfirstLucas´scontributiontobusinesscyclestheory(1972,1973)andhismethodology(1981)andlatertheRealBusinessCyclesmodelsbyKydlandandPrescott(1982)orLongandPlosser(1983).

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Byanalyzingthedebatesinbothperiods,wetrytoshowthatthereisofcoursesimilarityinthe

natureofthedebatesbutthatthemoderntoolsfromwhichourtheoriesbenefit,farfrombeing

neutral,havealsodeeplychangedthenatureofbusinesscyclestheories.Moreprecisely,the

moreshocksbecameessentialelementsofbusinesscyclestheories,themoredrasticallythe

roleofpropagationmechanismsisreduced(e.g.CogleyandNason,1995).Thisreducedroleof

propagation mechanisms in DSGE models has two important consequences for current

debates. First, there is anoveremphasison the capacityof themodels tomimic (versus to

explain) cyclical fluctuations. Second, there is a clear incapacity of thesemodels to explain

(eventomimic)largescalecrises,i.e.themajorcrisesthatresultfromrelativelysmallshocks

(Stiglitz,2015,2018).Bothelements,althoughapparentlydistinct,revealadeepchangeinthe

relationshipbetweentheempiricalfindings(data,stylizedfacts)andthetheory(heremodels)

whichshouldgetmoreattentionfromhistoriansofeconomicthought.

Byinvestigatingthemethodologicalandtheoreticaldebatesthatoccurredbetweenthosetwo

periods,wetrytoidentifyhowthenatureofthesemodelshaschanged,andhowthischange

hasaffectedboththequestionsthatcanbeaddressed(ornot)viathemodelsandhowthose

questionsareformulated.Byemphasizingtherelativeimportanceofimpulseandpropagation

mechanismsinbusinesscycles(equilibrium)models,weexaminethestatusofthosemodels,

i.e. their linking of the theory with the constraints imposed by their empirical validation

method(s).

Thepaperisorganizedasfollows.Section2analyzesthedebatesthatoccurredintheinterwar

periodcomprisingthevarietyofapproachesdealingwiththemethodsandproblemsrelated

tobusinesscyclestheory.Inthisperiodtherewasalackofconsensusonthequestionwhether

the equilibrium method is a proper framework for business cycles analysis. Furthermore,

different concepts of equilibrium existed, and it is in this context that we discuss their

implications on other debates - dynamic versus static analysis of fluctuations, real versus

monetaryexplanationsofbusinesscycles,andexogenousversusendogenousbusinesscycles

models–andmeasuretherelativeimportanceofimpulsesandpropagationmechanismsinthe

explanationofbusinesscycles. In section3wediscuss the rationalexpectationshypothesis

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(REH)associatedtomicroeconomicfoundationsàlaLucas,andhowitaffectedthewaythose

equilibriumbusinesscyclesmodelsconsiderfluctuations,i.e.thenatureofthepossibleorigins

(shocks) and their capacity to propagate. A stream of the literature presents a systematic

comparisonbetweenthatfirstgenerationofEquilibriumBusinessCycles(EBC)models6andthe

equilibrium approaches in the interwar period7. This literature has already proved that

comparisonsaredelicate8.Weadd to thisby comparingwith the latest versionof theEBC

models,i.e.DSGEmodels.Thosemodelsdeserveattentionforseveralreasons.First,theywere

atthebasisofalargeconsensusamongmacroeconomists9beforetheemergenceofthemost

recentcrisisandwereconsideredsuitable(andsufficientlysimple)modelsforpolicyanalysis.

Second,theirmacroeconomicstructureallowedthemtohandlealargesetofeconomicissues

withinthesamemodel.Thecanonicalmodelcombinedthreeimportantelementsnamelyi)

theintertemporaloptimizationprogram(thewell-identifiedcoreofrealbusinesscycle-RBC

models),ii)anewKeynesianPhillipscurve,i.e.introducingrigidities,iii)policyreactionviathe

incorporationof the Taylor rule.A strandof literatureemergedwhichpresented that core

model as the new consensus or the New Synthesis10. Those models were presented as

encompassingallrelevantNew-ClassicalandNew-Keynesianbuildingblocks.Theywerebased

onsoundmicro-foundations,builtwithinaframeworkthatdealsjointlywithbusinesscycles

andgrowthdynamics,appearedempiricallyrelevantsincetheyexhibitedthecapacitytomimic

(reproduce)observedfluctuations,andwereabletoevaluatestabilizationpolicyefficiencyin

conductingwelfareanalyses.

6ItisusualtodistinguishamongdifferentgenerationsofEBCmodels.Thefirst,initiatedbyLucas’sseminalworkin1972,isknownalsoasMonetaryEquilibriumBusinessCyclemodels.TheseconddevelopedfromKydlandandPrescott’s(1982)paperwhichfoundunexpectedempiricalsupportfromNelsonandPlosser(1982)byshowingthatrealshocksweretheonlyonesthatcouldexplainthepermanentimpactonoutput,i.e.so-calledRBC(RealBusinessCycles)models.FollowingthiswasabriefepisodewhenmanymacroeconomiststriedtoanalyzethepossibleimpactoftheKeynesianhypothesis(i.e.diversesourcesofrigidities)ontheexplanatorypowerofthosemodels(seee.g.,Hénin1995,Cooley1995).ThesemodelscametobeknownasAugmentedRBC(ARBC)modelsandheavilyinfluencedwhatnowweconsiderDSGEmodels,thefocusofthispaper(seeDalPontLegrandandHagemann(2010)formoredetailsonthesesuccessiveEBCmodels).7SeeScheide(1986),Hoover(1988),Arena(1994),Laidler(1986[2001]),DalPontLegrandandHagemann(2010,2013).8Hoover(1988)andArena(1994)haveshownthatLucas’smodelisveryfarfromHayek’stheoreticalprojectandDalPontLegrandandHagemann(2010)havedocumenteddeepdifferencesinthedebateconfrontingrealversusmonetarybusinesscyclesmodelsinthetwoperiods,i.e.theinterwarperiodopposingHicksversusHayekandthemorerecentoneopposingLucastothefirstRBCmodels.9SeedeVroey(2016)p.309andmorespecificallypp.325-327fordetaileddevelopmentsexplaininghowthetwosideshadtoabandonseveralelements.10SeeWoodford(2009)andBlanchard(2009).

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Todaytheconsensushaseroded.Sincethecrisis,notonlyhavetheirproponentsbeenforced

toreevaluatewhattheyconsideredaslargelytheoreticallyaccepted11andempiricallyproved

butalsotheiropponentshaveseizedtheopportunityforstrongercriticism.Themainweakness

identifiedistheirincapacitytoexplainhowlarge(deepandlong-lasting)fluctuationscanbe

generatedbyrelativelysmall(er)shocks12.Thisisduetothelackofcapacityofthosemodelsto

explainpropagation,andmorespecificallytheamplificationoftheinitialshock.Weshowhow

modelsthatoveremphasizetheroleofshocksaremoreeasilycalibratedbutlosesomecapacity

toexplain. This isdue to their ability tomimic,which characteristicallydeeplyaffects their

relationshiptotheempiricalfacts(ordata).

