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Warning: possibly-strange comment caused by trying to jam the square peg of this post into the round hole of the stuff population ecologists know about...

Might business cycles affect long-run average growth rates because of nonlinear averaging (Jensen's inequality)? In general, if a variable of interest Y is a nonlinear function of some other variable X, Y=F(X), and the value of X fluctuates over time, then the long-term mean of Y is going to be different than the value of Y that you'd get if you evaluated F(X) at the mean value of X. In particular, if F(X) is a saturating (concave down) function, then the mean of Y will be less than F(X) evaluated at the mean of X. That's a situation in which Y can't take fall advantage of the good times (times when X is high), so variability in X reduces mean Y below what it would be if X didn't vary. Population ecologists think about this sort of thing a lot. Say X is the abundance of a prey species, Y is the abundance of its predator, and F(X) is concave-down because the predator's foraging rate is time-limited. There's an upper limit to how fast an individual predator can eat prey, no matter how abundant the prey are. So long run average predator density is lower than it would be if prey abundance didn't fluctuate.

Not sure how this logic applies in the context of short run business cycles vs. long run growth. Not sure what the variables X and Y would be.

Surely the big negative effect associated with recessions is unemployment with plenty of research showing how harmful it is to a person's well-being. Sorry I just had to get that out of the way.

On your main point I think an intuitive assumption would be that volatility harms productivity growth. Scientists are not robots, they can't just change their labour input with the vagaries of the business cycle while holding productivity per hour constant. If they are able to work in an environment with relative job safety and with the knowledge that they will be able to finish their projects surely improves research quality. Companies also go bankrupt during recessions which makes CEO's less interested in even considering investments in long-term research.

PS: I would be very interested to learn whether or not there is any truth to the "liquidationist" claim that recessions purge the economy of inefficiency.

@ Hugo
That's what the Krugman link on hysteresis is about.

@ Nick
Don't we want a permanent boom just without the negative side effects like asset price bubbles? Or what's you definition of a boom? And is it really correct to say that even if booms and busts cancel out in the long run, that differenet growth paths (smooth or fluctuating) are equally desirable? You'd somehow have to bring GDP cycles in relation to life cycles. That's where hysteresis comes in , I guess. Maybe they're also not equally desirable, depending on the overall wealth of an economy in relation to others. Maybe poor countries are more willing to risk higher fluctuation in search of higher growth than wealthier ones.

@Nick, Jeremy Fox:

> Investment is low in a recession, but it is also high in a boom. Maybe it all just cancels out, so the average level of investment would be exactly the same if we tamed the business cycle?

All you need here is a diminishing marginal return on investment.

If I attend university for four years, I receive a certain amount of human capital. If I attend a doubly-expensive university for four years, I receive less than double the effective human capital. (I can't, because of time limitations, attend two universities at once. Even if I could, holding a double-bachelor's is less than twice as good as holding a single one.)

In turn, all you need to have a diminishing marginal return on investment is short-term investment opportunities that cannot be made up in the future. For example, neglecting a regular oil-change on a car requires significantly more investment to "make up for" later, after engine damage has set in.

----

Another aspect of nonlinearity is risk tolerance. Humans are not clairvoyant, so we cannot see the forward-looking volatility. Instead, we extrapolate forward-looking volatility from historical levels, and if historical volatility is lower then a risk-adverse agent will be willing to take on more leverage, increasing aggregate demand. This may partially explain the "divine coincidence" of successful inflation targeting being generally good for employment.

Jeremy: not a strange comment at all. It's *all* about Jensen's inequality. When I talked about diminishing marginal utility of consumption, and increasing marginal disutility of labour, I was asserting that the utility function is non-linear (by talking about the second derivatives), so a higher variance of consumption (and employment), even with a given mean, leads to lower mean utility (like risk-aversion). And if you have diminishing marginal product of labour as well, you would also get lower mean consumption with higher variance of employment.

But those only mean the average *levels* of consumption and utility are lower with business cycles. We need something more to get a lower growth rate. Like some effect on investment. (And even with lower investment, we don't always get a permanently lower growth rate, like in the Solow model, which has diminishing returns to investment, (just like the Malthusian/biology growth model has diminishing returns to labour because land is fixed), so growth eventually grinds to a halt. The "AK" growth model does not have diminishing returns to investment.)

Hugo: "Surely the big negative effect associated with recessions is unemployment with plenty of research showing how harmful it is to a person's well-being. Sorry I just had to get that out of the way."

Sure. But if the Phillips Curve is linear, the average level of unemployment is independent of the variance. If it's curved (and it seems to be), we could reduce the average level of unemployment by reducing the variance, which is a Good Thing. But does that effect long run *growth*?

"Scientists are not robots, they can't just change their labour input with the vagaries of the business cycle while holding productivity per hour constant. If they are able to work in an environment with relative job safety and with the knowledge that they will be able to finish their projects surely improves research quality."

