Business Cycles

Business cycles

Economic Waves series

Cycle/Wave Name

Years
Kitchin inventory 3-5
Juglar fixed investment 7-11
Kuznets 15-25
Bronson Asset Allocation ~30
Kondratiev wave 45-60

The business cycle or economic cycle refers to the ups and downs seen somewhat simultaneously in most parts of an economy. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), alternating with periods of relative stagnation or decline (contraction or recession). These fluctuations are often measured using the real gross domestic product.

To call those fluctuations “cycles” is rather misleading as they don’t tend to repeat at fairly regular time intervals. Most observers find that their lengths (from peak to peak, or from trough to trough) vary, so that cycles are not mechanical in their regularity. Since no two cycles are alike in their details, some economists dispute the existence of cycles and use the word “fluctuations” (or the like) instead. Others see enough similarities between cycles that the cycle is a valid basis of studying the state of the economy. A key question is whether or not there are similar mechanisms that generate recessions and/or booms that exist in capitalist economies so that the dynamics that appear as a cycle will be seen again and again.

Types of business cycle

Traditional business cycle models

The main types of business cycles enumerated by Joseph Schumpeter and others in this field have been named after their discoverers or proposers:

  • the Kitchen inventory cycle (3-5 years) – after Joseph Kitchen.
  • 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 Kondratiev wave or cycle (45-60 years) — after Nikolai Kondratiev.

Even longer cycles are occasionally proposed, often as multiples of the Kondratiev cycle.

Kondratiev Wave (Kondratieff Cycle)

The cycle is supposedly more visible in international production data than in individual national economies. It affects all the sectors of an economy, and concerns mainly output rather than prices (although Kondratieff had made observations focusing more on prices, inflation and interest rates). According to Kondratieff, the ascendant phase is characterized by an increase in prices and low interest rates, while the other phase consists of a decrease in prices and high interest rates.

Kondratieff identified three phases in the cycle: expansion, stagnation, recession. More common today is the division into four periods with a turning point (collapse) between the first and second two. Writing in the 1920s, Kondratieff proposed to apply the theory to the 19th century:

1790 – 1849 with a turning point in 1815.
1850 – 1896 with a turning point in 1873.
Kondratieff supposed that in 1896, a new cycle had started.
The phases of Kondratieff’s waves also carry with them social shifts and changes in the public mood. The first stage of expansion and growth, the “Spring” stage, encompasses a social shift in which the wealth, accumulation, and innovation that are present in this first period of the cycle create upheavals and displacements in society. The economic changes result in redefining work and the role of participants in society. In the next phase, the “Summer” stagflation, there is a mood of affluence from the previous growth stage that change the attitude towards work in society, creating inefficiencies. After this stage comes the season of deflationary growth, or the plateau period. The popular mood changes during this period as well. It shifts toward stability, normalcy, and isolationism after the policies and economics during unpopular excesses of war. Finally, the “Winter” stage, that of severe depression, includes the integration of previous social shifts and changes into the social fabric of society, supported by the shifts in innovation and technology.

A fourth cycle may have roughly coincided with the Cold War: beginning in 1949, turning with the economic peak of the mid-1960s and the Vietnam War escalation, hitting a trough in 1982 amidst growing predictions in the United States of worldwide Soviet domination and ending with the fall of the Berlin Wall in 1989. The current cycle most likely peaked in 1999 with a possible winter phase beginning in late 2008. The Austrian-school economists point out that extreme price inflation in the absence of economic growth is a form of capital destruction, allowing either stagflation (as in the 1970s and much of the 2000s during the gold and oil price run-ups) or deflation (as in the 1930s and possibly following the crash in commodity prices beginning in 2008) to represent a recession or depression phase of the Kondratieff theory.

Kondratiev could also e spelled as Kondratieff, Kondratief, Kontratiev, Kondradieff, Kondradiev.

Juglar cycle

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 stabilization due the government’s budget helped defeat the cycle even without conscious action by policy-makers.

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 Polling Day.

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. Government intervention in the economy can be risky, however. For instance, some of Herbert Hoover’s efforts (including tax increases) are widely, though not universally, believed to have deepened the depression.

No-one argues that managing economic policy to even out the cycle is an easy job 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.

Therefore, good forecasts of cyclical turning points are critical to improve policy decisions. The Economist noted that the Weekly Leading Index published by the Economic Cycle Research Institute (ECRI) is a successful real-time indicator to watch. ECRI was founded by Geoffrey H. Moore, who created the first ever Index of Leading Economic Indicators in the 1950s.

Alternative Interpretations of Business Cycles

Austrian School

The Austrian School of economics rejects the suggestion that the business cycle is an inherent feature of an unregulated economy and argues that it is caused by 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, 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. Government control of the money supply through central banks disturbs this equilibrium such that the interest rate no longer reflects the real supply of and demand for investment capital. Austrian School economists conclude that, if the interest rate is artificially low, 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 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 theory also predicts that the imposition of artificially low interest rates, and the resulting increase in the supply of fiat credit, generates inflation, which obliges the central bank to increase the supply of credit yet further to maintain the artificially low interest rate, thus prolonging the “boom” and worsening the inevitable “correction.” Austrian School economists point to the dot-com investment frenzy as a modern example of artificially abundant credit subsidizing unsustainable over investment.

In the Keynesian view, this Austrian theory assumes that the “natural” rate of interest is unique at any given time and cannot be affected by policy. To Keynesian economists, this rate is only unique if the economy is assumed to always be at 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. It should be noted that, in the Austrian School, the absence of full employment is typically attributed to government interference in the labour markets, such as minimum wage laws, employment regulations, and taxes levied against employers, which prevent the employment market from fully clearing.

Marxist Views

Michal Kalecki’s Marxian-influenced “political business cycle” theory blames the government: 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.

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.

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 deterministic cycle formulae.

These fluctuations can be modeled in terms of fluctuations of aggregate demand. However, the main influence in this direction has been 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 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel.

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. Whilst this was a ground breaking work, Baceliers model failed to account for big fluctuations such as the Great Depression. In the 1960’s îBenot Mandelbrot proposed that fluctuation in cotton prices follow a Lvy flight distribution, which have a fat tail allowing greater probability for large fluctuations. In 1995 physicists R. Mantegna and G. Stanley analyzed over a million records of stock market indices from the previous five years, 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. An accurate model is yet to be found.

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. Accordingly, there is a mismatch between the state of economic health as perceived by many individuals and that perceived by the bankers and economists, which most likely drives them further apart politically. However, unlike with issues of long-term economic growth, the economists and bankers may be right to use real GDP when studying business cycles. After all, it is fluctuations in real GDP, not those of measures of well-being, 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 cash flow 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.