Modern economic theory has come to think of important macro-economic events as caused by shocks. The types of shocks are usually organized into four broad categories: supply shocks, demand shocks, policy shocks, and bubbles/debt shocks. United States examples of very large shocks include the recession of 1974, (a supply shock), the Great Depression, the 1981 to 1983 recession (bubble/debt and policy shocks), and the 2008 Great Recession, (a bubble/debt shock).

In late 1973, crude oil prices rose dramatically, raising the cost of production and causing a negative supply shock for many western economies. In 1929, the stock market crashed and the Great Depression commenced with real per-capita GDP falling 32.3 percent during 1930 through 1933, by far the largest fall since that time. The Great Depression was thought of by John Maynard Keynes to be a negative demand shock but research since then seems to favor a combination bubble/debt shock that was accompanied by a policy shock in the form of a restrictive monetary policy.

The recession that just ended, the Great Recession, was caused by over-investment in housing. The bubble formed over some number of years. It was accompanied by an accumulation of debt as participants borrowed to fund additional investment into housing. That activity attained a tipping point in 2008 where perhaps the best measure of that point is household debt. Given the Fed’s excess-reserves interest-payment policy, which is a restrictive monetary policy, perhaps the Great Recession shock was also a combo bubble/debt and policy shock as was the Great Depression.

We are beginning a research program on business cycles at CERF. This will involve blog posts as well as research papers. Dynamic stochastic general equilibrium (DSGE) models use both technology (supply) shocks and demand shocks in their study of the macro economy. However, Business Cycle researchers have not found these types of shocks alone as convincing models of recessions. They note that internal stresses, sectoral shifts, and imbalances are endogenous, that there are unique characteristics to each cycle, and that thus far stochastic shock models do not properly explain all observed characteristics.

The study of cycles is complicated by changes in regimes to alternate equilibria as discussed in my posts of July 18 and July 28. The ultimate severity of the recession might be influenced by the nature of the original shock, but it will also be influenced by any accompanying change in regime. In the fall of 2008, economic decision-makers (the federal government, households, and firms) suffered from a dramatic shift in risk preferences and away from risk-taking, precipitating a sudden change to a “bad” equilibrium, worsening the effect of the original shock.

Studies have found that the largest structural macroeconomic forecast errors have been at business cycle turning points, particularly at the peaks. This hints that bubble growth, debt accumulation, and leverage might be places to begin our research.