2. ReflectionsontheInterwarDebates

Businesscycleswasadominantthemeintheoreticalandempiricalresearchconductedinthe

interwarperiod.Attheoriginofintenseandheateddebateswasthecentralquestionofthe

(in) compatibility of the business cycle explanationwith the dominant general equilibrium

approachineconomics.Economistswhobelievedstronglyintheneedtoconstructabusiness

cyclestheorywithintheexistinggeneralequilibriumframeworkwereopposedbythosewho

wereconvincedthata‘realistic’dynamictheorycouldonlybebuiltuponanout-of-equilibrium

concept. In theopeningpassageto ‘UnderstandingBusinessCycles’,oneofhismostly read

contributions,Lucas(1977,p.7)quoteswithapprovalHayek’sstatementinMonetaryTheory

andtheTradeCycle“thattheincorporationofcyclicalphenomenaintothesystemofeconomic

equilibriumtheory,withwhichtheyareinapparentcontradiction,remainsthecrucialproblem

ofTradeCycletheory”(Hayek1933,p.33n).

OneofthemostinfluentialauthorsintheinterwarperiodwasJosephSchumpeter(1883-1950)

whosemonumentalBusinessCycles openedwith the statement: “Analyzingbusiness cycles

means neither more nor less than analyzing the economic process of the capitalist era”

(Schumpeter1939:V).Fromtheoutset,itwascentraltoSchumpeter’sthinkingthateconomic

11SeeBlanchard(2018)inVinesandWills(2018)stressingthatthose(DSGE)models“mustbeimprovedratherthandiscarded”andcontinuouslyrecognizingthat“(…)weneeddifferenttypesofmacroeconomicmodelsfordifferentpurposes”(2018:43).12SeeStiglitz(2015).

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progress occurs in waves, that crises are turning-points necessary for the re-equilibration

process,andthataTheoryofEconomicDevelopment(1911)hadtobeconstructedasatheory

ofbusinesscycles.Schumpeter’stheoreticalsystemisbasedonthefundamentaldistinction

betweenstaticsanddynamics.WhereashisViennahabilitationthesisonTheNatureandthe

MainContentofTheoreticalEconomics(Schumpeter1908)inspiredbyhisgreatheroWalras,

focusesonthepurelogicofageneralequilibriumsystem,hisTheoryofEconomicDevelopment

dealswithdynamicanalysisandwasinspiredbythechallengeposedbyMarx’svisionofthe

long-run evolution of the capitalist economy which emphasized capital accumulation and

technicalprogress.

In themid-1920s,Schumpeter’s theoryhadbecomeacentral referencepoint for themore

theoretically-mindedeconomistsintheGermanlanguagearea.Thus,AdolfLöwe(1893-1995)

clearly was inspired by Schumpeter’s view that a Walrasian system of general economic

equilibrium was inappropriate for business-cycle theory, when he made his claim to the

necessaryabandonmentofstaticequilibriumtheoryintheanalysisofbusinesscycleswhich

wasmadeexplicitinhisKielhabilitationthesis‘Howisbusiness-cycletheorypossibleatall?’

(Löwe [1926] 1997). In this “brilliant article” (Kuznets (1930b: 128), Löwe highlighted the

fundamentalconflictbetweentheequilibriumapproachasthedominantmethodofeconomic

theoryandthesubjectofinquiry,i.e.cyclicalfluctuationsoftheeconomywhichhaveagenuine

out-of-equilibriumcharacter.Inhiscriticalinvestigationoftheexistingbodyofbusiness-cycle

theoriesLöweconcludedthatallseriousapproacheseitherintroduceexogenousfactorssuch

aswarsorbadharvests,or fullyorpartlyabandon the interdependency requirementsofa

systemofgeneraleconomicequilibrium.Heconcludedthereforethat:

Thebusinesscycleproblem… is solvableonly inasystem inwhich thepolarityofupswingandcrisisarisesanalyticallyfromtheconditionsofthesystemjustastheundisturbedadjustmentderivesfromtheconditionsofthestaticsystem.Thosewhowishtosolvethebusinesscycleproblemmustsacrificethestaticsystem.Thosewhoadheretothestaticsystemmustabandonthebusinesscycleproblem.(Löwe[1926]1997:267).

If economic theory is to explain the business cycle satisfactorily, it cannot do so simply by

outlining the consequencesof a disturbing factor exogenously imposedupon anotherwise

staticeconomy.Rather,itmustseekforsomecausalfactorendogenoustothesystemitself

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whichcandistorttherigidinterrelationsimpliedinthesystemofstaticequilibrium.Intheera

of progressive industrialization Löwe identified technological change as this decisive

endogenousfactorgeneratingthebusinesscycle.

AsHansjoergKlausinger, theeditorof the twovolumesonBusinessCyclesof theCollected

WorksofF.A.Hayekpointedout,“thebasictenetforinterpretingHayek’swritingsonmoney

andthecycleintheinterwarperiodistheirfirmfoundationonanequilibriumapproach,which

servedasthebenchmarktowhichcyclicalmovementsaretoberelated”(Klausinger2012I:

12). The challenge arising from Löwe’s attack against the traditional concept of a static

equilibrium and his plea for an alternative ‘dynamic’ system approach to explain cyclical

fluctuations,posedamajorissuetoHayekwhichisreflectedbestinchapterI‘TheProblemof

theTradeCycle’ofhisMonetaryTheoryandtheTradeCycle.

WhileHayekagreedwithLöwe’sidentificationoftheincorporationofcyclicalphenomenain

equilibrium theory as the crucial problem of business cycle theory, the two differed

fundamentally intheconclusionsdrawnfromtheirmethodological reflections.13Thisapplies

particularlytotheroleoftheconceptofequilibrium.IncontrasttoLöwe,Hayekadheredto

this idea as indispensable to economic theory in general, and to an understanding of

intertemporal price relationships in particular. Hayek considered the field of application of

equilibriumtheoryas“identicalwiththatofeconomictheory,sinceonlywithitsassistanceis

itpossibletogiveasummarydepictionoftheverygreatnumberofdifferenttendenciesof

movementwhichareoperativeineveryeconomicsystemateverypointintime”(Hayek[1928]

1984,p.73).AlthoughHayekunderstoodthattheeconomywasinastateofdisequilibrium

duringanadjustmentprocess,heconsidered itessential tostart theexplanationofcyclical

fluctuationsfromanassumptionofaneconomyinequilibriumwithfullutilizationofresources.

ThusHayekwasatissuewithWesleyC.MitchellwhohadpointedoutinhisBusinessCycles.

