Here’s the story.
In 1927, a Russian economist by the name of Eugen Slutsky wrote a paper entitled “The Summation of Random Causes as the Source of Cyclic Processes“. At the time Slutsky was working for the Institute of Conjuncture in Moskow. That institute was headed by a man called Nikolai Kondratiev.
This was in the early days of the Soviet Union, before Stalin managed to turn it into a totalitarian hellhole, a time when the Communist leadership was relatively tolerant towards scientists and even occasionally listened to their advice. The institute’s job was basically to collect and analyze statistics on the Russian economy in order to help the Party with their central planning. But Kondratiev seemed to take the view that it would be best to allow the market to work, at least in the agricultural sector, and use the proceeds from agricultural exports to pay for industrialization. Lenin apparently took the advice and in 1922 launched the so-called New Economic Policy which allowed private property and markets for land and agricultural goods and re-privatized some industries which had been nationalized after the October Revolution. This policy turned out to be rather successful – at least it ended the mass starvation which War Communism had caused during the years of the Russian civil war.
But then Lenin died and Stalin took over and decided that time had come to get serious about socialism again and finally abolish private property and markets for good. Dissenting voices like Kondratiev’s clearly couldn’t be tolerated in this great enterprise, so in 1928 Kondratiev was sacked and the institute was closed down. Some time later, Kondratiev was arrested, found guilty of being a „kulak professor“ and sent off to a labor camp. Even there he continued to do research until Stalin had him killed by firing squad during the Great Purge of 1938.
But I’m digressing, so back to Slutsky. His 1927 paper was written in the wake of Kondratiev’s 1925 book “The Major Economic Cycles“. That book claimed that capitalist economies exhibit regular boom-bust waves of about 50 years duration, known today as Kondratiev Waves. Other „conjuncture” researchers had claimed the existence of shorter waves.
Slutsky’s first observation was that when you really look at time series of aggregate economic output, you don’t see regular waves, but a lot of irregular fluctuations. So trying to find deterministic, sinusoidal waves in economic time series is probably not a very fruitful exercise.
Slutsky’s second observation was that when you draw a long series of independently and identically distributed random variables (modern terminology, not his) and then take some moving average of them… you get a time series that looks an awful lot like real-world business cycles!
He showed that in two ways. First, he performed simulations. Remember this is 1927 – so how did he simulate his random numbers? Well, the People’s Commissariat of Finance ran a lottery. So Slutsky took the last digits of the numbers drawn in the lottery (this is the basic series shown in figure 1). He then computed a bunch of different moving average schemes one of which is shown in figure 2. See the boom-bust cycles in that picture? Pretty cool, huh?
But Slutsky didn’t just show cool graphs. He also had a beautiful argument for why these moving averages looked like recurrent waves:
We shall first observe a series of independent values of a random variable. If, for sake of simplicity, we assume that the distribution of probabilities does not change, then, for the entire series, there will exist a certain horizontal level such that the probabilities of obtaining a value either above or below it would be equal. The probability that a value which has just passed from the positive deviation region to the negative, will remain below at the subsequent trial is 1/2; the probability that it will remain below two times in succession is 1/4; three times 1/8; ans so on. Thus the probability that the values will remain for a long time above the level or below the level is quite negligible. It is, therefore, practically certain that, for a somewhat long series, the values will pass many times from the positive deviations to the negative and vice versa.
(For the mathematically minded, there’s also a formal proof just in case you’re wondering.)
Since it was written in Russian, the paper went unnoticed by economists in the West until it came to the attention of Henry Schultz, professor at the University of Chicago and one of the founders of the Econometric Society. He had the paper translated and published in Econometrica in 1937.
And so Slutsky’s „random causes“ provided the first stepping stone for the modern business cycle theories which explain how random shocks produce, via the intertemporal choices of households, firms and government agencies, the cyclical patterns we see in aggregate time series.
P.S.: All this time you have probably asked yourself: Slutsky, Slutsky,… that name rings a bell. Oh right, the Slutsky Equation! Yep. Same guy.