Economists tend to view the business cycle as one of the main stylized facts which any theory must account for, rather than a principle in itself.
In terms of statistical evidence, market price movements are definitely not a vanilla random walk—random walks don’t have long tails unless you add something else into the theory. The usual baseline model is a random walk in which the variance is also governed by a random walk; a quant trading shop will augment this with occasional jumps and a few small terms to account for higher moments of the distribution. And even that is just the baseline to reasonably model a single asset—modelling multiple assets is far more complicated, since they usually become more correlated during a crash (another phenomenon which wouldn’t happen in a vanilla random walk). If you want to learn more about this stuff, look for a mathematical finance class.
Getting back to the economics side, every major class of macroeconomic theories has an answer to the question “What the heck is up with these business cycles? Why do markets sometimes crash way harder than they should with random walks?” Real business cycle (RBC) theory posits that they’re the result of shocks to the economy, e.g. hurricanes or wars. Market monetarism attributes crashes to tight money, as measured by NGDP. Keynesianism focuses on variation in aggregate demand. Monetarism focuses on variation in the money supply and/or money velocity. Etc, etc. If you want to see the fancy stuff, pick up a book on “recursive macroeconomic theory”.
But to the degree that the business cycle is a separate understandable phenomenon, can’t investors use that understanding to place bets which make them money while dampening the effect?
This is part of what the various theories try to explain. Some require irrationality in order for business cycles to exist—usually in the form of “sticky wages”, meaning that people don’t like wage cuts even if the alternative is getting fired and accepting lower pay elsewhere. In this case, traders can’t necessarily counterbalance the whole effect, no matter how clever they are—so markets will crash as soon as the traders know that a sticky wage problem is on the horizon. On the other hand, RBC explains (some) business cycles without any irrationality at all: if a big hurricane significantly lowers GDP this year, then society as a whole will eat into their savings to cover the costs—which means eating into the capital stock, and lowering GDP over the next few years. Traders can’t price that in until they know about the damage, at which point there’s a market crash.
Economists tend to view the business cycle as one of the main stylized facts which any theory must account for, rather than a principle in itself.
In terms of statistical evidence, market price movements are definitely not a vanilla random walk—random walks don’t have long tails unless you add something else into the theory. The usual baseline model is a random walk in which the variance is also governed by a random walk; a quant trading shop will augment this with occasional jumps and a few small terms to account for higher moments of the distribution. And even that is just the baseline to reasonably model a single asset—modelling multiple assets is far more complicated, since they usually become more correlated during a crash (another phenomenon which wouldn’t happen in a vanilla random walk). If you want to learn more about this stuff, look for a mathematical finance class.
Getting back to the economics side, every major class of macroeconomic theories has an answer to the question “What the heck is up with these business cycles? Why do markets sometimes crash way harder than they should with random walks?” Real business cycle (RBC) theory posits that they’re the result of shocks to the economy, e.g. hurricanes or wars. Market monetarism attributes crashes to tight money, as measured by NGDP. Keynesianism focuses on variation in aggregate demand. Monetarism focuses on variation in the money supply and/or money velocity. Etc, etc. If you want to see the fancy stuff, pick up a book on “recursive macroeconomic theory”.
This is part of what the various theories try to explain. Some require irrationality in order for business cycles to exist—usually in the form of “sticky wages”, meaning that people don’t like wage cuts even if the alternative is getting fired and accepting lower pay elsewhere. In this case, traders can’t necessarily counterbalance the whole effect, no matter how clever they are—so markets will crash as soon as the traders know that a sticky wage problem is on the horizon. On the other hand, RBC explains (some) business cycles without any irrationality at all: if a big hurricane significantly lowers GDP this year, then society as a whole will eat into their savings to cover the costs—which means eating into the capital stock, and lowering GDP over the next few years. Traders can’t price that in until they know about the damage, at which point there’s a market crash.