TheProblemandItsSettingthat“itisnopartofmytasktodeterminehowthefactofcyclical

oscillations ineconomicactivitycanbereconciledwiththegeneraltheoryofequilibriumor

13ForamoredetailedcomparativeanalysisseeHagemann(1994).WhenLucaspresentedhis“UnderstandingBusinessCycles”(Lucas1977)attheKielConferenceonGrowthwithoutInflationinJune1976heseeminglywasunaware that in his Vienna habilitation thesis Hayek had reacted to Löwe`s habilitation thesis (1926) whichqualifiedLöwetobecomethefoundingDirectorof theDepartmentofBusinessCyclesat theKiel InstituteofWorldEconomicswherethe1976conferencetookplace.

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howthattheorycanbereconciledwithfacts” (Mitchell1927,p.462).ChallengingMitchell,

Hayekunderlinedhis“convictionthatifwewanttoexplaineconomicphenomenaatall,we

havenomeansavailablebuttobuildonthefoundationsgivenbytheconceptofatendency

towardsanequilibrium”(Hayek1935,p.34).

NowwhatisHayek’sconceptofequilibrium?Hecertainlyconsidereditimportanttoincludein

thenotionof equilibrium theelementof time toanalyzedynamicquestions and to regard

differencesinthepricesofthesamegoodsatdifferentpointsintime.Thereisawidespread

viewthatHayek’sconceptofequilibriumoriginatesfromWalrasasmediatedintheGerman

language literature in particular in the works of Schumpeter (1908) and Cassel.14 Walras’s

influenceonHayekisidentifiedusuallyinthenoteinMonetaryTheoryandtheTradeCyclein

whichHayekstatesexplicitlythat“[b]y‘equilibriumtheory’wehereprimarilyunderstandthe

modern theoryof thegeneral interdependenceof all economicquantities,whichhasbeen

mostperfectlyexpressedbytheLausanneSchooloftheoreticaleconomics”(Hayek1933,p.

42).15

Thecausesofthecycle,orthedynamicimpulsescanberealaswellasmonetary.Incontrast

to Löwe but also Wicksell, Schumpeter and Hicks16 who emphasized the role of technical

progress,Hayekconsideredcyclical fluctuationstobecausedbymonetary factors.While in

MonetaryTheoryandtheTradeCycleHayek’sfocusisonthemonetaryfactorspromotingthe

cycle,inhissubsequentPricesandProductionlecturestheemphasisisontherealstructureof

production.AgreeingwithLöwe’semphasisontheimportanceofproductionstructures,Hayek

deviated by employing a vertical rather than a horizontal or sectoral disaggregation of

productionstructures,stimulatedbyBöhm-Bawerk’sAustriantheoryofcapitalstressingthe

timedimensionoftheproductionprocessasinthefamoustriangles.AlthoughHayek’stheory

essentially is amonetary (overinvestment) theory,he feltobliged to separatehis approach

fromallmonetary tradecycle theorieswhichproceed fromchanges in thegeneral levelof

14ItisdebatablewhetherHayekreallyhadaWalrasiannotionofequilibriuminmind.SeeArena(1994,p.211)who points out that “[t]here is little common room between Walras’s tâtonnement and Hayek’s marketdiscovery”.15However,thisinterpretationneedstobequalifiedduetoHayek’sfurtherreferencetoJamesMillandSay,aswellasthefactthatthisnotewasnotincludedinhisoriginalGermantextGeldtheorieundKonjunkturtheorie.16Hickswhoconsideredtechnologicalchangeasmorefundamental,hadalife-longcontroversywithHayekforwhommonetarydisorderswereoffirstimportance.SeeHagemann(1998).

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prices.Incontrast,Cantilloneffectsofchangesinthemoneysupplyonthestructureofrelative

prices,andhence,onthestructureofproductioni.e.non-neutralityofmoneyintheshortand

mediumrun,andRicardoeffectsofashortageofconsumptiongoodsontheproductionof

investment goods, play a decisive role in his business cycle theory.17 Thus, whilemonetary

factors,inparticularexcessivecreditcreationbythebankingsystem,causethecycle,theyare

not just the impulsebutalsoarepartof thepropagationmechanism.Thedistortionof the

structure of relative prices leads to consequential disproportionalities in the structure of

productioni.e.amisallocationofresourceswhichsoonerorlatermustbecorrected.

Hayek perceived the introduction ofmoney as the proper starting point for a satisfactory

theoryofthebusinesscycleandasovercomingthemethodologicaldilemmahighlightedby

Löwebecausemoney“doesawaywiththerigid interdependenceandself-sufficiencyofthe

‘closed’systemofequilibriumandmakespossiblemovementswhichwouldbeexcludedfrom

the latter” (Hayek 1933, pp. 44-45). According to Hayek, a Walrasian system of general

economicequilibriumalonewouldbeinsufficienttoexplaincyclicalfluctuations,because

the logicofequilibrium theory…-properly followed through, candonomore thandemonstratethatsuchdisturbancesofequilibriumcanonlycomefromoutside–i.e.thattheyrepresentachangeintheeconomicdata–andthattheeconomicsystemalways reacts to such changes by itswell-knownmethods of adaption, i.e. by theformationofanewequilibrium.(Ibid:42-43)

WhatHayekregardedasaweakness,FriedrichLutz(1901-1975)consideredtobeastrength.

LutzconcludedtheGermanlanguagedebateonthe(in)compatibilityofbusinesscycletheory

with the theory of general economic equilibrium before the Nazis’ rise to power with his

FreiburghabilitationTheProblemofBusinessCyclesinEconomics(Lutz1932).

Lutz’spositioncanbesummarizedasfollows:18

1. Analysisoftheeffectsofchangesinthedatawhichisthetaskofbusiness-cycletheory,

couldbedonewithintheexistingequilibriumtheory frameworkbytheuseof thevariation

method.Therewouldbenoneedfora‘newdynamic’theory.

17SeeHagemannandTrautwein(1998)foramoredetailedanalysisofCantillonandRicardoeffectsinHayek’stheory.18ForamoredetailedanalysisofLutz’scontributionseeDalPontLegrandandHagemann(2013).Alloriginalemphases.

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2. Everybusinesscycleisahistoricaleventwhichconstitutesanindividualcase.Itisthe

task of the theory to explain individual real business-cycle trajectories by applying all the

findingsofstatictheory,particularlythoseoftheeffectsofvariousdatachanges.

3. Therecannotbeageneraltheoryofthebusinesscyclebeyondwhatequilibriumtheory

hasaccomplished.Therefore,allattemptstodevelopa“newdynamic”theoryhavefailed.

