Talk:Welfare cost of business cycles

Name of article

I agree that this is a notable topic, but I'm not convinced "Lucas Welfare Cost of Fluctuations" is the right name for the article, because I don't think it is a standard term. The concept and term "welfare cost of fluctuations" or "welfare cost of business cycles" is widely accepted. And it's true that the most famous analysis of the welfare cost of business cycles is that of Lucas. But the term "Lucas welfare cost of fluctuations" is not used, as far as I know.

One possibility: write an article on "Welfare cost of business cycles", and include a section on "Welfare cost measure of Robert Lucas". Alternatively, focus specifically on Lucas' viewpoint in this article, and call it "Welfare cost of business cycles (measure of Robert Lucas)" or something like that. I realize that sounds a little clumsy, but I think it is more accurate. And remember, Wikipedia should not be used to establish neologisms. --Rinconsoleao (talk) 14:12, 12 June 2009 (UTC)

Hi, I wrote the article and I based it mostly on Lucas' work. However, I'm perfectly fine with moving it to "Welfare Cost of Fluctuations" and hoping that someone will expand it (though Lucas is still the main figure in this literature). In fact I would very much welcome it. Move away.radek (talk) 20:28, 13 July 2009 (UTC)

One more small point: "fluctuations" refers to many things (waves in the ocean, for example). So "Welfare cost of business cycles" is equally standard, but clearer and more specific for general audiences, than "Welfare cost of fluctuations". --Rinconsoleao (talk) 14:14, 12 June 2009 (UTC)

Good point. Move to "Welfare cost of business cycle then".radek (talk) 20:28, 13 July 2009 (UTC)

I agree that "Welfare cost of business cycles" would be a more appropriate title. I eventually would like to add a section on the Alvarez-Jermann cost of cycles implied by asset prices. It seems silly to have separate articles for every economist who has quantified the cost of cycles. I do agree that Lucas' calculation is the most influential and important. Wik-e-wik (talk)

I was going to add Alvarez-Jermann as well as other work, but honestly the article was quite a bit of work and by the time I was finished I was a bit exhausted and put off that bit. Please expand!radek (talk) 20:28, 13 July 2009 (UTC)

Move and preliminary re-edit done. --Rinconsoleao (talk) 15:24, 14 July 2009 (UTC)

controversial?

The article doesn't put the topic in context. Is the result controversial? Is the interpretation of the result controversial? The article says that according to Lucas, "the focus of both academic economists and policy makers on economic stabilization policy rather than on long term growth has been misplaced." The fact that they still are focusing on it, 22 years later, would seem to indciate that his interpretation is not widely accepted...?--76.167.77.165 (talk) 02:56, 21 June 2009 (UTC)

Yes, it's extremely controversial, though it has also been very influential. --Rinconsoleao (talk) 13:34, 23 June 2009 (UTC)

Jumping the gun?

I'm curious. How did an article that (1) has not been quality rated, (2) has not been importance rated, and (3) has a questionable (challenged by me, anyway) title which appears to be a neologism get featured in Did you know?? --Rinconsoleao (talk) 13:40, 23 June 2009 (UTC)

Usually DYKs are brand new articles so very often they're not quality or importance rated. The two activities - DYKs (which just need to be new (or newly expanded), of sufficient length and proper hook) and rating articles are for all I know unrelated. Same for importance. It is generally understood that brand new articles are not going to be perfect so there is no quality/importance threshold for them. I'm actually sympathetic to the view that the Wiki incentive system is skewed towards creating new articles rather than improving existing ones (which is what the purpose of the quality/importance rating is) - but the incentives being what they are.... And your points about the title are correct, so feel free to move it.radek (talk) 20:28, 13 July 2009 (UTC)

Expanding and improving the article

Rinconsoleao, thanks for moving and expanding the article. I'm going to be a nit picky here and I hope you understand. Basically I don't think this:

"Keynesian economists typically argue that business cycles should not be understood as fluctuations above and below a trend. Instead, they argue that booms are times when the economy is near its potential output trend, and that recessions are times when the economy is substantially below trend, so that there is a large output gap. Under this viewpoint, the welfare cost of business cycles is larger."

is a relevant argument. In Lucas' way of measuring the welfare cost it doesn't matter where the fluctuations come from or whether or not a recession is an output gap or just a period of low economic activity. Keynesians could be perfectly correct (and btw, I don't think this view is representative of all Keynesians but ok) in their characterization of what recessions are but the Lucas Welfare Cost would still be small. The argument here would not be about the size of the costs of the business cycle (which would still be small) but whether or not it is possible to do something about reducing the business cycle (Keynesians - yes, New Classicals - more or less no). So it's a different argument. There are criticisms of Lucas' method out there - and when I get a bit more time I hope to expand the article to include them - but they have to do either with 1) the risk aversion of individuals (I'm throwing Behavioral Economics related criticisms in here), 2) the measurement of the actual or implied volatility of the fluctuations and possibly 3) the agent heterogeneity that the representative agent framework misses.

To be careful we should cite the criticisms with actual papers.radek (talk) 15:36, 14 July 2009 (UTC)

As I understand it, Lucas' idea is to give a back-of-the-envelope upper bound on the possible benefits of stabilization policy. Without going into the details of how (and whether) stabilization policy would work, his formula asks 'what if we could just wave a wand and get rid of the business cycle?' By showing that even a costless, perfect stabilization program would have negligible benefits, he strongly calls into question real-world stabilization attempts which would obviously be more costly and less successful.

