Famous Conditional Forecasts from the Real Business Cycle Side

Or, who else misunderstood the nature of the financial crisis and recession

As I was reviewing material to use in teaching how new classical models relate to the popular aggregate demand/aggregate supply models [0] used in policy analysis, I ran into this forecast in the real business cycle vein from October 26, 2008.

Barring a nuclear war or other violent national disaster, employment will not drop below 134,000,000 and real GDP will not drop below $11 trillion.

All this is to illustrate that in the fog of business cycles, one’s got to be careful about making forecasts (the rest of the article is a must-read, as is this rousing defense by Professor Mulligan in October 2009). Here is the actual evolution of nonfarm payroll employment.


Figure 1: Nonfarm payroll employment (000’s, January release). Dashed line at October 2008. Source: BLS via FRED.

At first glance, Professor Mulligan’s forecast of GDP does better.


Figure 2: Real GDP in Ch00$, SAAR. Source: BEA, 2011Q4 advance release, in Ch.05$ adjusted by ratio of 2000 GDP deflator in 2000 to 2005, and author’s calculations.

Of course, while Professor Mulligan did condition on no-nuclear war, he didn’t condition on ARRA.


Figure 3: Real GDP in Ch00$, SAAR (black), and counterfactual assuming low end of CBO estimates of impact (red) and high end (blue). Source: BEA, 2011Q4 advance release, in Ch.05$ adjusted by ratio of 2000 GDP deflator in 2000 to 2005, CBO (Nov. 2011), and author’s calculations.

Depending on one’s view of the multipliers, in the absence of the ARRA, the economy would have breached the $11 trillion. Now, in Professor Mulligan’s world, as I understand it, the ARRA would have little or negative impact, so his view regarding the course of GDP could be vindicated. And in fact, since Professor Mulligan believes that unemployment insurance reduces employment (see discussion here), then it’s fair to say he could be viewed as being vindicated, insofar as he conditioned on no ARRA. Of course, then you have to disbelieve a lot of empirical evidence indicating that output and hence employment is sustained by such measures (including the range cited by CBO). I might also note that it’s unclear whether Professor Mulligan conditions on the Fed’s extraordinary measures to support the credit markets; I think he believed they were not necessary, given this October 2008 post supporting the Minneapolis Fed working paper debunking the existence of a banking crisis (my discussion of Chari et al. (2008), aka wp 666 here).

I think all this is useful to recall the next time we hear a criticism of forecasts generated by models of the aggregate demand/aggregate supply mode, and forecasted responses to the ARRA, without any reference to conditioning statements [1] (Incidentally, the CBO has just released its latest assessment of the ARRA’s impact. There’s an excellent discussion of the range of models used in the CBO’s analysis in the Appendix.)

24 thoughts on “Famous Conditional Forecasts from the Real Business Cycle Side

  1. Jeff

    I think all this is useful to recall the next time we hear a criticism of forecasts generated by models of the aggregate demand/aggregate supply mode, and forecasted responses to the ARRA, without any reference to conditioning statements

    Agreed. But apparently you think conditioning statements are only required when criticizing and not when championing the ARRA? Because I do not see any reference to monetary policy response with respect to Figure 3.

  2. Garrison J

    You completely vindicated Mulligan here. He says that unemployment insurance will kill employment. He says that ARRA will kill GDP. His forecast is right on the money when you add in these factors.
    This is a good example of how somebody with an ideological agenda (you) can completely misinterpret evidence.

  3. Menzie Chinn

    Jeff: Well, I could add in estimates of the impact from the quantitative easing and other measures taken to respond to exigent conditions. But that would merely give me lines that were further down below the blue line, pushing below the Mulligan floors.

    Garrison J: I … don’t … think … so. Read the hyperlink provided in the text, where I discuss the parameterization Professor Mulligan used.

    By the way, it is sometimes useful to consult some facts. Unemployment extensions associated with the ARRA could not have occurred before the passage of the ARRA in February 2009, by which time we had already gone through the Mulligan floor….

  4. Jeff

    No, that’s not the proper way to think about. The exercise is not what would output be if we exclude this or that. The question is what is the effect of ARRA. In order to answer that you must address what happened to monetary policy when ARRA was included, something you have not considered.

  5. 2slugbaits

    Jeff I’m not understanding your comment. The Federal Funds Rate has not changed since the waning days of the Bush Administration (Dec 2008), so conventional Fed policy hasn’t changed since ARRA was enacted. Nothing happened to monetary policy…or at least conventional monetary policy. And I don’t think anyone believes QE1 and QE2 had particularly dramatic effects. So what’s your point?