Lutzalsodeals intensivelywithLöwe’sanalysisofthe(in)compatibilityofthebusinesscycle

problemand theequilibriummethod,andLöwe’sclaimtoanewdynamic theory (seeLutz

1932:114-122,2002:202-209).HeconfirmsthatLöweclearlyhadseenandpreciselyidentified

the problems that cyclical fluctuations cause for static theory but that he had proposed a

solution,i.e.hisdemandforanewdynamictheory,whichwasimpossible.AccordingtoLutz,

the idea of equilibrium is the result of thinking through processes of economicchange, it is the product of the recognition that the economy tends towardsequilibrium…thestatictheoryiswellabletodealwiththetaskswhichClarkassignstothedynamictheory.Itsdomainnecessarilyincludesproblemsofchange.Thesameforcesoperateindynamicsasinstatics,butinthelattercasetheyareinbalance.Staticsisreallybutabranchofdynamics,asMarshallputsit....themerefactthatbusinesscycletheorydealswithprocessesofchangedoesnotmeanthatitispartofadynamictheoryratherthanthestaticone.(Lutz[1932]2002:187-188n.2)

TheintroductionoftechnicalprogressfavoredbyLöweisnothingmorethanachangeinthe

datawhichwouldleadtoanewequilibrium“Inanycase,whatmustbestressedisthatsince

‘independentvariables’onlyrepresentchangesindata,introducingthemcanneitherhelpshow

awayoutof the static systemnor resolve thedifficultiesposedby theproblemofbusiness

cycles”(Ibid:205).

Followingthesamereasoning,LutzcriticizedKuznets’s(1930a)accusationthatstatictheory

overlookedthedifferentreactionspeeds.Kuznetsregarded“theequilibriumapproach…tobe

ablindalleyfromthepointofviewofbusiness-cycletheory”(Kuznets1930a,399),andeven

moreradicalthanLöweinhisconclusions,statedthat“...thepracticeoftreatingchangeasa

deviationfromanimaginarypictureofarigidequilibriumsystemmustbeabandoned”(ibid:

415).

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LutzconcedesonlythatequilibriumtheoryparticularlyinitsLausanneschoolblend,whichdoes

not include the timeelement,doesnot sufficientlyemphasizeadjustmentprocesses,while

statictheoryalsoincludes“investigationofhowequilibriumcomesabout,i.e.themovement

towards equilibrium following a change in data” (Lutz [1932] 2002:208). However, the

introductionofthetimeelementdoesnotruleoutgeneralinterdependence.

Timeandagain,Lutzstatesthatthereisnogeneralparadigmor‘nature’ofbusinesscycles,and

thatthereforetheycannotbesqueezedintoaunifyingscheme.Anendogenousinevitabilityof

businesscyclesis incompatiblewithmoderneconomictheorywhichisbasedonthecentral

ideathattheeconomytendstowardsequilibrium19.Toascribetheperiodicityofthebusiness

cycletointernaleconomicforceswouldimplyabandoningtheequilibriumconcept.Lutzwas

notwillingtodothis.

The argumentsdevelopedby Eugen Slutsky in his 1927 article 'The Summationof Random

CausesastheSourceofCyclicProcesses'20deeplychangedthedebatetraditionallyopposing

exogenous versus endogenous business cycles models. Slutsky’s contribution was already

regardedamongspecialistsasaclassicpaperintime-seriesanalysisandbusiness-cycletheory

whenitwaspublishedin itsrevised1937EnglishversioninEconometrica,duetoanearlier

translationwhichhadbeeninitiatedbyHenrySchultz.Slutskywasoneofthepioneersofthe

theoryofstochasticprocesses,andinhis1937articleheusedserialcorrelationtoprovethat

thesummationofrandomcausescanbethesourceofcyclicorundulatoryprocesseswhich

showanapproximateregularityofthewaves.LikeSchumpeter,heidentified"(t)hepresence

of waves of definite orders, the long waves embracing decades, shorter cycles from

approximatelyfivetotenyearsinlength,andfinallytheveryshortwaves"(Slutsky1937:107).

LikeLutz,Slutskywasconvincedthatcyclicalfluctuationsneverexactlyrepeatearlieronesin

either duration or in amplitude.Nevertheless, he considered it possible to identify specific

approximateuniformitiesandregularitiesinempiricalinvestigations.Havingin1926joinedthe

19Hayek,inalecturedeliveredinCopenhageninDecember1933,switchedexplicitlyfromhisearlierview“thatthetheoryofthetradecycleatwhichwewereaimingoughttobeorganicallysuperimposedupontheexistingtheoryofequilibrium”toLutz’sviewthat“ourtaskisnottoconstructaseparatetheoryofthetradecycle…butratheradevelopmentofthosesectionsofgeneraltheorywhichweneedintheanalysisofparticularcycles-whichoftendifferfromoneanotherveryconsiderably”(Hayek1939,pp.137-8).20ThefollowingpassagesarebasedonHagemann(2002).

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researchstaffoftheConjunctureInstitutedirectedbyKondratieff,Slutskywasinterestedin

empiricalvalidationofbusiness-cycletheories.Slutsky'sideathatrandomshocksthatwerenot

themselvescyclicalinnaturecouldgenerateregularoscillationsoftheeconomicvariableswas

importantandseminal.Itnotonlystimulatedfurtherresearchintime-seriesanalysisbutalso

freedeconomistsfromthebeliefthatcyclical fluctuationsmustbeduetocausesthatwere

themselves of a periodic nature and this way, affected the traditional divide between

endogenousandexogenousbusinesscyclesexplanations.

SimonKuznetswasoneofthefewtheoristswhoimmediatelyrecognizedtheimportanceof

Slutsky'scontribution.ShortlyafterpublicationofSlutsky'soriginalpaperinRussianKuznets

wrote his 'RandomEvents and CyclicalOscillations' article inwhich he emphasized that "if

cyclesarisefromrandomevents,assumingthesummationofthelatter,thenweobviouslydo

not need the hypothesis of an independent regularly recurring cause which is deemed

necessarybysometheoristsofbusinesscycles"(Kuznets1929:274).Thatpaperwasfollowed

bythearticle 'EquilibriumEconomicsandBusiness-CycleTheory' inwhichKuznetsaimsata

general theoryofeconomicchange.Hecombines three ideas inan innovativeway,namely

Slutsky's thesis with Paul Rosenstein-Rodan's (1929) emphasis on the importance of time

differencesandLöwe'smethodologicalcritiqueoftheexistingbodyofbusiness-cycletheories

forrelyingontheconceptofequilibriumwhichistoorigidlystatictograspdynamicprocesses

suchascyclicalfluctuations.

Kuznetsmakes it clear that it is only the conceptof a too static equilibriumapproach that

shouldbediscardednottherelationsofinterdependenceinvolved.Itshouldbesupplemented

withamuchstrongertimeelementcomponent.Thus,fortheconstructivepartofhisargument

heaimsatasynthesisofSlutsky’sandRosenstein-Rodan’sideaswhichmadehimawareofthe

importance of different speeds of response to a stimulus in different industries. Time

coefficientdifferencesmayarisenotonlybecauseofdifferencesintimingofreactionsbutalso

becauseoftheirdisproportionalitywhichalthoughnotinitselfacauseofdisequilibrium,may

aggravate theeffectsof timedifferences. Kuznetsdidnotdoubt that randomdisturbances

occurpermanently,andthattherewillbeasummationofrandomchangesaslongasthereare

differencesintimecoefficients:"Thus,anypossibilityofanequilibriumbecomesexceedingly

13

remote. For the inequality in time coefficients, be it only initial, opens the way to the

cumulationof randomcauses,andthey in their turnaccount for theappearanceofcyclical

fluctuations. Intheseconditionsanypersistentstateofequilibriumiscompletelyoutofthe

picture"(Kuznets1930a:411).However,Kuznetswhoseresearchinterestsshortlyafterwards

shiftedtoanalysisoflong-termtrendsandeconomicgrowthprocesses,wasalreadyawareof

twocomplicationsfromacertainskewness,i.e.thetrendmovementinrandomevents,and

fromthefactthatthestreamofrandomchangescannotbetreatedascontinuouslyrandom

becauseaftersometimethetrendcomponentwillaffectbusinesspeople'sbehavior.Thus,

relativelysmalldisturbancesmaycauseratherimportantdisproportionalitiesandmayresult

inprolongedoscillationsofformidablemagnitude.

