To Invalidate Real Business Cycle (RBC) Theory, We Must Refute the Fundamental Causal Factors that RBC Theory Claims to be at Work

I show that RBC (Real Business Cycle) theory, in all of its variations, is not a valid theory of the business cycle. Hence, it does not provide a valid explanation of recessions and depressions. This is the case primarily because it does not explain the type of economy-wide fluctuations we see and the events that occur on the side of money during the business cycle. These observations, in essence, were made long ago by the great Austrian economist Ludwig von Mises in his comments on nonmonetary explanations of the business cycle. He showed that they are all invalid. My analysis goes much farther than Mises's analysis because I go into much more detail to show why RBC theory is invalid. I also cover a far broader range of topics than Mises. However, his analysis does serve as a guide for my analysis.

In considering my critique of RBC theory, one should keep in mind that there are many RBC theories. The critiques I provide below can be used to refute all of them. This is the case because all the different RBC theories are fundamentally the same; they are all based on some nonmonetary explanation of the business cycle. Hence, in order to refute RBC theory, one does not have to refute every specific RBC theory. One can generalize from the specific versions of RBC theory addressed below to refute other versions not mentioned here. Hence I focus on the more prominent RBC theories.

The most important task in showing that RBC theory is invalid is to refute the fundamental causal factors that RBC theory claims to be at work. Once the fundamental claims are shown to be invalid, no version of it will be tenable. As an analogy, think of it this way: once the foundation of a skyscraper is shown to be weak, one does not have to show that the structure of a particular floor of the building is weak to be sure that the floor is in danger of collapsing. That floor, and every other floor, will collapse because of the weak foundation. The same is true of different RBC theories.

--Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 80-81.

The Inflexible Price and Wage Theory of the Business Cycle

The inflexible price and wage theory of the business cycle says that capitalists and businessmen are reluctant to change prices and therefore, in the face of continuously rising spending, business owners step up production since there will be more demand for goods with a greater volume of spending if prices have not risen to offset the spending. This constitutes the essence of the expansion phase of the business cycle. Eventually, businessmen give in and raise prices because, as advocates of this theory state, firms run out of excess capacity with which to increase production. Hence, prices rise to catch up with the increased spending, production is reduced, and the contraction phase of the business cycle sets in.

The above description is one way Keynesians use “sticky price and wage theory” to explain the business cycle. Another version of the theory says that spending increases during the expansion but decreases during the contraction. The expansion phase in this version looks like the expansion phase discussed in the first version of the theory. As spending increases during the expansion, prices and wages do not rise quickly enough and thus employment and output expand in response. If prices and wages increased sufficiently in the face of the increased spending, according to Keynesians, no increased output or employment would result.

The contraction phase is a little different than in the first version of the theory. Here, as spending contracts during the recession or depression, prices and wages do not fall quickly enough to offset the decreased spending. If they did fall quickly enough, the same goods and labor could be purchased with the decreased money and spending. Therefore, output and employment would not decline and the contraction could be averted. In this scenario, inflexible price and wage theory is supposed to explain why output fluctuates more during the cycle than prices. It is also supposed to explain why recessions and depressions can be so deep and last so long.

--Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 46.

Closely Related to the Overproduction Theory of the Business Cycle Is the Underconsumption Theory

Closely related to the overproduction theory of the business cycle is the underconsumption theory of the cycle. This theory has been put forward by Sismondi, Keynes, and others. Although the details may vary among supporters of this theory, the main claim is that when there is not enough consumptive spending in the economy, goods go unsold, workers are laid off, and businesses shut their doors. In other words, a depression occurs. One reason given why there is not enough consumptive spending is that capitalists might shift their spending from hiring workers to purchasing capital goods (i.e., substitute capital for labor). This means workers will be paid less and thus will allegedly not have enough money with which to consume all the goods produced. Whatever the reason given for the lack of consumption, the result is the same according to supporters of underconsumption theory: economic crisis and depression.

--Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 13.

The Overproduction Theory of the Business Cycle Originated with Socialist Thinkers

The overproduction theory of the business cycle originated with socialist thinkers or those who leaned in that direction and was advocated by such individuals as Thomas Malthus, the nineteenth-century Swiss socialist J. C. L. de Sismondi, and Karl Marx. This theory says recessions and depressions occur because capitalism is characterized by periods of too much production. During these periods of excess production, businesses begin to accumulate inventory, cannot sell the inventory at profitable prices, and must cut back on production. The cutback in production leads to workers being laid off, factories being shut down, and causes a general decline in business activity. Hence, recessions and depressions result from overproduction in the free market.

Employment and production increase only after the inventories of businesses have been depleted sufficiently to make production profitable once again. So the economy goes back and forth between these periods of overproduction and production, in an endless cycle.

The specific reasons why it is said capitalists periodically produce too much vary, but it is generally based on the belief that the need and desire for goods is limited and the rapidly expanding production in a capitalist society inherently leads to the supply of goods outstripping the limited need and desire. If the need and desire for goods is less than the supply, then of course the demand will also be insufficient to purchase all the goods produced. Hence, production is periodically reduced back down to the demand for goods in recurring recessions and depressions.

--Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 9-10.

 

In a Sense, Real Business Cycle Theory Is Worse Than Keynesian “Sticky Price Theory”

In a sense, RBC [Real Business Cycle] theory is worse than Keynesian “sticky price theory.” The Keynesians are right to claim that the characteristics of perfect competition do not hold in reality because these characteristics have nothing to do with the nature of competition. The RBC theorists are not deterred by this and claim that the business cycle consists of natural fluctuations within a perfectly competitive equilibrium. While it may seem plausible that expansions are consistent with market clearing economic activity, it is more difficult to believe this for contractions. This is the case in particular for severe contractions. Are we to believe that the recession of the early 1980s, the recession of 2008–9, and even the Great Depression were fluctuations in which markets cleared?

--Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 82.

Mises Claims That All Nonmonetary Explanations of the Business Cycle Are Invalid

I show that RBC [Real Business Cycle] theory, in all of its variations, is not a valid theory of the business cycle. Hence, it does not provide a valid explanation of recessions and depressions. This is the case primarily because it does not explain the type of economy-wide fluctuations we see and the events that occur on the side of money during the business cycle. These observations, in essence, were made long ago by the great Austrian economist Ludwig von Mises in his comments on nonmonetary explanations of the business cycle. He showed that they are all invalid. My analysis goes much farther than Mises’s analysis because I go into much more detail to show why RBC theory is invalid. I also cover a far broader range of topics than Mises. However, his analysis does serve as a guide for my analysis.

--Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 80.

Real Business Cycle (RBC) Theories Are Nonmonetary Explanations of the Business Cycle

Real business cycle (RBC) theories are nonmonetary explanations of the business cycle. Supporters of RBC theory claim that business cycles arise due to changes in real factors, instead of monetary factors, in the economy. The focus is on alleged causes of the business cycle that emanate from places other than changes in the supply of money and spending. Further, such cycle theory assumes markets are always in equilibrium (i.e., they always clear, even during recessions and depressions).

Probably the most popular version of RBC theory claims that changes in the level of technology affect the economy such that it causes fluctuations in output and employment (i.e., a business cycle).

Another RBC theory is the fad theory of the cycle. If a product suddenly comes into fashion, there will be an increase in demand for the product and a boom will be created in the production of that product.... If the expansion is widespread enough, it might create the expansion phase of a general business cycle, according to supporters of this theory. When the fad ends, demand and production decline and create a slump.

--Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 79.