The Business Cycle

business cycleBusiness cycle describes the rise and fall in production output of goods and services in an economy.

The business cycle, also known as the economic cycle or trade cycle, is the downward and upward movement of gross domestic product (GDP) around its long-term growth trend. The length of a business cycle is the period of time containing a single boom and contraction in sequence. These fluctuations typically involve shifts over time between periods of relatively rapid economic growth (expansions or booms), and periods of relative stagnation or decline (contractions or recessions).

Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite the often-applied term cycles, these fluctuations in economic activity do not exhibit uniform or predictable periodicity. They are generally measured using rise and fall in real – inflation-adjusted – gross domestic product (GDP), which includes output from the household and nonprofit sector and the government sector, as well as business output. Output cycle is therefore a better description of what is measured. The business or output cycle should not be confused with market cycles, measured using broad stock market indices; or the debt cycle, referring to the rise and fall in household and government debt.

The business cycle or output cycle is often visualized in terms of consistent expansions and contraction, almost like a sine wave. Actual fluctuations in real GDP, however, are far from consistent.

After World War II, expansions were mostly associated with population growth, urban sprawl and the advent of consumerism. By the 1970s, growth came more from debt injections from consumer credit cards, mortgages, commercial and industrial loans (as opposed to equity funding), followed by the dotcom speculation, and then more mortgage debt. Fiscal and regulatory policy, technology and demographics have also had an effect on the business cycle, as have external events such as the oil price spikes of 1973-4 and 1979.

Real gross domestic product is a macroeconomic assessment that measures the value of the goods and services produced by an economic entity in a specific period, adjusted for inflation. GDP is derived by valuing all production by an economy using a specific year’s average prices. Governments use GDP as a comparison tool to analyze an economy’s purchasing power and growth over time. This is done by looking at the economic output of two periods and valuing each period with the same average prices and comparing the two together.

Real GDP Versus Nominal GDP

Nominal GDP is a macroeconomic assessment that includes current prices in its measure. The main differentiating factor between nominal GDP and GDP is nominal GDP includes inflation and is therefore normally higher than GDP. Since GDP is calculated using a base year and does not include inflation, it represents an economy’s nominal GDP if that economy did not realize any price changes when compared to the base year.

For example, say that in 2004, nominal GDP was $200 billion. However, due to an increase in the level of prices from the base year 2000 to 2004, GDP is $170 billion. The lower real GDP reflects the price changes while nominal GDP does not.

The Business Cycle’s Effect on Markets

Recessions can extract a tremendous toll on stock markets. Most major equity indexes around the world endured declines of over 50% in the 18-month period of the Great Recession, which was the worst global contraction since the 1930s Depression. Global equities also underwent a significant correction in the 2001 recession, with the Nasdaq Composite among the worst-hit: the index plunged by almost 80% from its 2001 peak to its 2002 low. Importantly, recessions due to credit bubbles bursting are far worse on income and consumption than from stock market speculative bubbles bursting.

The explanation of fluctuations in aggregate economic activity is one of the primary concerns of macroeconomics. The main framework for explaining such fluctuations is 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, Keynesian theory states that monetary policy and fiscal policy can have a positive role to play in smoothing the fluctuations of the business cycle.

Credit / Debt Cycle

One alternative theory is that the primary cause of economic cycles is due to the credit cycle: the net expansion of credit (increase in private credit, equivalently debt, as a percentage of GDP) yields economic expansions, while the net contraction causes recessions, and if it persists, depressions. In particular, the bursting of speculative bubbles is seen as the proximate cause of depressions, and this theory places finance and banks at the center of the business cycle.

A primary theory in this vein is the debt deflation theory of Irving Fisher, which he proposed to explain the Great Depression. A more recent complementary theory is the Financial Instability Hypothesis of Hyman Minsky, and the credit theory of economic cycles is often associated with Post-Keynesian economics such as Steve Keen.

Post-Keynesian economist Hyman Minsky has proposed an explanation of cycles founded on fluctuations in credit, interest rates and financial frailty, called the Financial Instability Hypothesis. In an expansion period, interest rates are low and companies easily borrow money from banks to invest. Banks are not reluctant to grant them loans, because expanding economic activity allows business increasing cash flows and therefore they will be able to easily pay back the loans. This process leads to firms becoming excessively indebted, so that they stop investing, and the economy goes into recession.

While credit causes have not been a primary theory of the economic cycle within the mainstream, they have gained occasional mention.

Product Based Theory of Economic Cycles

This theory explains the nature and causes of economic cycles from the viewpoint of life-cycle of marketable goods. The theory originates from the work of Raymond Vernon, who described the development of international trade in terms of product life-cycle – a period of time during which the product circulates in the market. Vernon stated that some countries specialize in the production and export of technologically new products, while others specialize in the production of already known products. The most developed countries are able to invest large amounts of money in the technological innovations and produce new products, thus obtaining a dynamic comparative advantage over developing countries.

Recent research by Georgiy Revyakin proves initial Vernon theory and shows that economic cycles in developed countries overrun economic cycles in developing countries. He also presumes that economic cycles with different periodicity can be compared to the products with various life-cycles.

In case of Kondratiev waves such products correlate with fundamental discoveries implemented in production (inventions which form the technological paradigm: Richard Arkwright’s machines, steam engines, industrial use of electricity, computer invention, etc.);

Kuznets cycles describe such products as infrastructural components (roadways, transport, utilities, etc.); Juglar cycles may go in parallel with enterprise fixed capital (equipment, machinery, etc.), and Kitchin cycles are characterized by change in the society preferences (tastes) for consumer goods, and time, which is necessary to start the production.

Simultaneous technological updates by all economic agents (as a result, cycle formation) would be determined by highly competitive market conditions: in case if a manufacturing technology at an enterprise does not meet the current technological environment, – such company loses its competitiveness and eventually goes bankrupt.

Politically Based Business Cycle

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.

The political business cycle theory is strongly linked to the name of Michał Kalecki who discussed the reluctance of the ‘captains of industry’ to accept government intervention in the matter of employment. 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.

Yield Curve

The slope of the yield curve is one of the most powerful predictors of future economic growth, inflation, and recessions. One measure of the yield curve slope (i.e. the difference between 10-year Treasury bond rate and the 3-month Treasury bond rate) is included in the Financial Stress Index published by the St. Louis Fed. A different measure of the slope (i.e. the difference between 10-year Treasury bond rates and the federal funds rate) is incorporated into the Index of Leading Economic Indicators published by The Conference Board.

An inverted yield curve is often a harbinger of recession. A positively sloped yield curve is often a harbinger of inflationary growth. Work by Arturo Estrella and Tobias Adrian has established the predictive power of an inverted yield curve to signal a recession. Their models show that when the difference between short-term interest rates (they use 3-month T-bills) and long-term interest rates (10-year Treasury bonds) at the end of a federal reserve tightening cycle is negative or less than 93 basis points positive that a rise in unemployment usually occurs. The New York Fed publishes a monthly recession probability prediction derived from the yield curve and based on Estrella’s work.

All the recessions in the US since 1970 (up through 2017) have been preceded by an inverted yield curve (10-year vs 3-month). Over the same time frame, every occurrence of an inverted yield curve has been followed by recession as declared by the NBER business cycle dating committee.



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