In the same year Erik Lundberg (1907-1987)wrote his licentiate thesis 'On the Concept of

Economic Equilibrium'(1930). The core of the essay consists of an assessment of the

equilibriummethodforatheoreticalanalysisofeconomicchange.21Althoughhedoesnotrefer

directlytoSlutsky'scontributionwhichatthattimewasavailableonlyintheRussianoriginal,

LundberghadcompletelygraspedtheessentialsofSlutsky'sargument,pointingoutthat"there

are countless possibilities for oscillations which could become cumulative" and that "the

proliferationofbusiness cycle theoriesare toa largerdegreedue to themanypossibilities

offeredbydifferenttimecoefficients"(Lundberg[1930]1995,30).

Lundberg's analysis also benefited from the knowledge of Frisch's pioneeringwork on the

conceptsofstaticsanddynamicsineconomictheorywhichconstitutesthepreciseuseofthese

terms inmodern economics but firstwas only published inNorwegian in a Danish journal

(Frisch1929).Frisch´sprecisedistinctionbetweenstaticanddynamicanalysis impliesthata

genuinedynamicanalysiscontainsatleastoneeconomicvariablewhichisrelatedtodifferent

pointsintime."Anytheoreticallawwhichissuchthatitinvolvesthenotionofrateofchange

orthenotionofspeedofreaction(intermsoftime),isadynamiclaw.Allothertheoreticallaws

arestatic.Astaticlawisacomparisonbetweenalternativesituations,adynamiclawananalysis

of rates of change" (Frisch [1929] 1992: 394). From this it follows that Frisch thought a

Walrasiansystemofgeneraleconomicequilibriuminappropriateforbusiness-cycletheory.

21FortheimportanceofLundberg’searlycontributionseeHenriksson(1996).

14

Following Frisch, Lundbergwas concernedwith the staticmethodwhich is essential to all

partialandgeneralequilibriumtheories.Healsosawadistinguishingelementasdecisiveinthe

factthatthestaticmethoddisregardsthatsupplyanddemandnotonlydependontheprice

butalsoontherateofchangewhereasthedynamicmethodinvolvestherateofchangeor

speedofreaction.Lundberg'sessayalsoincludesaprecisedistinctionbetweentwopairsof

concepts:staticversusdynamic,andstationaryversusevolutionarystates.Themainaimisto

elaborate the hidden premises and the limitation to the applicability of the equilibrium

concept.Theyoungauthorsucceedstoaremarkableextent.Hecomestotheconclusion"that

adynamicanalysishastoprecedestaticanalysisandnotviceversa"(Lundberg[1930],1995,

p.36)butthatthetwoconceptsshouldbeusedsimultaneouslyandthatgeneralequilibrium

theory is indispensable to economic thought since it comprises the interrelatedness of

economic variables which cannot for a longer period diverge considerably from 'normal'

positions.

RagnarFrisch(1895–1973)embarkedonhisbusiness-cyclesanalysisintheearly1930s.Inhis

famouscontributiontotheCasselFestschrift,“PropagationProblemsandImpulseProblemsin

DynamicEconomics”Frisch(1933)22distinguishesbetweentwofundamentalproblemsinthe

analysisofcyclicalfluctuations:thepropagationproblemandtheimpulseproblem,elaborating

anideawhichheattributestoWicksell(1907).Frisch(p.198)alsorefersexplicitlytoSlutsky's

ideathaterraticshocksmaycausemoreorlessregularcyclicalmovementsbuthiscontribution

to business cycles analysis is of a different nature. Frisch develops a sharp and fruitful

distinction between exogenous random disturbances (exterior disturbances, called also

impulses), and the intrinsic structure or propagation mechanism by which the economy

transforms them into cyclical fluctuations. This distinction has proved seminal to modern

business-cycle theory. Frisch assumes the economy to be dynamically stable so that the

intrinsicstructureisdampeningtheoscillationcausedbyasingleshock.However,shocksoccur

quite frequently so the economy keeps on fluctuating.While the amplitude of the cyclical

swings is determined mainly by the strength of the exogenous impulse, the propagation

22ForadetailedanalysisofFrisch'sdevelopmentandhiscontributionstobusiness-cycleanalysisintheinterwarperiodseeAndvig(1981).

15

mechanismaccountsfortheregularityofalternatingmovementsofexpansionandcontraction

includingthelengthofthecycles.

Whereasinhis1933essayFrischdistinguishesbetweenthreecyclesofvariouslengths,helater

believedfirmlyintheKondratieffcycle23whichcanbecausedbyhisdetailedexchangeofideas

with Schumpeter on the role of innovations as key to maintaining oscillations.24

Methodologically, Frisch tried to bridge the gap which existed in the late 1920s between

empiricalresearchonbusinesscyclessuchasthatconductedbyMitchellfavoringtheinductive

method,andpurelytheoreticalresearchwhichdidnotevenaimatsoundempiricalanalysis

using modern statistical techniques and making their approaches operational25. It is then

naturalthathewasinvolvedinthedebatesaroundTinbergen’s1938report.Tinbergenwas

commissioned by the League of Nations to implement statistical tests of business cycles

theories and Frisch (1938)26 discussed the method in a paper27. This debate reveals an

importantpoint.FrischandTinbergenbothsharedtheviewthat“theexplanationofbusiness

cycle phenomena can be summarized as follows: a phenomenon is explained when its

endogenous mechanism is given. That is the phenomenon should be explained by the

mechanism itself and not by external phenomena” (Boumans 1995: 147). However, Frisch

showedthatusingdifferenceequations(insteadofdifferentialequations)doesnotallowto

constructamodelwithsuchanobjective.Indeed,“anecessaryconditionforidentificationof

difference equations is the presence of exogenous variables” (ibid: 147). The constraints

associatedtotheidentificationhadadeepinfluenceonmodelingchoices.Boumansconcludes

thattheprogressiveabandonmentofmodelsbasedonbothcomponentcyclesanddifference

butalsodifferentialequationsformodelsbasedonstochasticvariablesandlineardifference

equationsledtotheabandonmentoftheendogenousmechanisticexplanationoffluctuations.

