The microeconomic foundations of business cycles: from institutions to autocatalytic networks.

Author:Matutinovic, Igor

In his seminal book Capitalism, Socialism, and Democracy, Joseph Schumpeter argued that the very nature of capitalism is economic change and that capitalism never was nor will it ever be stationary (1976). Large-scale fluctuations are one of the key aspects of nonstationary behavior of market economies where total output, employment, and investments exhibit aperiodic ups and downs of various durations and intensity. One of the unresolved questions in economic theory is whether business cycles are an inherent and thus irremovable feature of capitalist economies or they result from external shocks acting on economic systems otherwise poised at equilibrium. During unusually long phases of economic expansions, some distinguished mainstream economists have even proclaimed that business cycles might be gone forever (Fuhrer and Schuh 1998; Auyang 1998, 282; De Long 1999). During the last long expansion of the U.S. economy, an economic conference held in Boston in 1997 addressed especially this issue and most participants rejected the idea that the business cycle is dead (Fuhrer and Schuh 1998). However, there was no consensus on the causes of recessions past and future, except for the notion that an economy exhibits some kind of "vulnerability" which eventually transfers into a recession.

This debated field of the origins of business cycles is stretched between exogenous, shock-based and endogenous, evolutionary-like theorizing. Theories and models that posit an equilibrium economic setting, disturbed by random technology shocks, like real business cycle theory, lack explanatory plausibility while they do not prove themselves valid in predictions either (Auyang 1998; Dow 1998; Ormerod 1998). The present work, among other things, presents an implicit critique of such theorizing.

Endogenous theorizing, which originated with classical economists, maintains its tradition in institutional (evolutionary) and (post) Keynesian economics. Endogenous theorizing often has been directed to the real causes of business cycles--those related to production and consumption. This line of thought started with Karl Marx and probably had its creative peak with Wesley Mitchell, John Maynard Keynes, and Joseph Schumpeter. (1) One branch of these theories--the trade cycle theories, or theories of real macroeconomic disequilibrium--which expanded the analysis as laid down by Marx and others rather than on neoclassical views, addressed especially the overcapacity problem (Screpanti and Zamagni 1993, 219). The common theme of these theories can be summarized as follows: in the upturn phase, the excess of savings, opening of new markets, or technological innovations stimulate expansion of investments and consequently the growth of employment, prices, and profits. Driven by rising prices and profits, investments continue to expand until the production of capital and consumer goods exceeds its demand. At this point, profits decrease, bank loans contract while interest rates go up, and investments come to a halt, eventually pushing the economy into recession (219-247). Creation of productive overcapacity is viewed as the main trigger of recessions in trade cycle theories, (2) but precisely how this overcapacity arises from agents' interactions is not explained. This is, in my view, the general shortcoming of most endogenous theories--they try to explain the origins of business cycles by relying exclusively on aggregate variables like demand, money and credit supply, savings and investments, prices and wages, and so on but fail to provide a plausible micro-mechanism that produces, again and again, the very fluctuations in these and other relevant macro-variables. Moreover, the explanatory and explained variables mostly coincide, and this surely does not contribute to theoretical clarity.

