Journal Article

No. 2012-41 | November 12, 2012
Predicting the Unpredictable: Forecastable Bubbles and Business Cycles under Rational Expectations PDF Icon

Abstract

A popular interpretation of the Rational Expectations/Efficient Markets hypothesis states that, if it holds, market valuations must follow a random walk; hence, the hypothesis is frequently criticized on the basis of empirical evidence against such a prediction. Yet this reasoning incurs what we could call the ‘fallacy of probability diffusion symmetry’: although market efficiency does indeed imply that the mean (i.e. ‘expected’) path must rule out any cyclical or otherwise arbitrage-enabling pattern, if the probability diffusion process is asymmetric the observed path will most closely resemble not the mean but the median, which is not subject to this condition. In this context, this paper develops an efficient markets model where the median path of Tobin’s q ratio displays regular, periodic cycles of bubbles and crashes reflecting an agency problem between investors and producers. The model is tested against U.S. market data, and its results suggest that such a regular cycle does indeed exist and is statistically significant. The aggregate production model in Gracia (Uncertainty and Capacity Constraints: Reconsidering the Aggregate Production Function, 2011) is then put forward to show how financial fluctuations can drive the business cycle by periodically impacting aggregate productivity and, as a consequence, GDP growth.

Data Set

Data sets for articles published in "Economics" are available at Dataverse. Please have a look at our repository.

The data set for this article can be found at: http://hdl.handle.net/1902.1/18339

JEL Classification

G14 G12 E32 E22 E23

Citation

Eduard Gracia (2012). Predicting the Unpredictable: Forecastable Bubbles and Business Cycles under Rational Expectations. Economics: The Open-Access, Open-Assessment E-Journal, 6 (2012-41): 1—43. http://dx.doi.org/10.5018/economics-ejournal.ja.2012-41

Assessment

Downloads: 1738 (Journalarticle: 959, Discussionpaper: 779)
external link Search this article at Google Scholar



Comments and Questions


Joshua Konov - 2001 & 2007 Recessions
November 13, 2012 - 13:34

In both cases of 2001 & 2007 Recessions the over-capitalization of particular sectors in the economy ( in the first case the internet stocks bubble; in the second the real estate bobble), whereas the rest of the economy sectors were substantially disconnected in terms of profitability could be easily overseeing ...[more]

... their burst, however the magnitude of a recession was very difficult to be predicted, if not impossible. The 2007-09 "Great" Recession and post recession upheaval spreading all over the world markets is very random by nature occurrence; to seek equilibria on a local scale is fruitless under the circumstances of ongoing globalization, to seek such on GLOBAL SCALE SEEMS IMPOSSIBLE at least to the statistic mathematical methods, therefor, I believe, business cycles are loosing their functionality and predictability giving place to more randomly used parameters of economic agents more attached to the inflation dynamics than to the productivity such.


Eduard Gracia - Business cycles and the 2001 & 2007 recessions
November 15, 2012 - 13:24

Thank you very much for your comments. Yes, of course, I agree that the magnitude and precise timing of a downturn are necessarily difficult to predict due to the stochastic nature of the underlying functions: all we could potentially hope a forecasting model to allow us to say is that ...[more]

... at a given point in time there is an X percent probability of a downturn of such and such characteristics. I do not agree, however, with the statement that "business cycles are losing their functionality and predictability": such a statement strikes me as a new version of the old "this time is different" assertion one hears during booms to justify why the crash might never come... until it eventually does. To be sure, every recession is different: per the model discussed in my paper, the trigger is always a random shock and therefore, by definition, unexpected - yet there is a probability that a new random shock lead to a recession that is different at different points in the cycle, and which we should be able to estimate on the basis of an appropriate model. I do not think the 2001 and 2007 recessions have changed this.


Joshua Konov - Reply to Reply
November 19, 2012 - 13:05

When I considered business cycles of becoming less distinguishable I consider the rising noise boosted by the expanding Globalization and rising Productivity, not so much that market redundancies would not eventually bring downturns and need for adjustments, because downturn business cycle is such natural market adjustment; however, I would argue ...[more]

... that in time the diversity of market noise is aggregating to bring randomness in such probabilities and possible observation of disequilibrium. As in Physics the philosophy of certainty has evolved into Quantum uncertainty ion Economics the processes of comprehension should go from certainty to uncertainty, so to speak the schemes of understanding should go to applying market/economic agents on counter-cyclical approach on different market segments, the one for all monetary policy to cure these different segments may not work anymore. To wait on cyclicallity to self-adjust markets as shown by the last 2007-9 Recession, whereas the governments did not interfere a catastrophe was imminent. On the remark that no new economic pressures possible, the EU with its stubborn ideological approaches that have brought disastrous results is my best answer... The world economy has changed, moreover the changes are fundamental. Deindustrialization of many markets, shortages of industrial jobs, fiscal shortages, mass outsourcing and moving of industrial production, China, India, and Vietnam... nothing is the same and will never be such. The vision of recessions as agents of adjusting redundancies controlled by monetary policies only is unrealistic, indeed. Quantitative Easing, Stimulus packages, and overall mass governmental market interference is the consequence of lack of comprehension of these new developments.
Coming back to the predictability of economic recessions, the over-capitalization of some market segments (as the Real Estate under the last recession) should be located and fought by multiple approaches instead of waiting these segments to bring the whole economy down. Also, over-capitalization capable to prompt recession should be offset by overall boosting of business activities, whereas just productivity as currently used may not do it.