Morethanthat,inthelightofthisdebate,onecaneasilyrecognizetheweightFrischgranted

tothepropagationmechanism.This isclearlydistinctfromSlutsky.AsLines(1990)showed,

23SeeAndvig(1981:708).24Seethefinalsection6ofhis1933essay.25Thelatterattitudewasquitecommon, inparticularamongmonetarytheoristsofbusinesscycles, includingleadingrepresentativesofschoolsasdiverseastheCambridgeandAustrianones.26 Frisch´s 1938 paper is considered by many historians of economic thought (Morgan 1990) but also byKoopmans,RubinandLeipnik(1950)asaseminalcontributiontotheproblemof identification(seeBoumans1995:130).27Foradetailedanalysisoftheimportanceoftheseeconometricdevelopmentsandtheirinfluenceonbusinesscycletheories,seeBoumans(1995).

16

Frischconsidersshocksasanecessaryreinvigorationelementoftheoscillatorysystembased

on lags,acceleratorand limiting factors, soaway tomaintain theswing28.ThenFrischwas

superimposingrandomdisturbancesondeterministicoscillations.Slutskyheldadifferentview.

Considering fluctuations as the summation of random causes, he studied under which

conditionsrandomfactorscanbetransformedintoaregularwave(cyclical)movement.Tothis

respect“hisworkisfamiliartoustodayasananalysisoflinearfiltering”(ibid:360).Hethen

exhibitedautocorrelatedstochasticfluctuations.Sorandomdisturbancesclearlydonothave

thesamestatusinbothkindsofmodels.

In theearlierattempts toprovidebusiness cyclesmodels, the statusof shocks candepend

ambiguouslyonthenatureofthemathematicaltoolsinvolved,andthechoicebetweenthese

toolsiscloselyrelatedtotheconstraintsimposedbytheidentificationmethod.Itisonlythe

beginningofthestory.DuarteandHoover(2012)havedocumentedhow,fromtheearly1970s,

thestatusofshocksevolvedfromobserveddatatoinferablephenomena.Itistheobjectiveof

thenextsectiontoexaminesymmetrically,howpropagationmechanismswereprogressively

discarded,shocksbeingconsideredaskey-elementstounderstandbusinesscycles.

3. DGSE:riseand…fall?

Althougheconomistsneverceasedtoworkonbusinesscyclestheory,itcamebackcenterstage

onlywhenLucasstartedtolookforsomenewfoundationswhichcouldexplaintheemerging

puzzlingrelationshipbetween inflationandunemployment, i.e.Stagflation. It iswell-known

todaythatthemaininfluenceofLucas’s1972paperonmacroeconomicsresearchliesmuch

moreinhismethodologicalcontributionthaninhisbusinesscyclesmodel29,althoughitwas

the first successful attempt to model monetary equilibrium business cycles. Under the

hypotheses of rational expectations and continuous market clearing, fluctuations are

28SeeLines(1990:370).29WedonotfocushereonthecorehypothesesoftheLucas1972modelbutmoreonhismethodologysincetheyarenotoffundamentalimportanceforthedevelopmentofbusinesscyclesmodels.TheimportantelementsarethosefinallyselectedbytheRBCandthenDSGEmodels.

17

considered as the manifestation of changes of equilibrium positions30. Nevertheless, the

business cycles theory suffered fromother importantweaknesses. First, themodeldidnot

allowpersistencyinoutputdynamicstobeexhibited.Second(andconsequently),inorderto

generatefluctuationswiththecharacteristicsoftheobservedoutputmovements,theremust

be an assumption of i) the occurrence of regular unexpectedmonetary shocks, and ii) the

admissionthatagentsareneverwellinformedaboutmonetarypolicy,ahighlyquestionable

point already in the 1970s. Tobin (1980), certainly unintentionally, delivered one of the

cleverestanalyses,offeringjustificationsfortheforthcomingRBCcounter-propositionarguing

that it would have been much more convincing to provide a model based on a shift in

productivity. What changed fundamentally was that as soon as the rational expectations

hypothesis(REH)becameacoreelementofthenewmodelingstrategyofmacroeconomists,

shocks ceased to have a secondary role, and instead became central elements of business

cyclesanalysis.First,systematicuseofREH,especiallywhenassociatedtoaperfectinformation

hypothesis,preventedanalysisoffluctuationswhich“previously”couldhavebeengenerated

bythediscrepancybetweenexpectedandrealizedvariables.Theideaofrationalexpectations

impliesalsoastochasticcharacterizationoftheagents’environment.

(…) viewing a commodity as a function of stochastically determined shocks… insituationinwhichinformationdiffersinvariouswaysamongtraders…permitsonetouse economic theory to make precise what one means by information, and todeterminehowitisvaluedeconomically.(Lucas1981:707)

30Thenotionofequilibriumisherequitedifferentfromtheoneusedintheinterwarperiod.Formanyeconomistsof that period (except for economists such as Lowe or Kuznets), equilibrium and disequilibrium wereencapsulatedconcepts.ThisisnotanymorethecaseforLucas’sREHequilibrium(seedeVroey2016:176-186).AsDavidLaidleremphasized,“thedifficultywiththenew-classicaleconomicsliesnotintheequilibriumpostulateperse,butinitsinsistencethatwemodeltheeconomyasawholeasiftheequilibriumstrategiesofindividualswereformulatedandexecutedinaninstitutionalframeworkcharacterizedbycontinuouslyclearingcompetitivemarkets”(1986:349).Formoredetailsonthebuildingprocessofthenewclassicalschool,seeDalPont(1999)ordeVroey(2016).

18

Morethan that,asemphasizedbyDuarteandHoover (2012), shocksprogressivelybecame

modelers’ instruments to introduce a (sort of) manageable instability. In selecting the

stochasticpropertiesoftheshocks,themodelercancapture/characterizedifferentartificial

economies.

In1982,KydlandandPrescottpublishedtheirpioneeringmodel“Timetobuildandaggregate

fluctuations”butinthesameyear,amore“empirical”paperwasoffundamentalimportance:

the contribution by Nelson and Plosser. This paper provided an empirical justification for

KydlandandPrescott’sRBCmodel,givingsupporttothefactthatonlyrealshockscanhave

persistent effects. However, there was some opposition to that vision. This result was

challengedsharplybyStadler(1990)whodemonstratedthatthe“empirical”findingsofNelson

andPlosserwere in factdeeplyrooted(only!) intheirmodel.Endogenizingtechnology, the

model provides a (powerful) propagationmechanism to shocks and reveals thatmonetary

shocksalsocanhavepermanenteffects.Thesecondcriticismwasan internalone. In1995,

CogleyandNasonaimedat investigatingwhethertheRBCmodelswereconsistentwiththe

stylizedfacts.Surveyinganalreadyvastliterature,theyfirstreplicatedtime-seriesevidence,

and thendiscussed thecapacityofdifferentRBCmodels toexhibit thisempiricalevidence.

