A Response to Summers’ “Some skeptical observations on real business cycle theory”

Lawrence Summers starts out by comparing the foundations of Keynesian macroeconomic theory to that of astrological science.  That is, both are “premised on the relevance of variables that are in fact irrelevant.”  According to real business cycle economists, Keynesian economics didn’t explain the macro economy because it wasn’t based on microfoundations.  As we have learned in class, RBC models are based off of utility maximization and profit maximization principles, which evolve at the microeconomic level.  Summers brings Prescott’s “Theory Ahead of Business Cycle Measurement” into his critique of RBC models.  Prescott’s article is essentially asserting the claim that the theory cannot be currently tested because there does not yet exist measurement tools capable of testing the theory.  Nevertheless, Summers critiques Prescott’s article on four levels–the parameter estimation, the shocks present in the model, price levels, and exchange failures.  Summers goes on to say that throughout history theories have been developed that seemed plausible (or at least a good starting point) because they “mimic” or approximate reality well enough for that period in time.  However, as measurement tools improve and people are made more aware of their surroundings, theories will change (i.e. the Earth was at one point considered the center).  This is what this critique attempts to accomplish–that is, to determine whether or not Prescott’s theory mimics the economy in its current state coincidentally or if it captures the observed business cycle trends.

With respect to the parameter estimates, Summer can find no evidence to support Prescott’s claim that the one-third of all household time is devoted to market activities.  Most other studies, such as Martin Eichenbaum, Lars Hansen, and Kenneth Singleton (1986) have estimated that to be only one-sixth since 1956.  In addition, Prescott’s model assumes the average real interest rate to be four percent.  Over his thirty year study, however, the real interest rate only averaged out to one percent.  Summers’ last critique with regards to parameter estimates is Prescott’s inability to display evidence that supports his claim on the elasticity measurements of labor supply.  According to Summers’ reading of many studies, labor supply is only minimally effected by changes to the real wage.

Like many RBC models, the observed cyclical behavior is caused by external/exogenous shocks, known as technological shocks.  However, the critique makes the claim that he doesn’t have nay evidence to support the business cycle movements.  Even the oil shocks of the early 1970s haven’t contributed to “large movements in measured total factor productivity.”  In small sectors of the economy, however, such as in the mining and construction sectors, negative productivity growth has been observed.  In addition, technology shocks may not be as large as originally thought.  Studies have shown, especially in Jon Fay and James Medoff (1985) that the reason for cyclical behavior is due to firms holding more labor than necessary during troughs.  Known as “labor hoarding,” firms may hold labor in excess of regular production requirements during recessions because it is deemed more costly than the wage rate to hire or fire employees.  Therefore, when the economy is experiencing a peak, the labor force is being fully utilized and shown as productive.  However, when a recession occurs, those excess laborers are kept on rather than fired, which makes it appear as each labor unit is now less productive and factor productivity will decrease.  While Summers doesn’t think of “labor hoarding” as a technological shock, many RBC economists do think of any deviation from the long-run potential output as a technological shock.

The third argument that Summers makes is the absence of price data in his model.  I don’t understand this paragraph because I do not comprehend what Summers means when he argues that Prescott’s model was tested without price data.  To me, it is unfathomable as to how any economics can be empirically tested without paying attention to price.  I will have to do some exploration as to what a “price-free economic analysis” means in the eyes of Summers.  The last objection to the Prescott model is the inattention to exchange breakdowns.  From the critique, it is mentioned that studies that analyzed the Great Depression made it clear that firms had output to sell and workers wanted to exhange their labor for those products, but there was a breakdown in the exchange mechanism of labor for products and the exchange never transpired.  This “breakdown” caused U.S. GNP to decline fifty percent over the years 1929 to 1933.  The best explanation for these exchange mechanism failures is due to the credit market breakdown during the same time period.

Summers sums up the critique to say that economists will continue to be better at explaining behaviors of individual economic agents than explaining the equilibrium in markets when many economic agents interact.  With that being said, Summers stresses that the importance of being able to explain why exchange markets breakdown, and if that can be accomplished, then these macroeconomic models will be able to help forecast economic fluctuations.  What I was hoping for the critique to address was the parameterization issue that was discussed in class on 3/12.  If models are constantly changing to fit the data, how can we be sure that it’s the best model out there and not one that simply “mimics” the available data–which is something that Summers starts out discussing?

Source: Summers, Lawrence H.  1986.  Some skeptical observations on real business cycle theory.  Federal Reserve Bank of Minneapolis Quarterly Review (Fall): 23-27.  (This can be found in the Reader.)

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