  6. Paul

    Good to know that most of the unemployment in the U.S. is just an illusion caused by U.I. No doubt all these slackers on U.I. would happily retire to their vacation homes in Hawaii if U.I. were repealed.
    Mighty Casey has struck out . . . again.

  7. jay

    The often overlooked wrinkle in the UI debate is the legislation buried in the 2009 Recovery Act that warped the fabric of space and time allowing the expanded UI benefits to go back to 2008. Right when employment started falling apart. Coincidence? I dont think so.
    The usual parties will either ignore this or try to explain it away.

  8. Ricardo

    Keynes always saw himself as creating a new economics and his followers always see themselves as forging a new path. Actually they simply repeat the ancient economic error. The WSJ printed this wonderful quote from John Stuart Mill from 1844. Mill though he and his fellow scientific economists had refuted the error. Little did he know how it would return with a vengence in less than 100 years.
    Among the [economic] mistakes which were most pernicious in their direct consequences . . . was the immense importance attached to consumption. The great end of legislation in matters of national wealth, according to the prevalent opinion, was to create consumers. . . . It is not necessary, in the present state of the science, to contest this doctrine in the most flagrantly absurd of its forms or of its applications. The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained.
    Taxes are not now esteemed to be “like the dews of heaven, which return again in prolific showers.” It is no longer supposed that you benefit the producer by taking his money, provided you give it to him again in exchange for his goods. There is nothing which impresses a person of reflection with a stronger sense of the shallowness of the political reasonings of the last two centuries, than the general reception so long given to a doctrine which, if it proves anything, proves that the more you take from the pockets of the people to spend on your own pleasures, the richer they grow; that the man who steals money out of a shop, provided he expends it all again at the same shop, is a benefactor to the tradesman whom he robs, and that the same operation, repeated sufficiently often, would make the tradesman’s fortune. . . .
    What a country wants to make it richer, is never consumption, but production.

  9. acerimusdux

    Ricardo: “What a country wants to make it richer, is never consumption, but production.”

    Perhaps the greatest common error in economics is to ever say it is one or the other which matters, and not both. You aren’t going to improve upon AS/AD for policy analysis with any model (no matter how complex) that looks only at one of either supply or demand.

    It is true that there are certain conditions under which one or the other matters more. But those can be identified by paying attention to measurable real world variables like interest rates, inflation, employment, corporate cash and savings, and capacity utilization.

    It is true that the production side is normally more important when one is most concerned with increasing long term potential growth. But why would anyone be worrying much about that in the midst of a recession? Get the economy performing near to potential first, then we can worry about what long term growth models say.

  10. Paul

    Hey Ricardo, Remember the Gold Standard?
    Once the ENTIRE WORLD went to fiat money, Mill’s analysis became nonsense.
    Governments can easily spur production with consumption by deficit financing with “printed” money. BTW, here’s a news flash from the Great Depression: Supply does NOT create demand.

  11. Frank in midtown

    That’s a new look for you Ricardo. Strong but not all cap’s. Taxes are theft, government is crime, and you live in 1650. Try this on for size: Deficits are pre-paid out taxes that households get to earn the carry on in the mean-time, like a giant hedge fund of funds. The government borrows cheap, gives it to the households, the households turn it into capital which they lend out dear. This works great as long as households earn a return greater than the Government’s cost of borrowing. Now realistically, it would be unacceptable just to give the money straight to the rich so we let the poor touch it along the way. A positive carry trade makes a country richer.

  12. JazzBumpa

    @ Garrison J
    I just have to tell you that you have immeasurably brightened this dreary February afternoon with your acerbic wit. Do you write for The Onion?

  13. AWH

    it is good and accurate stuff

    but perhaps the best treatment of these delusional lysenkoist types who populate much of academic macro is to ignore them

    the rest of the world, university presidents, the queen of england, etc are catching on to how completely counterproductive and worse than useless they are?

    doing actual databased macro modelling was less than perfect either? but
    not that hard to see we were going over the falls by summer 2008, from the collapse of securitization, incomes dropping, first ministimulus reversing, credit withdrawal resulting in items like auto sales collapse down 10% by July 2008. Oh excuse me am i not operating at a high enough level of rigor and abstraction for someone?

    the main problem was no macro modeling history of credit withdrawal. Even now both sides–excluding yourself with your excellent chart Financial boom…and bust– ignore that collapse of capital markets issue this time (and it hasnt recovered much).
    and by the way the same losers who rewrote great depression history managed never to look at capital markets issue collapse and a CAPEX cycle or housing for that big one either. anyone? anyone?