Theirconclusionswerestraightforward:RBCmodelsreliedtooheavilyonexogenousshocksin

order to replicate those stylized facts: “in models that rely on intertemporal substitution,

capitalaccumulationandcostsofadjustingthecapitalstock,outputdynamicsarenearlythe

sameas impulsedynamics” (ibid. p. 509). Their final conclusionwas that theRBC research

program should consist of devoting “further attention to modeling internal source of

propagation”(ourboldletters,ibid.p.509).Theproblemwasthenclearlyidentifiedbyseveral

19

economists but is evidence also that the concept of propagation had been radically

transformed:now,themainsourceofpropagationoftheirmodelisexternal(i.e.duetothe

shocks’stochasticproperties).

Business cyclesmodels experienced adouble evolution: themore they reliedon shocks to

reproduce the observed fluctuations, the more they overlooked endogenous propagation

mechanisms. Thismodeling strategy had a profound effect on the questions addressed by

macroeconomicmodels,preventingtheanalysisofnumerouscoordinationissueswhichwere

dominating the debates during the interwar period. As Romer (2016:4) emphasizes:

“Macroeconomists got comfortable with the idea that fluctuations in macroeconomic

aggregatesarecausedbyimaginaryshocks,insteadofactionsthatpeopletake,afterKydland

andPrescott(1982)launchedtherealbusinesscycles(RBC)model.”Itshouldbenotedthat

despitecritiquesofthisempiricalapproach,thepracticaldimensionofRBCbecamenotonly

central to academic research strategy but was characterized by convergence to a unique

potential method; the measurement of the co-movements among aggregate variables. As

Zarnowitz(1985:524)identifieswithprecision,“itisthe‘stylizedfacts’whichitprovidesthat

oughttobeexplainedbythetheory”.

The transition from RBC to DSGE models, and the Keynesian influence on that process

benefitedfromtheattentiongivenbyhistoriansofeconomicthought31.Wecanidentifytwo

phasesofthis“convergence”process.ThefirstconsistsoftheintroductionoffrictionsinRBC

models,theso-calledARBC(AugmentedRealBusinessCycles).Researchalongtheselineswas

31SeeDuarte(2015).

20

described as ‘Keynesian’ until 2003 whenWoodford published his important Interest and

Prices.ThiswastheoriginofaNewSynthesiswhichcombinedthreeimportantelements:i)the

intertemporal optimization program (the core of RBCmodels), ii) aNewKeynesian Phillips

curve,i.e.introducingrigidities,andiii)policyreactionviaintegrationoftheTaylorrule.Those

models,i.e.DSGEmodels,werepresentedasencompassingallrelevantNewClassicalandNew

Keynesianbuildingblocks.ThisNewSynthesisemergedatamomentidentifiedbybothNew

Keynesians (Bernanke) andNew Classical economists (Lucas) as the “Greatmoderation”, a

period characterized by decreasing volatility of themacroeconomic variables attributed to

successfuleconomicpolicies,drivenbyourmoderntools(DSGEmodels).Thesemodelswere

notonlylargelyadoptedbytheacademiccommunitybutalsoquicklydiffusedthroughmore

institutional networks such as the Central Banks’ economic departments. Although debate

continued,itinvolvedeconomistswhofolloweddifferentlinesofresearch.

ThedirectconsequenceofthisconsensuswasthattheDSGEmodelwasusedtoaddressvarious

economicissues.Thiswasanimportantchangetothedisciplinecomparedtothediversityof

approaches which characterized the interwar period. It should be recalled that numerous

economists from Keynes to Solow and Leijonhufvud, considered that a large part of

economists’expertiseconsistednotofbuildingmodelsbutofthecapacitytoselectthemost

appropriateoneforspecificsituations.Thus,Solowargues:

I cannot say the same about the use made of the intertemporally- optimizingrepresentativeagent.Maybe I revealmyselfmerelyasold-fashioned,but I seenoredeeming social value in using this construction, which Ramsey intended as arepresentationofthedecision-makingofanidealizedpolicy-maker,asifitwereadescriptivemodelofanindustrialcapitalisteconomy.Itaddslittleornothingtothestory anyway, while encumbering it with unnecessary implausibilities andcomplexities.(Solow1994:49)

21

Convergence towards a single model was accompanied by acceptance of new criteria

determining“the”goodmodel.ClearlyforsupportersoftheDSGEapproach,agoodmodelwas

a workable model which behaves according to the observed data. The plausibility of the

hypothesescannotdependonreasonablecriteria.InlinewithFriedman’s1953statement,“the

more significant the theory, the more unrealistic the assumptions” (p. 14), the DSGE

proponents avoid discussion of the realism of hypotheses and consider that ultimately all

modelsarefalseandtheir“reliability”shouldbeevaluatednotbyconsideringeachequation

independently but by considering the behavior of the system (of equations). So, DSGE

economistsjudgeamodelas“useful”assoonasitcanreplicateobservedfluctuations,i.e.as

soon as it produces datawith the same stochastic properties as the observed data.More

specifically, the typical test of a RBCmodel once calibrated, consists of checking “whether

simulations of the model with reasonable disturbances can reproduce a few of the low

momentsofobservedtimeseries:ratiosofvariancesorcorrelationcoefficients,forinstance”

(Solow 2008: 245). Today, with DSGE models, empirical validation has evolved. First, the

number of autoregressive shocks involved in themodels has increased to be equal to the

number of forward variables. Second, “identification” of parameters (instead of only

calibration) is now the main method32. This means that the modelers calculate Bayesian

estimates, a method very often (almost systematically) presented as an improvement

comparedtothecalibrationmethod,althoughasshown(amongothers)byRomer(2016:6-7),

theidentificationmethodispossibleonlyiftheDSGEeconometricianintroducesprior(s):

Theidentificationproblemmeansthattogetresults,aneconometricianhastofeedinsomethingotherthandataonthevariablesinthesimultaneoussystem.(…)ThecurrentpracticeinDSGEeconometricsisfeedinsomeFWUTV’s(factswithunknowntruthvalue)by“calibrating”thevaluesofsomeparametersandtofeedinotherstightBayesian Priors. As Olivier Blanchard (2016) observes with his typical

32SeeSergi(2017)fordebatesonempiricalvalidationmethodswiththeDSGEapproach.

22

understatement,‘inmanycases,thejustificationofthetightpriorisweakatbest,andwhatisestimatedreflectsmoretheprioroftheresearcherthanthelikelihoodfunction’.

