Dillow - technology shocks are a thing!
I haven't studied RBC yet, but from my position of ignorance, to the extent people have explained it to me, it always seemed nonsensical.
I mean, how can anyone assert that "productivity variations" are the cause of "business cycles" in the face of the 70s Arab oil embargo, the 1980 Iranian revolution, Volcker, the S&L crisis, LTCM, the Asian crisis, the NASDAQ collapse and the real estate collapse?
That's all either political economy (Arabs, Iran, Volcker), asset price shocks (S&L, LTCM, NASDAQ, real estate), or international finance (Asia).
Where is Solow's z in all that? Not one of those has anything to do with "productivity", right?
Then Chris Dillow posts this, and for a while I was convinced that RBC might be a thing:
However, if we ditch representative agent thinking and think instead of firms as being inherently heterogenous, the notion of a negative technology shock seems more reasonable.
Xavier Gabaix points out that even in a large economy aggregate fluctuations can arise from the failure of one or two big firms. This is especially possible if those firms are important hubs, whose troubles plunge supplier or customer firms into trouble: as Daron Acemoglu shows, networks are crucial in transmitting (or dampening) firm-level shocks throughout the economy.
It seems to me that this is a plausible description of the financial crisis. Banks became less able to supply credit than we thought; this was a firm- or industry-level negative technology shock. And because banks were key hubs, this shock was transmitted to the wider economy.
You can squeeze this into DSGE-style models, as (for example) Michael Wickens (pdf) and Hashem Pesaran (pdf) have done.
OK, fine. Institutions are part of z; they are necessary if you want to multiply f(K,L) to get Y. So then institutions could indeed cause shocks! I'm convinced.
But then I thought about this at a more basic level and became unconvinced.
"The residual" is simply everything in an economy that's not capital, labour, or the production function of the two, right? So by this line of reasoning, all that's being said here is that some vague, unknown thing that's not capital, labour, or the production function is going to be the cause of business cycles.
Or, using logic,
P1) B is a set that contains K, L and f, as well as an indefinite* large number of other things (including phlogiston).
P2) Anything which is not K, L or f can cause a recession.
C1) P1 true + P2 true means that there is an indefinite large number of things (including phlogiston) that cause a recession.
I'm sorry, but that seems to be the sort of emptiness that Romer was mocking this week. Want banks to originate technology shocks? Make them explicit in your model.
I'll repeat what I've said before: show me an RBC model where an exogenous political economy variable, or even better where an endogenous asset price variable, causes regular cycles, and I'll be impressed.
* - I use "indefinite" to mean "some huge, undefineable number that certainly won't be anywhere near infinity, but is still big enough for us to treat it that way". E.g., the mathematical term "gazillion".