    Academic macro is a provable travesty, and has not taken the opportunity to learn anything about finance and capital markets

  14. Jonathan

    This is a comment on Ricardo’s comment. That is a quotation from Mill in which he makes a bunch of statements. Those statements contain no evidence at all; they are assertions which reflect his perspective. That is not refutation. To refute an argument requires actual points to be made with evidence to back them up. That Mill lived a long time ago is not evidence, nor is his use of 3 names, but those are all that’s offered.
    By contrast, Keynes made a direct argument backed by evidence which described an actual mechanism by which deficit spending would have an effect in times of crisis. That’s the hurdle, not that Mill said something or that David Ricardo said something a long time ago.

  15. JBH

    Regarding the first link “Five Reasons …”, I have to wonder where the financial sector is in all those diagrams. The financial sector froze up. The monetary transmission mechanism broke. A retrospective on the January 2009 posting might be informative now from the standpoint of learning something from what was left out. To this point, O’s posting that the IS/LM model is considered defunct in graduate macro classes stood out. As did the lack of response to his question about if this is so.

    As for link two, it was posted at the very end of October 2008. The Dow was plunging at an historic rate with no end in sight. The post’s clearly-stated hedge about adverse effects of the financial crisis – “I have stated that its adverse effects (if any)” – showed little insight into the quintessence of that recession. Namely, real-time fear that the financial system was collapsing. A priori, if the financial system collapses the economy does also. Reflection on this gap in understanding is the only reason I see this post might be a “must-read”.

    Link three, from the same author, was indeed an exculpation. (1) In a severe recession, employment is always going to decline severely. What was already known to experts about the down phase of the cycle was that employment had declined sequentially further after each of the prior recessions. Something was up. How much more was this likely in the wake of a financial crisis the likes of which hadn’t been seen since the 30s? It is no excuse that the Obama Council of Economic Advisors got it wrong. There were no such experts on that Council. (2) How is it possible to make a sensible statement about the down phase of the cycle, and the recovery afterword, without mentioning inventory investment?

    About ARRA. No astute observer – and by this I mean hedge fund operators, Wall Street economists, bond portfolio managers, and the like – for a single moment imagined in the months subsequent to Lehman and before Obama took office that there would NOT be an ARRA. The cavalry was just over the hills, and the front line troops were stiffened because they were all but certain stimulus was big and it was coming. In my judgment, this subjective expectation is the most important variable in Menzie’s conditional information set of Ω t-1 during the dangerous time period of late-2008 early-2009. [See the first link in Menzie’s last paragraph.] Had the public at that time heard from President Bush, the presidential candidates, Congress, Paulson, Bernanke, Geithner, and the other district Fed presidents that fiscal stimulus was simply not on the table, the all-critical financial dimension of the recession may have gone on unabated. By December, the funds rate had already been dropped to zero (16 basis points), and only at that late date did the first intimation by the Fed of a never-before-tried QE appear in the press. Since we do not know where the snapping point of the system was, we’ll never have any way of quantifying the full story of what went on. But – and here is my point – the instantaneous fiscal multiplier may well have approached infinity in the expectational sense. Unfortunately regression analysis does not work with just one observation.

    2slugbaits It is my professional judgment that QE1 and QE2 had very important effects on stemming the financial crisis, ending the bear market in stocks, and on the timing and magnitude of the initial stage of the recovery. Indeed, I believe even the less quantifiable effects of the stress tests of the big banks, and the Fed’s hurried announcement of the results of those tests, comforted the marketplace and thus turned things up. We were thereby assured that the banking system was not going to collapse. Again, fear of financial collapse is manifestly at the heart of the Great Recession. Interest rates are a slender reed on which to base macroeconomic theory. All the more so when the short rate has gone to zero, as it had by December. The salubrious effects of then pouring more liquidity into the system were manifold: asset prices in raw material markets, the stock market, numerous other channels whereby liquidity leaked out to the public, boosting the perceived prices of toxic assets on the books of banks, flows entering into the shadow banking system allowing institutions to rapidly shed assets to shrink balance sheets as was so necessary because short-term liabilities were being pell-mell withdrawn threatening insolvencies, and myriad wealth effects in housing, stocks, corporate bonds, MBS, and many other channels too numerous to mention. All this is detailed at great length in the work of Hyman Minsky as what to do when a Ponzi scheme unravels.