AsRomeremphasizes,sincesuchpriorshaveadirectimpactonthemodelconclusions,one

cannot exclude that themodeler finally selects the priors for parameters thatmight seem

unimportantbutwhichwillproduce theexpectedresult for theparameterof interest.This

point is investigated in detail by Chatelain and Ralf (2018). Since Lucas (1976),

microfoundations are “empirically justified by the endogeneity of macroeconomic policy

instruments leading to parameter identification problems” (Ibid:3). More than that they

emphasizethatoftenmicrofoundationsimplytoomanystructuralparameterssothatweare

inasituationofunder-identificationofthestatisticalmodelwiththedirectconsequencethat

a“usefulnormativemacroeconomictheorycanbeauselesspositivemacroeconomictheory”

(ibid).Indeed,observationallyequivalentmodelscanofferdifferentpredictionsaboutpolicy

Interventions.Morethanthat,andperhapssurprisingly,theincreasingreliancetoempirical

validationinordertomeasuretherelevanceofatheoreticalcontributionwasdoneinaway

whichallowedthesemodelstoavoidfalsificationmethodandthen,todisentangletheory’s

diffusionfromitscapacitytosettleclearempiricalfacts.Itissurprisingtonotethatthispoint

isnotaddressedmoreoften indiscussionsof therelativemeritsofcompetingmodels.The

existenceofsuchablindspotandespeciallythequasi-absenceofdebatesonitsconsequences

arepuzzling.

Duetotherecentcrisis,alreadyexistingcriticsgotagreaterresonance.In1996Hansenand

Heckman(p.87)noted“(…)thatasaparadigmfororganizingandsynthesizingeconomicdata,

it (General Equilibrium Theory) poses some arduous challenges”. Simulations are not new,

Tinbergenproceededinthisway,andFrischandKleinrefertoafew.Thepointisnotaboutthe

23

usefulnessofsimulationsbutratherthatthequalityofthesimulationiscompletelydependent

onthequalityofthedata.Soperhapsmacroeconomistsshouldbemoreawareconcerningthe

trade-offbetweenambitiousversusreliablemodels.

Withtheincreasingroleofshocksinbusinesscyclesmodelsandtheemphasisputonmodels’

capacity to replicate (versus to explain) observed fluctuations, it became necessary for

modelers to rely on “external” propagation mechanisms (the system being described as

intrinsicallystable)whichcanbecontrolled.Thisisachievedusingtheidentificationmethod.

Thedirect counterpart is thatmacroeconomists,whatever their response to critics such as

Solow,mustadmit that theyceased todedicate seriouseffort to improving the theoretical

rootsoftheirmodels.ThiscanbepartlyexplainedbythefeelingofconfidenceduringtheGreat

Moderation period: themain economic indicators (at least those onwhich they tended to

focus)seemedtoconfirmtheperformanceoftheireconomicpolicyguidance.

However,onmanyoccasions(andevenbeforethecrisis),economistswerequestioningtheir

micro-foundationsandcouldnotunderstandwhymoreattentionwasnotbeingpaidtothe

transitionfrommicrotomacrointheRBCliterature.Indeed,

(…)microeconometric estimates routinely incorporate heterogeneity that is oftenabstractedfromthespecificationofdynamic,stochasticgeneralequilibriummodels(…),giventhatunderstandingthedistributionofheterogeneityiscentraltomakingthistransition(…)”(HansenandHeckman1996:101).

This argument echoes that one already developed by Cogley andNason (1995)when they

emphasizedtheneedforaninternalpropagationmechanism.AsSolow(2008:246)perfectly

24

summarizes, questions about theoretical foundations andempirical validationmethods are

stronglylinkedsincemodelers,iftheyarenotcareful,canbeconstrained:

My general preference is for small, transparent, tailored models, often partialequilibrium, usually aimed at understanding some little piece of the (macro-)economicmechanism. I would also be for broadening the kinds of data that areeligibleforuseinestimationandtesting.Oneoftheadvantagesofthisalternativestyle of research is that it should be easier to accommodate relevant empiricalregularitiesderivedfrombehavioraleconomicsastheybecomeestablished.

What did the crisis reveal that we did not know before? Possibly, not much. However, it

perhapshelpedmacroeconomiststodefinebetterwheretheywanttogo.ThefactthatDSGE

cannotpredictcrisesisonepointbutmaynotbeasufficientargumentonitsowntodismiss

thosecontributions.Thefactthattheycannotprovide,evenexpost,convincingexplanations

ofwhathappened,oreconomicpolicyadvice,maybeabiggerflaw.

Tenyearsafterthecrisisvariousspecialissueshavebeenpublished.Someauthorsurgeadeep

renewalofmacroeconomictheory33whileothersfighttosave(partof)theircontributions34.It

isnotourobjectheretoexaminetherelativetruthsoftheirrespectiveargumentsbutwemust

agreewithStiglitzthatweneedabusinesscyclestheorywhichcanexplaindeepdownturns,

and in theabsenceofproper internal (andmicro-based)propagationmechanisms,wecan

havereasonabledoubtsaboutthecapacityofthecurrentDSGEmodelstoproducesuchan

explanation. Indeed,DSGEmodeling choicesareundera twofold influencenamely, a strict

definition for acceptablemicrofoundations and restrictions dictated by empirical validation

methods.Suchanacknowledgmentshouldpushmacroeconomiststoconsiderhowtooffer

33SeethespecialissueRebuildingMacroeconomicTheoryeditedbyVinesandWills(2018)34 See the last symposia “Macroeconomics a Decade after the great Recession” in the Journal of EconomicPerspectives,32:3,summer2018.

25

modelswithperhapsmoremodestbutcertainlymorerobustempirical resultsandperhaps

alsohowtointroduceagaindiversityinmacroeconomicmodelling.

4. ConcludingRemarks

DuarteandHoover(2012)provideahistoryofshocksanalysisinmacroeconomics,underlining

how the nature and the status of the shocks involved in business cycles analysis changed

progressively. Open questions still were why macroeconomists started invoking shocks as

“imaginarydrivingforces”(Romer2016)inordertoproducebusinesscyclesanalysis,whythey

didittosuchanextentthatitledtototalneglectofinternalpropagationmechanisms,andto

whatextentthisprogressiveshiftaffectedtheresearchprogramofbusinesscycleanalysis?

Webelievethattheinvestigationofthetwoperiodsdrawattentiontosomemissinglinks.It

explainsfirsthowpropagationmechanismswereprogressivelyoverlookedbutitalsopoints

outthatsuchaview(i.e.basedonexternalpropagationmechanisms)wasalreadypresentin

Slutsky’spioneeringcontribution.Withnodoubtthenatureofthemodelshassomuchevolved

that no strict comparison would be useful. However, it is interesting to note that despite

technicalprogresses,macroeconomistsaretodaystillfacingatrade-offbetweentheoretically

satisfyingandempiricallytestablemodels.

Thisshortepisodeperhapsrevealsthatitmightbetimeforhistoriansofeconomicthoughtto

emphasize in the “stories” they tell, how academics decide to focus on one sort ofmodel

comparedtoothers,i.e.whataretheirtheoreticalandempiricalcriteria,andhowthosecriteria

evolved. This remains part of the history of modern macroeconomics which is not often

carefullydocumentedbyhistoriansofeconomicthought.

26

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Documents De travail GreDeG parus en 2019GREDEG Working Papers Released in 2019

2019-01 Muriel Dal Pont Legrand & Harald Hagemann Impulses and Propagation Mechanisms in Equilibrium Business Cycles Theories: From Interwar Debates to DSGE “Consensus”