Utopia, you are standing in it!

David Andolfatto argues for the Schumpeterian view of economic development where the distinction between growth and business cycles is artificial. Everyone agrees that long-run growth is the product of technological advancement. The Keynesian school views trend growth as being stable with new technologies unfolding at a smooth rate.

In the Schumpeterian view, there is no reason to believe that the process of technological advancement is smooth. It is more reasonable to suppose that new technologies appear in clusters.

There will be incremental innovations, and from time to time, grand innovations that transformed the entire economy. These grand innovations require the economy to slow down while it invests in a whole range of secondary innovations to make the most of these great new technologies. Writing workable software for new computers is an example.

These technology shocks may cause fluctuations in the growth rate through what Schumpeter called a process of creative destruction. Innovations cluster in specific industries and this generates the boom. When the cluster of innovation comes to an end in a particular sector, there is a generally increased risk of failure as old and new firms and entrepreneurs and investors adapt themselves to the new situation.

If business cycles come from innovation, they are an essential feature of economic development. They cannot be eliminated without harming innovation so we should not be too quick to smooth out the business cycle.

Technological advancements that ultimately lead to higher productivity may, in the short run, induce cyclical adjustments as the economy restructures: resources flow out from declining sectors to the expanding sectors, and people retrain and learn the next technologies and invest in the secondary innovations to make, for example, new computers to be of practical application. The first innovators will find the job a difficult one, later innovators will find things very easy, and the last to adopt the innovation will find not much to do. Faster or slower adoption of new technologies will have important implications for production, investment and consumption.

There is no guarantee that all new technologies will work out as planned. What may have looked promising may turn out to be a disappointment.

This leads to the role in news on the business cycle. Obviously, people form expectations about future technologies and invest and consume in the expectation of better or worse times ahead. They will adjust investor and consumer expectations as new information of varying and conflicting quality becomes available about technological prospects and the success of technological developments to date.

Output and employment will go up and down on the basis of these shifting expectations. These shifts in expectations are perfectly rational and are made on the basis of new information about the prospects and performance of new and existing technologies. Of course, some of these forecasts will turn out to be a disappointment and there will be a slowdown in the economy as people regroup.

The problem is not a lack of accurate forecasting by both the old and new firms. If technologies come in clusters, and are clustered in industries, there will be an above and below average number of forecasting errors with resulting consequences for business failures and new investment.

The productivity slowdown in the 1970s is attributed by some to a doubling of technology adoption costs because of the ICT revolution. This doubling in the cost of adopting new technologies was not measured as investment in the national accounts when constructing GDP data.

Boyan Jovanovic argues that the share market crash in the early 1970s may have been driven by an expectation by investors that a lot of existing capital had become obsolete because of the ICT revolution. investors wrote down the value of the companies with the soon-to-be obsolete capital and the stock-market incumbents of the day which were not ready to implement it.  Product-market entry of new firms and new capital takes time, and their stock-market entry takes even longer. In the meantime, the stock market declines.

Why do people assume the trend growth is stable? Economic growth is no more than a random collection of innovations that are adopted across the economy each year.