    AWH Your post is spot on. Predictive accuracy of the economy with macro models – tenuous in the best of circumstances as it is the future we are talking about – will not be much improved until the financial sector is given its proper, vital role. The banking system is not liquidity-constrained today; it is capital-constrained. That’s why the gigantic pool of base money is not flowing though. The concept of leverage, to mention just one, needs to be fully incorporated in the model. Consumers are constrained by their debt burden to a degree not seen since the Great Depression. Mortgage debt is key, and household deleveraging is the main obstacle to growth today. Monetary and fiscal policy need be complimented by something we might call credit policy. We could also use a housing policy. You do not perform surgery without the anesthetist present. The administration and profession do not even vaguely comprehend this. Ergo the slow growth trajectory stretching well into the future America is being condemned to. Unless something changes.

  16. 2slugbaits

    JBH Just to be clear, I supported QE1 and QE2. In fact, I would like to see QE3+. I just don’t think the effects of QE were anywhere near powerful enough to get us out of the recession. Normally monetary policy is both the first policy choice and the only necessary policy choice; but this recession was so deep and the Fed reached ZIRP so quickly that fiscal policy was also needed. At the margin QE helped, but I hope you’re not suggesting that QE alone would have been enough to do the trick.
    Your comment about the market already factoring in a big stimulus package seems a bit strange. As we now know, Romer’s initial figure was $1.8T, which she cut back to $1.3T after Summers complained that the higher number wouldn’t fly. Then the political wonks trimmed that number down even further. And even that trimmed down number barely passed Congress and only after it had been neutered with all kinds of less effective tax cuts. So while everyone might have expected ARRA, you can hardly make the claim that by late October everyone knew the magnitude of ARRA. At the time GDP was falling three times faster than we thought.
    As to “astute observers” in the know (bond traders & Wall St types) understanding all this…well, I recall being on the late night ferry back to the Jersey shore the night that the govt announced a bailout agreement. Those “astute observers” were lined up at bar on the ferry and drunk on their butts. They were all cheering, singing songs and confident that a recession had been avoided. In fact, earlier in the evening you could hear them throughout lower Manhattan as they sang in front of the NYSE building. Do you mean those “astute observers”?

  17. Menzie Chinn

    JBH: Financial markets are incorporated into IS-LM in the LM curve. Admittedly that is a particularly simple depiction of the money market. That is why I teach the Bernanke-Blinder CC-LM model in my intermediate macro course, and have discussed on this blog here and here.

    I might observe that IS-LM as taught to undergraduates is not taught in PhD level classes. But rational expectations versions are still taught, and many SVARs of the 2000’s are in this vein.

    As a point of information in support of your critique, the overwhelming majority of DSGEs incorporate much simpler financial sectors than in IS-LM (e.g., a single one period bond, or complete (Arrow-Debreu) markets.

  18. billj

    Well if we’re considering historical discussions of crisis, surely Marx must be a reference point? How about this one;
    “`in a general crisis of overproduction the contradiction is not between different types of productive capital, but between industrial and loan capital, between capital as it is directly involved in the production process and capital as it appears as money independently outside that process’ (CW28, 340).”
    Simon Clarke’s excellent overview of Marx’s theory can be downloaded free here;

  19. Ricardo

    Mill is vindicated. Those who responded to my post all recognized that Mill was describing Keynesian pump priming as originating 200 years before Mill.
    acerimusdux – Traders consume because they produce. Without production there can be no consumption.
    Paul – When the entire world went on a fiat currency the entire world became nonsense. This is not the first time it has been tried. All other attempts have failed. The evidence and the trend say this experiment will end with the same result.
    Jonathan – Keynes had many faithful disciples who admitted they didn’t understand the General Theory. Mill understood Keynes better than Keynes understood Keynes. Mills thought the ancient mercantilist delusion was dead. This was his biggest mistake. Errors in reasoning have to be refuted every couple of generations, or perhaps better would be to say they have to fail every couple of generations.
    How many years was it between John Law destroying the franc and the French republic’s assignat failure? And over and over the French intellectuals running the republic kept saying we are too intelligent to repeat the errors of John Law. Oops!