Trade cycle theories, and likewise later neoclassical theories, did not include the institutional dimension in their explanation of business cycles. If we consider an economic system as a "coordinated set of formal and informal institutions" (Dallago 2002) which direct and constrain agents' behavior, then the failure to account for these may constitute a serious methodological shortcoming. I refer hereinafter to Malcolm Rutherford's definition of institution as "a regularity of behavior or a rule that is generally accepted by members of a social group, that specifies behavior in specific situations, and that is either self-policed or policed by external authority" (1996, 182). Mitchell argued that business cycles are "unintended and perverse consequence of behavior patterns created by society's monetary, business and other institutions" (1927, in Rutherford 1996, 41). He also outlined profit making as a central process influencing all other activities in a business economy ([1927] 1954). The imperative of profit making for private enterprises that are run by professional managers is in fact one of the central institutions of a capitalist economy. Besides being a generally accepted rule of efficiency of business activities and, therefore, a major criteria of selection among different options with different social, environmental, and economic outcomes, it also specifies behavior in specific situations such as, for example, cost-cutting measures and reduction of output in times of falling profitability. Cutting prices to the "market-clearing level" of stock and productive capacity is theoretically possible, but it does not guarantee that profitability will eventually be reached as compared with the cost cutting, which is under the full control of a firm. Management adherence to such a behavior is usually policed by supervisory boards and institutional investors (financial markets), which react positively to official announcements of cost-cutting plans such as large lay-offs and plant closures. Another important issue to be considered here is the managerial pursuit of business growth, which is an institution insofar as it represents a generally accepted rule of behavior in the business community. John K. Galbraith asserted that "the primary affirmative purpose of the technostructure is the growth of the firm" as larger firms with substantial market share gain better control over their costs, prices, suppliers, and consumers (1973, 96). Besides that, growth serves the pecuniary interests of managers while the large size of the firm shields them against takeovers from competitors.

The next relevant issue in our discussion of business cycles is the feedback mechanism, which propagates change among economic agents and provides dynamic impetus to prosperity and recession phases at the economy level. Mitchell identified a "cumulative process" in the diffusion of business activity:

And each enterprise that finds its own trade increasing becomes an agency in extending activity to still other enterprises.... Thus the revival gathers momentum as the industries that receive a mild stimulus one after the other begin to react upon those in which the movement started. (1941) This cumulative process works also in reverse and has its modern conceptual counterpart in autocatalysis, which will be discussed in detail later. The intensity of change propagation in an economy is dependent on the size of firms which originate or transmit a positive or a negative change in the business activity. Mitchell briefly pointed to the importance of large-scale enterprise and specific industries, which he called centers, in the causation of cycles ([1927] 1954)--an issue which will be addressed in the section dealing with economic networks, "hubs," and degree distribution of size of firms.

Finally, there is the issue of expectations and uncertainty and their effects upon the cycle. Mitchell pointed out that "increase in profits during the expansion phase, combined with the prevalence of business optimism, leads to a marked expansion of investments" (1941, chap. 5). Later he stated that "the twist given by overconfidence to forecasts of future demand, always difficult to make with accuracy, thus leads in every period of prosperity to an overstocking of certain markets." Overheated optimism, which results in illusory expectations about future returns of investments, is one of the central themes in Keynes' discussion of business cycles (1973a,b). Illusory expectations about the future behavior of markets go hand in hand with the lack of forecast accuracy of economic agents, which brings about two basic types of uncertainty that constrain the rationality of their business decisions. The first is known as "operative indeterminacy" (Monod 1970) or "procedural uncertainty" (Dosi and Egidi 1991, in Dequech 2001), and it basically reflects the gap between theoretically available information and information reasonably obtainable for a decision maker with respect to the time and cost of its retrieval from the environment. The second type of uncertainty, usually referred to as fundamental (also "essential" and "substantive" (Monod 1970; Dequech 2001), is characteristic of Keynesian tradition and has a profound impact on long-term expectations for the purposes of investment decisions (Fontana and Gerard 2004). It refers to matters for which "there is no scientific basis on which to form any calculable probability whatever" (Keynes 1973a, 113-114, in Fontana and Gerard 2004), including long-term changes in politics, technology, and consumer tastes. Both types of uncertainty prevent economic agents from maximizing behavior while the latter introduces systemic ambiguity in the evolution of single markets and in the economy as a whole.

In this paper I will try to show how a systemic interplay between two main forces--institutional arrangements and autocatalysis, under the constraints of uncertainty and nonconvex production costs, suffice to produce intermittent waves of prosperity and recession. I also hope to demonstrate that the bottom-up approach, which explains large-scale fluctuations solely from...

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