Early analysts of business cycles believed that each cyclical phase of the economy carries within it the seed that generates the next cyclical phase. A boom generates the next recession; that recession generates the next boom; and the economy is caught forever in a self-sustaining cycle. In contrast, modern theories of business cycles attribute cyclical fluctuations to the cumulative effects of shocks and disturbances that continually buffet the economy. In other words, without shocks there are no cycles.
The evolution of thought about business cycles from an emphasis on self-sustaining behavior toward one in which random shocks take center stage is a significant development in macroeconomics, and it is an especially important one for policymaking institutions like the Federal Reserve. The view that cycles are self-sustaining implies that a market economy cannot deliver stable economic performance on a sustained basis. Generally speaking, this view points to aggressive countercyclical policies or institutional reform as the appropriate response to cyclical fluctuations.
In contrast, the view that shocks are the ultimate sources of business cycles does not point to a particular policy stance. Whether a countercyclical policy should be pursued depends on the nature of the shocks. If shocks can be eliminated, macroeconomic policy should endeavor to do so because a more stable economic environment is preferable to a less stable one. But if shocks cannot be eliminated, it may be in the long-run interests of society to adapt to the shocks. To the extent that countercyclical policies interfere with the necessary adaptations, they may do more harm than good.(1)
Not surprisingly, the shift of professional opinion toward the shock-based view of business cycles has been accompanied by increasing debate about the sources of cyclical volatility. Few macroeconomists doubt that random shocks underlie business cycles, but they have been unable to agree on which random shocks, historically, have been the main causes of cyclical volatility.
To a person not versed in business-cycle theory (including economists who are not macroeconomists), this situation must seem somewhat paradoxical: How can macroeconomists be certain that shocks cause cycles, yet not agree on which shocks are responsible for cyclical volatility? Moreover, if a person is told that despite this ignorance, macroeconomists have made great strides in understanding business cycles, his or her perplexity can only increase. How can there be any understanding of business cycles (let alone an improvement in it!) if economists don't know the causes of cyclical volatility?
This article will answer these questions by sketching the historical evolution of the shock-based theory of business cycles. The answer to the first question delineates the key discoveries that led macroeconomists away from the self-sustaining view of business cycles and toward the shock-based view. The impetus for the shock-based view of business cycles came in the 1920s when mathematicians made a major breakthrough in the statistical description of cyclical phenomena. They established that many kinds of irregular cyclical phenomena (in fields as diverse as economics, geology, and physics) are best explained by random shocks.
This discovery set economists on the search for a shock-based theory of business cycles. Initially, economists thought that observable random events, such as an unexpected increase in government spending or a financial panic, would turn out to be the shocks causing business cycles. And to some extent they are. But they are not the major source of cyclical volatility. The major source appears to be shocks that manifest themselves as deviations of macroeconomic variables from their model-predicted values. Such shocks cannot easily be connected to observable real-world events. The unobservable nature of these shocks is the fundamental …