Yep, maybe.

"Companies also go bankrupt during recessions which makes CEO's less interested in even considering investments in long-term research."

Yep, maybe.

"PS: I would be very interested to learn whether or not there is any truth to the "liquidationist" claim that recessions purge the economy of inefficiency."

Dunno for sure, but IIRC it's probably false. Vaguely remember reading some empirical research on this.

One of the more cited papers on topic: Ramey, Garey, and Valerie A. Ramey. Cross-country evidence on the link between volatility and growth. No. w4959. National bureau of economic research, 1994.

Fred: thanks. IIRC, they found that larger business cycles seemed to reduce long run growth.

@Nick:

"But those only mean the average *levels* of consumption and utility are lower with business cycles. We need something more to get a lower growth rate. Like some effect on investment. "

Yes, that's exactly what I was struggling to wrap my head around.

Glad my comment wasn't totally off base.

Here basically you need 3 things (which you touch upon) to get to the result that fluctuations matter for growth:

1. Asymmetric effects of the business cycle
3. Weak credit markets which make consumption smoothing difficult

1) is empirically plausible but theoretical models of this kind of are sort of ... quirky. I like'em but it's hard to generalize any particular one. So they shelved on the "here's an interesting possibility of a phenomenon" bookshelf rather than the "this is the way it actually works" desk. 2) is probably not empirically plausible (come on, we all believe in diminishing returns eventually!) at least if we're restricting attention to physical capital. Basically you need some model where the growth rate is a function of the saving rate and even many endogenous growth models won't get you that. 3) is empirically plausible but like 1) it's a bit of a mess to stick in the model and it's one of those things that macroeconomists seem to hate to have to think about.

It seems to me that the link between all three of this is credit constraints. I vaguely recall that Azariadis had a paper which sort of did 1) and 3) and then waved hands saying "AK model" to imply 2) but I can't find it right now.

notsneaky: why do we need 3?

Maybe we don't. I was thinking of a situation where investment/innovation opportunities arrive randomly and have large upfront fixed costs (which results in "lumpy investment", which is also empirically plausible). If you got access to credit markets you finance these by borrowing and keep your consumption smooth. If you're credit constrained you have to finance them out of current income and de-smooth your consumption which increases the utility-cost of investment.

...though thinking a bit more about it, it would depend on how this arrival of investment opportunities correlates with the business cycle too.

This is not an economics point of view, but rather a perspective from the investment capital industry: the negative end of business cycles accentuate the "risk averseness" of the people making investments more than the high end makes them risk positive. If you start from the position that investors are on average risk-averse (and I do, based on all the evidence in front of me every day), and that their experience shapes the degree of their aversion, then business cycle volatility is profoundly important. Having suffered through the financial crisis, investors are way, way further down the risk-reward curve than they were pre-crisis, and this does not appear to be changing quickly. For many people, it could be a permanent attitude shift.

Social historians have written plenty about the risk averse nature of the generation that lived through the Great Depression, and the impact that had on business behavior for decades. The financial crisis could easily go down in the books in a similar if not quite so dramatic fashion.

Bearing in mind that the crisis actually followed a period of bubbles around the internet and telecoms, the contrast could not be more stark. Even though many people made plenty of money during the go-go 90s and into the aughts, they are not referring back to those periods to say "well, some periods were up and some down, so I should be balanced". HA!

Count my vote for business cycles actually having long-term impacts on business and growth.

notsneaky: Ah, OK.

PelinoC: thanks for that comment. It's good to hear from someone who's a lot closer to the real world on this question than I am.

If only someone could have smoothed out that stop and start business we could have been far more evolved by now.

As someone with a business background, I often wonder what would happen if academic economics was reconstituted as a business. For starters, economists would have to ask which of their ideas the rest of the population would pay for.

My suspicion is that the rest of the population would pay economists for advice about business cycle theory but not for advice about growth theory. Economists have a unique edge in their understanding of business cycles. However, they would be out-competed in growth theory by business consultants with industry specific knowledge.

Nick: “a student who "buys" his own time to produce human capital is engaged in home production of investment goods, where no money changes hands; it's very different from a firm that buys investment goods from other firms”

What specifically do you mean by “investment goods”? What is included and excluded? I am never sure what economists think “investment” is. However, I’m pretty sure that it’s not what people with business / accounting backgrounds think it is. I have just read yet another lengthy blog post discussion (on another blog) about accounting identities where virtually no-one involved understood the concept of investment (or profit, which is related).

Nick: “When the business people who make investment decisions say they don't like "uncertainty", maybe they are trying to tell us something”

I think this is a red herring. One of the main differences between science / academia and business / government is that the first is mostly about facts and the second mostly about decisions. Decisions are always about the future, and the future is always uncertain. There is nothing that you or anyone else can do to help with this.