  20. kharris

    I must chastise Menzie and slugger and the rest of you who seem to misunderstand how a valid argument is formed.
    Step the 1st: Assume ARRA was an utter failure, and that nothing good could have come from it.
    Step the 2nd: Evaluate the role of factors other than ARRA (such as monetary policy) in light of the assumption that ARRA was an utter failure, and that nothing good could have come from it.
    Step the 3rd: Credit other factors for any and all improvement in conditions since the economy got into trouble, since ARRA was an utter failure, and nothing good could have come from it.
    Step Final: Conclude, based on the evidence that any and all improvement in conditions since the economy got into trouble is attributable to things other than ARRA, that ARRA was an utter failure, and that nothing good could have come from it.
    How is it that this perfectly obvious bit of reasoning has gotten past you, unappreciated?

  21. 2slugbaits

    kharris Thank you for the correction. I stand humbled and wiser. I’ll try not to repeat my mistakes.
    ricardo Have you ever actually read Mill and Jevons and Ricardo and Smith? Mill was addressing an argument first advanced by earlier classical economists that tried to justify a very wealthy minority as the solution to what they saw as a problem of too much saving undermining Say’s Law.

  22. AWH

    JBH and MENZIE

    thanks JBH i agree with yours. And suggest that coming back to ISLM or whatever else on offer still so misses the point. For starters, beyond all the agent bsed and real cycle BS–are Nobels retrievable?– you can pretty much dump all the capital M monetarism. still embedded in ISLM bernanke etc etc

    as distinct from following credit

    at some level its basic statistics. No credit extension incl asset backed, shadow banking etc? No growth. As to why no credit, lets have our academic derivatives and shadow banking experts help explain. Anyone Anyone? Oh excuse me thats way too instititutional. When you have “institutionalized” derivatives accounting where the two sides of an individual derivative deal price massively differently, care to model that efficient market Nobel winners?
    the academic discipline is mostly embarassing itself and wasting resources.

  23. AWH

    We are the laughingstock of the world

    a top Chinese monetery official keynoted the last NABE policy meeting

    and gently tried to suggest we ought to be following credit.

  24. AWH

    So I have tried to get with you and your references to earlier blogs and studies, which I quote and comment on

    QUOTE In other words, models (IS-LM and IC_LM) that do not have some sort of financial accelerator and role for banks are likely to provide highly misleading policy conclusions (so the debate is not “merely academic”).UNQUOTE

    Completely agree BUT but does not mean that adding them will be adequate either?

    QUOTE The foregoing IC LM) has been a static, extremely ad hoc, discussion. I’ve eschewed sophistication in favor of working in a framework that is somewhat familiar to those who’ve worked with IS-LM. For those who want a more sophisticated, dynamic, interpretation, see Chapter 21 of the Handbook of Macroeconomics, “The financial accelerator in a quantitative business cycle framework,”, by Ben S. Bernanke, Mark Gertler and Simon Gilchrist. UNQUOTE

    So mostly in hope– given his sorry other academic record including savings glut and great moderation just for starters– I tried to see if Bernanke etc had anything to offer with the financial accelerator you are so impressed with. If it is something other than “collateral valuations will be cyclical” collateralized lending will be cyclical and need counterbalancing let me know. Yawn. Minsky covers all this and better.

    So add these up to Nada. So you say you saw parts coming because you could see how big our debt was. But back then you said foreign only was the problem? I agree it’s a part. And said nothing about fake assets being a part of it except housing values could be unreliable. This is no more than the financial accelerator on collateral. Nothing that vaguely relates to CDO CDS and the collapse of the capital markets and securitization. Do you even really know what they are, much less put in a model?

    There is also a reference to Ackerloff-who i like and who gets most– too long to repeat. That offers some ways forward including a focus on capital markets. But other than this, you are not offering even a hint of explaining either the recent or the Great Depression.

    By the way all are time challenged there. Industrial production fell 38 % and housing over 60% by the end of 1930 before bank lending declines, much less a crisis really got started. Apparently you didn’t read Bernankes BS self justification about how hard it is to find bank lending and collateral values cycles in the 30s data.

    And finally from You QUOTE I reduced the time devoted to the New Classical models (the Lucas supply curve, and Real Business Cycle models).UNQUOTE

    Care to explain why you waste students time and devote more than zero to these? I’m sending you this followup because I think you are perhaps wise enough to seek a new direction. So say something, since you have ignored me till now. Otherwise I won’t waste my time on you, and most of academics, the paymasters are waking up amigo.

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