From business cycles to growth

In the mid-1980s new growth theory (NGT) emerged with Romer (1986) and Lucas (1988) as its main proponents. What is less well known is that this research contributed to the debate on business cycles and growth interactions, and, as a corollary, to arguments about the necessity (or not) of stabilization policy.

The initial project of NGT was to endogenize technical progress and to take into account different elements (institutions, education, and innovation) that influence growth. This objective was supported by the existence of a substantial empirical and theoretical literature which documented the endogenous nature of technical progress. It should be noted that previous contributions had emphasized the importance of some of the mechanisms inherent in those models (for example, the well-known contributions by Arrow 1962 about learning by doing, and Eltis 1971 on the importance of research and development expenditures for economic growth), but the novelty certainly lay in the tractability of those models and in their capacity to be tested econometrically.

Because NGT models build on endogenous growth mechanisms, long-run trends are not predetermined, a characteristic which confers on them only a “relative stability” (Henin 1994). More precisely, shocks affecting such a dynamics exhibit a - positive or negative - persistence. Indeed, Stadler (1990) proved that endogenous technical change acts as a strong propagation mechanism, whatever the nature (demand or supply) of the shocks: “real and monetary business cycles models with endogenous technology differ from the conventional models” (Stadler 1990: 764). Moreover, growth dynamics is characterized in these models by a kind of hysteresis phenomenon: an economy consecutively affected by two shocks, identical with the exception of the sign of their persistence, will not return to its initial rate of growth.

With the inclusion of a learning by doing production function, the model exhibits a positive persistence of the shocks while models based on a learning or doing mechanism, claimed to be inspired by Schumpeter and dealing explicitly with the process of input reallocation between production and increased productivity (sort of research and development - R&D) sectors, exhibit a negative persistence of the shocks. The authors of the second category of models (Aghion and Saint Paul 1991, 1998; Saint Paul 1997) refer explicitly to Schumpeter’s concept of the cleaning and restructuring effects both associated with periods of recession, in their emphasis (paraphrasing Schumpeter) that recessions are but temporary and that each occurrence represents the means to reconstruct the economic system according to a more efficient plan. Based on the “opportunity cost” approach, they consider that research and development activities that enhance productivity in the long run are nevertheless costly in the short run since they divert efforts (and the resources) from the productive sector. Thus, a recession can be seen as an opportunity to finance at low cost a productivity enhancing activity, and in this case, the persistence of the shock has a negative impact. Both endogenous mechanisms are interesting and contribute to our understanding of how growth may be affected by the nature of business cycles which means by their amplitude, frequency, and persistence. However, there is debate over the sign of persistence of shocks

Starting with the paper by Ramey and Ramey (1995), many contributions (see, for example, Barlevy 2004; Blackburn and Pelloni 2004, 2005) have tried - without success - to determine the sign of the relationship between growth and volatility; their conclusions are indeed oversensitive to the nature of the endogenous growth mechanism, and empirical investigations cannot tackle this issue. It is difficult then to draw sharp economic policy conclusions from these models, a weakness which certainly contributes to explaining the waning interest in these kinds of models.

Along the same lines but within a different analytical framework is the paper by Stiglitz (1993) which proposes a complete growth-cycles model and analyses how recessions can negatively impact on growth if they lead to an interruption in the financing of research and development, a decision which has direct consequences on the (future) rate of growth.

Finally, Aghion and Howitt (1992, 1998, 2009) developed another generation of endogenous growth models, the so-called neo-Schumpeterian growth models. Aghion and Howitt started from a monopolistic market structure and introduced Schumpeterian features of innovation and growth; creative destruction, productive recessions (already discussed by Aghion and Saint Paul), cleaning effects, obsolescence of goods, and so on (see Aghion et al. 2013). While it was not their primary objective, Aghion and Howitt covered the different ways growth and cycles intertwine. Their starting point was the concept of general purpose technologies (GPTs), developed by Bresnahan and Trajtenberg (1995) and Helpman and Trajtenberg (1998). General purpose technologies are understood as raising productivity levels in the long run, and as being the cause of cyclical fluctuations due to their absorption into the economic system. Aghion and Howitt also examined how the nature of growth affects fluctuations. Focusing more specifically on firm dynamics, they emphasized that “misallocation of resources is a major source of productivity gap across countries” (Aghion et al. 2013: 36) and again tried to link cycles and growth dynamics.

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Source: Faccarello G., Kurz H.-D.. Handbook on the history of economic analysis. Volume III, Developments in major fields of economics. Edward Elgar,2016. — 659 p. 2016

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