However, in spite of this apparently very general methodology, Lucas' calculation involves one enormous assumption. He assumes stabilizing the business cycle involves decreasing the variance of GDP (and consumption) without affecting its mean (or more precisely, without affecting its trend level). From a Keynesian perspective, however, that assumption defeats the whole purpose of the calculation. Oversimplifying, under a Keynesian viewpoint booms are times when the economy is near its potential, and recessions are times when resources are underutilized and therefore the economy is below potential. The cost of business cycles, under this viewpoint, is the cost of falling into all those recessions. An ideal stabilization policy would therefore be, from a Keynesian viewpoint, one that eliminated the recessions (without touching the booms). But therefore, stabilization would both decrease output variance and raise mean output (or more precisely, raise the mean output path up to the potential output trend).

Since the Keynesian viewpoint implies that the business cycles are costly both because they imply an increase in variance and a decrease in the mean, the Keynesian viewpoint means cycles are much more costly than Lucas' assumption implies. In the words of James Tobin, many years ago,

'It takes a heap of Harberger triangles to fill an Okun gap.'

I agree, of course, that these kinds of arguments need to be backed up with citations. I will work on that. --Rinconsoleao (talk) 14:43, 15 July 2009 (UTC)

Yes - especially "older-style" - Keynesians see recession in that way (though the so-called New Keynesians also worry about "over-heating" the economy during the boom and such), as a fall in output below potential. Of course eliminating fluctuations AND increasing the mean would generate greater welfare benefits than JUST eliminating fluctuations. But this is an argument over what "stabilization policy" is and what it can and cannot do - it doesn't effect the actual cost of eliminating the fluctuations (hence, in retrospect, perhaps a better name for the article would be "Welfare cost of economic fluctuations" or "Welfare cost of macroeconomic fluctuations" - to be clear about the fact that we're not talking about any change in the trend here).radek (talk) 17:04, 15 July 2009 (UTC)

I would argue that 'Welfare cost of business cycles' really is the most standard term. And nowadays it is used by economists of all schools, to mean the benefit of eliminating business cycles, if that were possible. Some economists buy Lucas' assumption that cycles are basically a change in variance, and therefore accept his calculations as an upper bound on the value of stabilization policy. Other economists disagree with his assumption, and assume that eliminating business cycles would alter the mean, as well as the variance, and therefore believe that his calculation is not very relevant. But in either case, the only reason anybody really cares is because it's an attempt to think about how social welfare would change if the business cycle could be eliminated. (Things get really interesting if you think about it from a Schumpeterian perspective and consider the possibility that eliminating fluctuations would reduce the mean growth rate!) --Rinconsoleao (talk) 19:15, 15 July 2009 (UTC)

My point here is that the criticism you offered is mixing up two different things; fluctuations and stabilization policy. The Lucas estimate deals directly with just the first. Is it a criticism of stabilization policy? Yes, if you think that stabilization policy involves returning the economy to its trend when it's in below or above it. No, if you think that stabilization policy means eliminating recessions but letting the booms happen (i.e. eliminating fluctuations but also raising the mean). But the argument about what stabilization policy is, or what it can do (and of course how it should be conducted) is a separate argument. The counterfactual experiment of "what would happen if we could have the economy always be STABLE and at its POTENTIAL" is different from the counterfactual experiment of "what would happen if we could have the economy always be stable". But I think this is pretty clear from Lucas' approach, as well as from the literature that followed it. What that means is that, yes, it's fine to have text here on what different views of what stabilization policy is and what it can do. But it should be in some kind of a "Background" or "Extension" section. In other words it's not "Criticism" (since it doesn't apply) but rather "Context".radek (talk) 00:37, 17 July 2009 (UTC)

Of course fluctuations and stabilization policy are different things, but I am not mixing them up, I am linking them in the way that is relevant for the issue at hand. Lucas made very clear that his calculation was intended as a simple, back-of-the-envelope way of thinking about the possible benefits of stabilization policy. On page 1 of 'Macroeconomic priorities' (AER 2003), he says his paper

'...describes a thought experiment in which a single consumer is magically relieved of all consumption variability... I will defend this estimate as giving the right order of magnitude of the potential gain to society from improved stabilization policies...'

That's why his measure has been influential. If it were purely a statistical measure, no one would really care about it. Instead, he intended it as a realistic quantitative guide to potential improvements in stabilization policy. And since he found that the potential benefits were small, he argued that 'further improvements in short-run demand management' were not a 'priority' of macroeconomic research. Therefore I think it is appropriate for the article to address the 'welfare cost of business cycles' into the context Lucas intended, namely, the implications for stabilization policy. --Rinconsoleao (talk) 17:30, 17 July 2009 (UTC)

Also, as far as the Keynesian viewpoint is concerned, it's certainly true that modern Keynesians take a less simplistic view than the one I have described. Nonetheless, influential people still express a pretty similar viewpoint. Gali, Gertler, and Lopez-Salido (R.E.Stat. 2007, p. 44), in their paper 'Markups, Gaps, and the Welfare Costs of Business Fluctuations' say that if there are nominal rigidities, then

'...the economy may oscillate between expansionary periods when the volume of economic activity is close to the social optimum, and recessions that feature a significant drop in production relative to the first best.'

--Rinconsoleao (talk) 17:36, 17 July 2009 (UTC)

Also, one of your references in the lead (the article by Akerlof, who is of course a major New Keynesian), makes clear that he thinks stabilization policy affects the average level of employment, not only the variability of employment:

'...stabilization policy can significantly reduce average levels of unemployment by providing stimulus to demand in circumstances where unemployment is high...'

So I would again argue that a central aspect of the Keynesian reply to Lucas is that he misrepresented stabilization policy by assuming it would only affect variances, whereas they believe it will also affect means. --Rinconsoleao (talk) 17:45, 17 July 2009 (UTC)

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