Business cycle
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The term business cycle or economic cycle refers to the fluctuations of economic activity (business fluctuations) around its long-term growth trend. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), and periods of relative stagnation or decline (contraction or recession). These fluctuations are often measured using the real gross domestic product. Despite being termed cycles, these fluctuations in economic growth and decline do not follow a purely mechanical or predictable periodic pattern.
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Types of business cycle
A number of types of business cycles, in the traditional sense of a fluctuation within a regular period have been proposed. The main types of business cycles enumerated by Joseph Schumpeter, and others in this field, have been named after their discoverers or proposers:
- the Kitchin inventory cycle (3–5 years) — after Joseph Kitchin,
- the Juglar fixed investment cycle (7–11 years) — after Clement Juglar,
- the Kuznets infrastructural investment cycle (15–25 years) — after Simon Kuznets, Nobel Laureate,
- the Kondratieff wave or cycle (45–60 years) — after Nikolai Kondratieff.
- the Forrester cycles (200 years) - after Jay Wright Forrester.
- the Toffler civilisation cycles (1000-2000 years) - after Alvin Toffler.
Even longer cycles are occasionally proposed, often as multiples of the Kondratieff cycle. Interest in traditional business cycles was strongest before World War II. However, interest has waned since the development of modern macroeconomics, which generally gives little support to the idea of regular periodic cycles.
Juglar cycle
In 1860, French economist Clement Juglar identified the presence of 8 to 11 year cycles. In Business Cycles, Schumpeter suggested this cycle be named after Juglar. These cycles are made up of four stages, each linked to the variation in prices, production and interest rates:
- expansion = increase in production and prices , and low interests rates.
- crisis = stock exchanges crash and bankruptcies of several companies occur.
- recession = decrease in price and in output, high interests rates.
- recovery= stocks recover thanks to the fall in prices and incomes.
In the Juglar cycle, which is sometimes called "the" business cycle, recovery and prosperity are associated with increases in productivity, consumer confidence, aggregate demand, and prices. In the cycles before World War II or that of the late 1990s in the United States, the growth periods usually ended with the failure of speculative investments built on a bubble of confidence that bursts or deflates. In these cycles, the periods of contraction and stagnation reflect a purging of unsuccessful enterprises as resources are transferred by market forces from less productive uses to more productive uses. Cycles between 1945 and the 1990s in the United States were generally more restrained and followed political factors, such as fiscal policy and monetary policy. Automatic stabilisation due to the government's budget helped defeat the cycle even without conscious action by policy-makers.
A colloquial term for a crisis of this time scale is a "decennial crisis" (meaning one that occurs after about ten years). This phrase was used during the Great Depression due its similarity with the Panic of 1825 in London ten years after the end of the Napoleonic Wars. After the Second World War, however, the nearest equivalent in time and intensity was the recession of 1958.
Cycles or fluctuations?
In recent years economic theory has moved towards the study of economic fluctuation rather than a 'business cycle' - though some economists use the phrase 'business cycle' as a convenient shorthand. Milton Friedman stated on a number of occasions that calling the business cycle a "cycle" is a misnomer, because of its non-cyclical nature. He believed that for the most part, excluding very large supply shocks, business declines are more of a monetary phenomenon.
Rational expectations theory states that no deterministic cycle can persist because it would consistently create arbitrage opportunities. Much economic theory also holds that the economy is usually at or close to equilibrium. These views led to the formulation of the idea that observed economic fluctuations can be modelled as shocks to a system.
A moving average of a stochastic stationary variable also bears resemblance to a graph of an economic time-series, such as inflation, unemployment, or investment. Such graphs arguably resemble actual events more closely than deteministic cycle formulae.
Random walks and chaotic patterns
In 1900 Louis Bachelier proposed that the fluctuations in share prices follow random walks, being complete random with no cyclic properties. While this was a ground breaking work, Bachelier's model failed to account for big fluctuations such as the Great Depression. In the 1960s, Benoît Mandelbrot proposed that fluctuation in cotton prices follow a Lévy flight distribution, which have a fat tail allowing greater probability for large fluctuations.[1] In 1995, physicists R. Mantegna and G. Stanley analyzed over a million records of stock market indices from the previous five years, and they found that the actual distribution lay between the Gaussian random walks and Lévy flights. They also found that similar distributions were found regardless of the time scale exhibiting self-similarity.[2] An accurate model is yet to be found.
