Thursday, January 22, 2009

Real business cycle theory rebutted

Joseph Schumpeter had argued that a "perennial gale of creative destruction" is an inevitable requirement for any advance in human condition and this in turn can take place only in the context of a cycle of boom and bust. New technologies and inventions arouses a wave of optimism and entrepreneurial spirit, leading to over-investments, funded by credit made available by banks eager to partake of a share in the boom. Then reality dawns and the bubble bursts, leading to banks exiting in the same irrational manner, which only exacerbates the crisis. But the reality of such a "creative destruction", with its attendant bad times, is an inevitable fact of such cycles. This in turn calls for government intervention to to smooth the rough edges of the "destruction" arising from the replacement of the old capital.

Robert Skidelsky takes up arguement against the contemporary "real business cycle" theories which claims that efficient markets, which always clear, will smooth over and minimize the "destructiveness" of the "creation" in any boom and bust, and therefore any government intervention will be counter-productive. He rejects their contention that the markets will clear by themselves, and argues that the non-intervention arguements of the "real business cycle" theorists is misplaced. However, he argues that unlike even the dot-com bubble, this time there was no positive technological shock and the easy credit financed only a massive house of financial innovation built on shaky and often illusory foundations.

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