Knowledge that Transforms

N a note in Econometrica,2 in I942, the author sketched a new approach to the theory of business fluctuations. He claimed that this was the approach in a mathematical sense, as defined by Jeffreys.3 It also can be considered as the simplest possible dynamic generalization of the Walrasian system of general equilibrium. Roughly speaking, the simple theory explains business fluctuations as resulting from the existence of interrelated markets. The buyers and sellers on these markets react not to existing prices but to anticipated prices. All functional relationships involved are assumed to be linear (as first approximations). If anticipations of the buyers and sellers are asymmetrical in a certain well defined sense, then there is the possibility of periodic fluctuations in prices and quantities. These magnitudes will fluctuate with the same period but with various amplitudes (which may be constant, damped, or exploding) and with leads and lags. Such a movement of prices and quantities is essentially what we mean if we speak of the business cycle.4 It is not claimed, of course, that this is in all cases the only possible explanation of booms and depressions. The author has indicated in an earlier publication that a variety of causes may be at work in creating these fluctuations.5 But it is possible that these speculative fluctuations are able to explain some of the cyclical phenomena met with in our economy.6 Strictly speaking, our theory would require a study of all or at least the most important markets. Such a study is not feasible because of the amount of computational work, which, as will be seen, is very great even with only three variables. We, therefore, shall limit ourselves to the most important markets and shall use for our verification data for stock prices, farm prices, and prices of nonfarm commodities, covering the period I920-42. All the series are in the form of index numbers; we hope that this fact does not unduly distort the picture. A model based upon our theory will be constructed and the unknown parameters determined by various methods, keeping always in mind the relationships necessarily implied by our theory.7 The fitted functions will be subjected to certain statistical tests in the final sections of this paper.8 Such a procedure cannot, of course, afford a complete test of the theory. Even if the statistical test were completely applicable, the model used is not unique for our theory. All that can be said is that ours is the simplest theory which will lead to the specific model.

THE Review of Economic Statistics came to life with the publication of two remarkable papers by Professor Warren M. Persons on the nature and measurement of time-series fluctuations. Persons conceived of an economic time series as a composite of four types of movements secular, seasonal, cyclical, and irregular. His main interest was in the problem of analyzing business conditions, and his hope was to develop, on the basis of historical records, a system of forecasting cyclical sequences in business life. Hence he eliminated secular trends and seasonal variations from time series, expressed the adjusted data in units of their standard deviation, and used coefficients of correlation to sort series according to their time sequence. This novel technique of handling economic data instantly attracted wide attention. Before long it was adopted by numerous investigators in this country and abroad; within a few years of its inception, it became the 'customary' or 'conventional' method of handling time series. But as its use spread, there came criticism and dissent. Some questioned the propriety of some of the detailed methods employed by Persons and his associates. Others questioned the classification of economic movements, and proceeded to develop hypotheses of structural changes, of secondary versus primary trends, of special cycles in different branches of trade, of the intermittence of cyclical waves, and of the coexistence of several sets of cycles each perhaps periodic but combining with others to produce the irregular waves of the familiar business indexes. Still others directed criticism at the 'empiricism' of Persons' methods. Will not the conventional technique decompose a series of random numbers as elegantly as an historical series? If movements of a given type are 'eliminated' from a time series, are the effects of a corresponding cause or group of causes likewise eliminated? Do not the forces of development within a capitalistic economy move in waves, cyclical depressions being the incidental wreckage of economic progress? If so, will the conventional technique bury real problems and create false ones? To the charge of empiricism, that of 'narrowness' was added. Is it wise to measure secular trends, seasonal variations, and cyclical amplitudes, only to discard them without further ado? Is not even the timing of cyclical fluctuations being handled with excessive simplicity? Is it proper to treat the problem of sequences without regard to the stage of the business cycle? Criticism along these and similar lines was inevitable as the study of business cycles deepened. But it is worth noting that critics have all too frequently laid at Persons' door and that of his collaborators abuses committed by a host of ill-trained imitators. Today, few economists seem to remember that Persons' technique was originally developed for handling the problem of constructing a set of forecasting indexes of business conditions, or appreciate that, taken as a whole and in the light of the statistical data available at the time, it was well suited to the purpose for which it was designed. But it is also fair to add that while the 'conventional technique' gave a strong stimulus to economic research in general and to business-cycle research in particular, it has proved of little aid in advancing the frontiers of our theoretical knowledge. There can be no regret that it is losing its pre-eminence. If economists are to gain authentic knowledge about business fluctuations, they must steadily test their tools of observation and seek to improve upon them. Professor Edwin Frickey has worked by this creed. His book on Economic Fluctuations ' makes an outstanding contribution to the methodology of time series. It is an original, painstaking, and scholarly work by an economist who for some years was closely associated