Explanation of business cycles
The explanation of fluctuations in the aggregate level of economic activity is one of the primary concerns of macroeconomics. The most commonly used framework for explaining such fluctuations is derived from Keynesian economics. In the Keynesian view, business cycles reflect the possibility that the economy may reach short-run equilibrium at levels below, or above full employment. If the economy is operating with less than full employment, i.e., with high unemployment above the NAIRU, then in theory monetary policy and fiscal policy can have a positive role to play rather than simply creating booms that necessarily collapse on themselves.
Keynesian models do not necessarily imply periodic business cycles. However, simple Keynesian models involving the interaction of the Keynesian multiplier and accelerator give rise to cyclical responses to initial shocks. A model was designed by Paul Samuelson, name the "oscillator model", is supposed to account for business cycles thanks to the multiplier and the accelerator. The amplitude of the variations in economic output depends on the level of the investment, for investment determine the level of aggregate output (multiplier), and is determined by aggregate demand (accelerator).
Another explanation linked to the Keynesian thought is that of Goodwin, who account for cycles in output by the distribution of income between benefits and wages. The fluctuations in wages are the same as in the level of employment, for when the economy is at full-employment, workers are able to demand rises in wages, whereas in unemployment periods, they cannot. According to Goodwin, when unemployment and the part of benefits rise, the output rise.
Keynesian economist Minski has proposed an explanation of cycles founded on fluctuations in interest rates: in an expansion period, interest rates are low and companies can easily borrow money from banks to invest. They do not hesitate to borrow money, and banks are not reluctant to grant them loans, because they know they would be able to easily pay back the loans thanks to the economic growth and the increase in incomes. But when companies become too indebted, they stop investing, and the economy goes into recession.
Keynesian views have been challenged by real business cycle models which consider fluctuations in supply (technology shocks). This theory is most associated with Finn E. Kydland and Edward C. Prescott, winners of the 2004 Nobel Prize in Economic Sciences. They consider that economic crisis and fluctuations cannot stem from a monetary shock, only from an external shock, such as an innovation.
Explanation of the recovery
Productive capital used by firms gets worn out over time and require replacements. Spending on capital equipment such as machinery is necessary, which increases aggregate expenditure (AE) and causes the economy to slowly climb. Secondly, the low prices characteristic of a trough phase causes increased demand for them, resulting in inflation which is characteristic of the boom phase. Lower interest rates stimulate increased borrowing. The repayments and interest which need to be paid back contribute to the rise in AE. Governments aim to improve the business cycle so as to provide stability, get re-elected and to ease worries about the state of the economy. They also do this to attract foreign investors and improve their international reputation.
Preventing business cycles
Because the periods of stagnation are painful for many who lose their jobs, pressure arises for politicians to try to smooth out the oscillations. An important goal of all Western nations since the Great Depression has been to limit the dips.
Managing economic policy to even out the cycle is a difficult task in a society with a complex economy, even when Keynesian theory is applied. According to some theorists, notably nineteenth-century advocates of communism, this difficulty is insurmountable. Karl Marx in particular claimed that the recurrent business cycle crises of capitalism were inevitable results of the system's operations. In this view, all that the government can do is to change the timing of economic crises. The crisis could also show up in a different form, for example as severe inflation or a steadily increasing government deficit. Worse, by delaying a crisis, government policy is seen as making it more dramatic and thus more painful.
Additionally, Neoclassical economics plays down the ability of Keynesian policies to manage an economy. Challenging the Phillips Curve since the 1960s, economists like Nobel Laureate Milton Friedman or 2006 Nobel Laureate Edmund Phelps have made ground in their arguments that inflationary expectations negate the Phillips Curve in the long run. The stagflation of the 70's supported their theory by flying in the face of Keynesian predictions. Friedman has gone so far as to argue, that all the Federal Reserve System can do is to avoid making large mistakes, as he believes they did by contracting the money supply very rapidly in the face of the Stock Market Crash of 1929, in which they made what would have been a recession into a great depression. (Friedman calls the Great Depression the "Great Contraction" because of this).
Alternative interpretations of business cycles
Politically-based business cycle models
Another set of models tries to derive the business cycle from political decisions.