Jamie: "What specifically do you mean by “investment goods”?"

Something very different to what accountants mean. I would define it as a good you produce today, that has present costs and future benefits. Building a machine counts. So does building a house. So does producing software. So does getting an education. So does squashing grapes that will age to become wine.

Me buying stocks does not count (though it might subsequently cause the company that issued the stocks to buy some investment goods).

"Decisions are always about the future, and the future is always uncertain."
Yep.

"There is nothing that you or anyone else can do to help with this."

Disagree. For example, a bad monetary policy would make the future more uncertain, and a good monetary policy would make the future less uncertain. (Though some might make the future more certain in some respects and less certain in others.)

Nick: “a bad monetary policy would make the future more uncertain”

There are many uncertainties facing a business: customers might decide they don’t want your products; competitors might introduce better or cheaper products; new entrants might make your products irrelevant; commodity / raw material costs might change; suppliers might go out of business; the labour markets might change; key staff might leave; government and regulatory regimes may change; your major IT project might fail; your website might be hacked and your customers’ details stolen; natural phenomena may intervene e.g. fire, weather, climate, earthquakes. Monetary policy is just one of many uncertainties.

In addition, what do you mean by “bad” monetary policy? Most businesses / ordinary people don’t understand QE and other esoteric aspects of monetary policy so they are not in a position to determine whether the policy is good or bad. Even if they do understand QE, if central banks have purchased lots of assets then there is uncertainty over if or when they might sell them again. Also, central banks seem to spend their time at the moment threatening to raise interest rates and then backing off. That’s more uncertainty, not less.

Nick: “Building a machine counts. So does building a house. So does producing software. So does getting an education. So does squashing grapes that will age to become wine”

Yes, I agree. Investment is concerned with “adding value”. Most of the economy is just about exchanging / trading / distributing things. Investment is about producing new things and improving existing things.

So when you say “it's very different from a firm that buys investment goods from other firms”, would you include that in “investment”? Buying “investment goods” (whatever they are) does not produce anything new.

I ask this because, in a recent thread on accounting identities, I read an economist (not an ordinary person) talk about a “consumption only economy”. However, that makes no sense if investment is about producing new things. Where did the products and services which were consumed come from if there was no investment?

Also, in the same context, you commented recently on yet another accounting identity thread (on Roger Farmer’s blog) about service businesses and implied that they had no investment. However, that is not true. The investment in service businesses is in time slots e.g. hotel rooms per night; car hires per day; consultants per hour. Service business produce timeslots based on their underlying assets e.g. hotel rooms, cars, people. This must be the case as service businesses incur costs even if no-one buys their services.

Nick,
During the recession that Canada went through in the early 90's I found myself out of a job in spite of being the holder of an impressive suite of degrees and job qualifications. I was unemployed for almost a year. I think of it as a time when the world grabbed me by scruff of the neck and dragged me to the edge of the abyss and forced me to look down. I clawed my way back, the story of which would warm the hearts of any one of the current Republican candidates for President. I might even be more productive as a result. (I certainly save more.) But I also know that I could also have fallen in, losing career, marriage, children, health in the process.
So don't worry. Business cycle theory is important. Because it is not just a theory.

Jamie: funnily enough (not many people know this) the Bank of Canada started targeting inflation (and the rest of the world followed) because a business lobby group (temporarily forgotten its name) asked the Bank of Canada: "Look, it's very hard for us to negotiate wages etc. if we don't know how much you are planning to bring inflation down. So could you please tell us what inflation rate you are aiming for?" So the Bank of Canada replied: "OK, 2%". And thus was monetary policy history created.

It is easy to imagine a consumption only economy. Labour and land produce consumption goods, which get consumed immediately they are produced. Yes, I am ignoring the shovels needed to dig the land, and the hairdresser's scissors, which are capital goods. Sometimes (almost always) economists simplify, to make a point.

Brad: thanks. Sorry to hear about your unemployment, but very pleased to hear you survived it, stronger than before. I can only hope I would have found the strength to have done the same. I've faced one episode that bad in my life, and did survive it, and came out stronger too. But it wasn't unemployment.

Nick: “It is easy to imagine a consumption only economy. Labour and land produce consumption goods, which get consumed immediately they are produced. Yes, I am ignoring the shovels needed to dig the land, and the hairdresser's scissors, which are capital goods. Sometimes (almost always) economists simplify, to make a point”

You are not simplifying here unfortunately. Rather, you are confusing two separate concepts which economists do all the time.

The first concept is the distinction between long lived products, which I would call assets (or capital goods), versus short lived products, which I would call consumables. This is about different types of product.

