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Q1 2019
Economic insights — Economists are not prophets. They can't accurately predict when the next recession will begin. But as Thorsten Drautzburg explains, their models can at least help us understand why recessions are happening and what we can do about them.
Economists don't know when the next recession will come […]Economic expansions do not end in old age, but die due to bubbles, central bank mistakes, or unexpected shocks to economic supply (e.g. rising energy prices, credit disruptions) or falling demand (e.g. falling incomes or assets).
—Jared Bernstein, The Washington Post, July 5, 2018
Business cycles are hard to predict, which is why economists can't predict when the next recession will occur. For example, when the 2001 recession began, the median forecaster in the Survey of Professional Forecasters (SPF) expected U.S. real gross domestic product (GDP) to grow 2.5% over the next year, when in fact output barely grew at all. And just before the Great Recession, forecasters expected GDP to grow 2.2% over the next four quarters, but we all know how that turned out.1 Why is it so hard to predict a recession, even when one is happening?
As Bernstein writes, most economists believe that business cycle fluctuations — contractions and expansions in economic output — are caused by random forces, such as unexpected shocks or mistakes. As I will show, models in which completely random events interact with economic forces can resemble the U.S. business cycle. The randomness of economic ups and downs poses a challenge for macroeconomic forecasters because random events are, by their very nature, unpredictable.
It might be tempting to conclude that if business cycles have their origins in random forces, then analyzing them must be a pointless endeavor. But not all random forces are the same. For our purposes, economists distinguish between two main types of random forces: demand shocks and supply shocks.2 As the term suggests, a shock is an unexpected event that, when applied to a mathematical model of the economy, produces a pattern in economic variables that resembles a business cycle.
This article appeared in the Q1 2019 edition. Economic InsightsDownload and read the full story.
[1]In the first quarter of 2001, forecasters expected cumulative GDP growth over the next four quarters to be 2.5 percent, but the actual growth rate (from initial announcements) averaged 0.5 percent. In the fourth quarter of 2007, forecasters expected cumulative GDP growth over the next four quarters to be 2.2 percent, but the actual growth rate (from initial announcements) averaged 0.6 percent.
[2]Bernstein's “central bank mistakes”, which are labelled as monetary policy shocks later in the article, are also demand shocks because they remove demand from the economy. “Bubbles” can affect the supply of credit by easing secured borrowing, and their creation and collapse are supply shocks in financial markets.
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