The partisan business cycle suggests that cycles result from the successive elections of administrations with different policy regimes. Regime A adopts expansionary policies, resulting in growth and inflation, but is voted out of office when inflation becomes unacceptably high. The replacement, Regime B, adopts contractionary policies reducing inflation and growth, and the downwards swing of the cycle. It is voted out of office when unemployment is too high, being replaced by Party A.
The political business cycle is an alternative theory stating that when an administration of any hue is elected, it initially adopts a contractionary policy to reduce inflation and gain a reputation for economic competence. It then adopts an expansionary policy in the lead up to the next election, hoping to achieve simultaneously low inflation and unemployment on election day.
Marxist
Michal Kalecki's Marxian-influenced "political business cycle" theory blames the government.[3] He argued that no democratic government under capitalism would allow the persistence of full employment, so that recessions would be caused by political decisions: persistent full employment would mean increasing workers' bargaining power to raise wages and to avoid doing unpaid labor, potentially hurting profitability. (He did not see this theory as applying under fascism, which would use direct force to destroy labor's power.) In recent years, proponents of the "electoral business cycle" theory have argued that incumbent politicians encourage prosperity before elections in order to ensure re-election -- and make the citizens pay for it with recessions afterwards.
Austrian school
The Austrian School of economics rejects the suggestion that the business cycle is an inherent feature of a market economy and argues that it is caused mainly by central government intervention in the money supply. Austrian School economists, following Ludwig von Mises, point to the role of the interest rate as the price of investment capital, guiding investment decisions. In an unregulated (free-market) economy, where there is no central bank, it is posited that the interest rate reflects the actual time preference of lenders and borrowers. Some follow Knut Wicksell to call this the "natural" interest rate.[4]
The government's attempt to gain control over money (through the creation of a central bank) destroys the natural equilibrium of interest rates between savers and borrowers. Austrian School economists conclude that, if the interest rate is held artificially low by the government or central bank, then the demand for loans will be higher than the actual supply of willing lenders, and if the interest rate is artificially high, the opposite situation will occur. This pricing misinformation leads investors to misallocate capital, borrowing and investing either too much or too little in long-term projects. Periodic recessions, then, are seen as necessary "corrections" following periods of fiat credit expansion, when unprofitable investments are liquidated, freeing capital for new investment.
The Austrian Business Cycle Theory also predicts that the imposition of artificially low interest rates, and the resulting increase in the supply of fiat credit, generates price inflation (often focused in captial or asset markets which employ many people). Once this monetary "boom" is in effect, often governments become fearful of a correction to the "monetary boom" given the negative employment effects of the inevitable correction. This then obliges the central bank to increase the supply of credit yet further to maintain the artificially low interest rate, thus prolonging the "fake" monetary boom and worsening the inevitable "correction" when credit expansion can no longer be sustained. In Austrian theory, depressions and recessions are positive forces in-so-much that they are the market's natural mechanism of undoing the misallocation of resources present during the “boom” or inflationary phase. Austrian School economists point to the dot-com investment frenzy and the U.S. housing bubble as a modern examples of artificially abundant credit subsidizing unsustainable overinvestment.
Problems of measurement
Some argue that modern business cycle theory often measures growth by using the flawed measure of the economy's aggregate production, i.e., real gross domestic product, which is not useful for measuring well-being and also generates distortions in the perception of economic growth because the price changes of the various products are disproportional. Accordingly, there may be a mismatch between the state of economic health as perceived by many individuals and that perceived by the bankers and economists, which would drive them apart politically. However it is fluctuations in real GDP that cause changes in employment, unemployment, interest rates, and inflation, i.e. economic issues which are their main concern of business cycle experts.
Business cycle theory has been most effective in microeconomics where it aids in the preparation of risk management scenarios and timing investment, especially in infrastructural capital that must pay for itself over a long period, and which must fund itself by cashflow in late years. When planning such large investments, it is often useful to use the anticipated business cycle as a baseline, so that unreasonable assumptions, e.g. constant exponential growth, are more easily eliminated.
See also
- Real Business Cycle Theory
- Dynamic stochastic general equilibrium
- World-systems approach
- Information revolution
References
- ↑ Philip Ball, Critical mass Random House, 2004. ISBN 0-09-945786-5
- ↑ Rosario N. Mantegna, H. Eugene Stanley, An Introduction to Econophysics: Correlations and Complexity in Finance, Cambridge University Press (Cambridge, 1999)
- ↑ Michal Kalecki, 1899-1970.
- ↑ Knut Wicksell (1851-1926)