The second concept is the distinction between products (or raw materials or intermediate products or labour) on which a business has spent money but has not yet sold, which I would call operational investment, versus products which a business has sold which I would call sales (or consumption in Keynes’ terms). This is about the point in the value chain which a product has reached and applies irrespective of the type of product.

Economists seems to think that businesses spend most of their time building new factories and other assets i.e. the first concept is the more significant. They don’t. They spend most of their time designing and producing their products and services and selling those products and services to the rest of society i.e. the second concept is more significant. The main operational investment of a car manufacturing business is cars. The main operational investment of a toilet roll manufacturing business is toilet rolls. The main operational investment of a hairdressing business is time slots for haircuts.

This is not a minor semantic point. Businesses cut back on production when they already have TOO MUCH investment in their product i.e. unsold inventory. Modern manufacturing businesses have computer systems which allow them to avoid building up any unsold inventory, so they just stop investing in new product completely as soon as they detect an absence of demand. It is too much unwanted operational investment which causes cutbacks in production which then cause recessions. Businesses will only invest in new factories and plant when their existing factories and plant cannot cope with demand. If businesses cut back on production in their existing factories, then that condition for strategic asset investment will not apply.

Products must be produced, and inventory created, before they are sold. That is investment followed by consumption. The idea of a “consumption only economy” where products can be sold without being produced is not a simplification. It’s silly.

If economists want to talk to business people about recessions, we need a common language and clear definitions which are consistent with the real world. Otherwise, economists are just talking to themselves.

Jamie: "Products must be produced, and inventory created, before they are sold. That is investment followed by consumption. The idea of a “consumption only economy” where products can be sold without being produced is not a simplification. It’s silly."

1. There is no inventory of unsold haircuts.

2. Some goods are produced to order; they are sold first (the deal is signed) and then they are produced.

I appreciate that you take time to discuss these things with complete strangers. Not many economists do that. That is good “customer service” to your readers even though your readers do not pay you any money. Nevertheless, you don’t understand the concept of investment as it applies to a business.

Nick: “There is no inventory of unsold haircuts”

This is wrong. As I said earlier,

“The main operational investment of a hairdressing business is time slots for haircuts”.

I worked in a service business for 20 years so I understand how this type of business works. You do not.

Suppose you run a hairdressing business. Assume you run it from home and you were given all your equipment. (That is the worst case scenario for the point I am making as there is no investment in assets). Assume an eight-hour working day and assume that each haircut takes 30 minutes. Assume that you value your time at \$10 per hour. Assume that a haircut costs \$\$20.

Your objective is to make a profit. As you value your time at \$10 per hour, and as the working day is eight hours, you invest eight hours of your time in the business each day and you value that investment at \$80. This is true irrespective of how many customers you get.

As each haircut costs \$20 you need at least four customers each day to break even i.e. for sales to match your investment of time. Six customers per day would earn you \$120, a profit for the business of \$40.

You are viewing haircuts from the perspective of the customer but you need to see them from the perspective of the business. Your observation that there is no inventory of unsold haircuts is wrong. Each day the business has a new inventory of 16 time slots for 30 minute haircuts corresponding to the investment of eight hours of time.

These points are fundamental to an understanding of the concepts of investment and profit in this type of business.

Nick: “Some goods are produced to order; they are sold first (the deal is signed) and then they are produced”

Yes, I made that point earlier when I said:

“Modern manufacturing businesses have computer systems which allow them to avoid building up any unsold inventory, so they just stop investing in new product completely as soon as they detect an absence of demand”

However, I would emphasise three points.

First, when businesses make to order they just stop in the absence of orders whereas a make for stock business would notice a lack of demand more slowly. That means that an economy full of make to order businesses would move into recession much more quickly. This is a key point regarding recession dynamics in a modern economy as more businesses move to make to order.

Second, businesses which make to order can avoid inventory costs of raw materials by ordering the raw materials only when they get an order for their product. However, it is much more difficult to avoid investment in labour. In the UK at least, companies like Amazon try to do this by offering workers zero-hours contracts i.e. if there is no work on a particular day, the workers don’t get paid. However, that is politically toxic and it is only possible for unskilled jobs anyway. Hence, most manufacturing businesses will accrue an investment in labour irrespective of orders.

Third, generically, investment is materials / products plus labour plus allocated overheads. Overheads include things like management time, asset depreciation and maintenance, and waste. Even if a business makes to order, it will still incur investment costs before the order due to overhead items such as the cost of sales, asset depreciation and maintenance, and, depending on the nature of the business, waste.

As I said before, if economists don’t take time to understand these things, they will end up talking to themselves. This is why economists have been discussing simple accounting identities for 80 years without reaching a conclusion. The reason that this stuff is so important is that it is like a bridge between the real worlds of business and government and the mental models of economists. If economists can’t persuade non-economists that they understand this basic stuff, there is no way that non-economists will believe the policy prescriptions put forward by economists.

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