Business Cycles (Encyclopedia of Business and Finance)

The business cycle is the ups and downs of the general level of economic activity. All modern, industrialized countries have fluctuations in their rates of economic activity, leading to the observation that one nation's economy is "booming" while another economy is in a "recession." When an economy goes from a positive to a negative rate of growth, it is said to have reached a "peak" and entered a recession. When an economy goes from a negative to a positive rate of growth, it is said to have reached a "trough" and entered a "recovery."

WHAT IS THE BUSINESS CYCLE?

Although something worthy of being called "the business cycle" does exist, attempts at finer classifications or subcategories of business cycles have not been particularly fruitful. Some economists have simply used a broad dichotomy between "major" and "minor" cycles. Descriptively this can be meaningful. A particularly severe recession is referred to as a "depression." The Depression of the 1930s was quantitatively different from the 1990-1991 recession. The output of the economy fell by almost 50 percent in the former and by less than 1 percent in the latter.

It is sometimes useful to speak of the cycles of specific time series; that is, the interest rate cycle, the inventory cycle, the construction cycle, and so forth. Given the diversity of general economic cycles, one can find turns in the general level of economic activity in which individual sectors of the economy do, at least for a time, appear to be independent of the rest of the economy. The most frequently mentioned individual cycles are the inventory cycle, the building or construction cycle, and the agricultural cycle. The standard business cycle is sometimes referred to as the inventory cycle, and some business cycle theorists popularly explain the severity of turns in the economy by the coincidence of timing in the individual cycles.

The idea of the timing of individual time series relative to the general level of business implies specific dates for the business cycle. How does one establish the peaks and troughs for the business cycle? To say whether something leads or lags the business cycle, one must have some frame of reference; hence, the business cycle is referred to as the reference cycle and its peaks and troughs as reference turning points. (See Table 1.)

For the United States, the reference turning points are established by the National Bureau of Economic Research (NBER), a nonprofit research organization. This organization, originally under the guidance of Wesley Claire Mitchell (1874948), pioneered business cycle research in the late 1920s. Today the NBER's decisions regarding the reference cycle are taken as gospel, although they are, in fact, quite subjective. No single time series or group of time series is decreed to be the reference cycle. A committee of professional business cycle analysts convened by the NBER establishes the official peaks and troughs in accordance with the following definition:

Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge in the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximately their own. (Burns and Mitchell, 1946, p. 3)

With slight modification, this definition has been used since 1927. Although most of the definition is self-explanatory, it is not all that rigorous. It does not say something like, for example, if the total output of the economy (real GDP) falls at an annual rate of 1 percent for two consecutive quarters, we have entered a recession. The definition does say unambiguously that business cycles are "recurrent but not periodic." The only real constraint in the definition is that if you define a business cycle, say, from peak to peak, you should not be able to find another cycle of equal amplitude between those two peaks. If so, you did it wrong.

As of mid-2000, Table 1 is still relevant. The most recent turning point identified by the NBER was March 1991. As of April 2000, the U.S. economy continued to expand. Notice from the table that all that is established with regard to the business cycle is the peak and trough of each cycle. This determination tells us absolutely nothing about the rate of rise or fall in the general level of economic activity, nothing about the magnitude of the boom or the severity of the recession. The most commonly used series as a proxy for the business cycle when more than just turning points is required is real GDP if one can get by with quarterly data, or the industrial production index if monthly data are required. The industrial production index is a measure of economic activity published monthly by the Federal Reserve Board in Washington, D.C. As might be guessed from the attention given them by the media, the consumer price index and the unemployment rate are commonly used measures of the severity of the business cycle. Neither corresponds very closely to the reference cycle.

THEORIES OF THE BUSINESS CYCLE

The first lecture in an introductory economics course usually makes the point that the expenditures of one economic unit are the incomes of other economic units. This provides a fairly firm basis for expecting sympathetic movements in many sectors of the economy. A good theoretical basis and substantial empirical support exist for cumulative upward and downward movement in the economy. One sector's expansion is the basis for another sector's expansion, general prosperity lowers risk and makes credit more readily available, and so on; but the weakest part of business cycle theory and the toughest problem in forecasting is turning points. Why does the general upward or downward movement end? Sometimes it is obvious. When, for example, a war begins or ends with a commensurate and dramatic change in military expenditures, the cause of the beginning or end of an economic boom is fairly unambiguous. Historically, however, only a small minority of the turning points are the result of specific, identifiable occurrences. There are many theories as to other causes of the business cycle.

In 1917 an eminent American economist by the name of J. M. Clark published an article entitled "Business Acceleration and the Law of Demand: A Technical Factor in Economic Cycles." His technical factor was the observation that with a fixed capital-output ratio, a small percentage change in final sales would give rise to a large percentage change in investment. Each innovation generates a temporary demand for the required investment goods. Once the initial investment has been made, the replacement market requires a lower rate of investment. This is referred to as the principle of acceleration. Ifit takes $10 worth of steel mills to produce $1 worth of steel per year, growth in demand for steel by $1 will temporarily generate $10 worth of demand for steel mills.

Another early business cycle theorist, Joseph Schumpeter (1883950), noted that nothing is constant over the business cycle and nothing ever really returns to its starting place. That is what makes each business cycle unique. The economy grows and changes with each cycleew products, new firms, new consumers. As Schumpeter observed in 1939, "As a matter of history, it is to physiology and zoology, not to mechanics, that our science is indebted for an analogous distinction which is at the threshold of all clear thinking about economic matters" (p. 37). The economy grows and changes. He referred to this as the process of "creative destruction."

Schumpeter concluded that what most of us consider "progress" is at the source of the problem.

Survey Of Current Business
BUSINESS CYCLE EXPANSIONS AND CONTRACTIONS

He felt that as entrepreneurs come up with new ways of doing things, this disturbs the equilibrium and creates fluctuations. Schumpeter distinguishes between inventions (which may gather dust for years) and innovations, which are commercial applications of previous inventions. Inventions occur randomly through time. Innovations tend to be bunched, thereby creating cycles of economic activity.

Many business cycle theorists give a prominent role to the monetary system and interest rates. Early in the twentieth century, a Swedish economist, Knut Wicksell (1851926), argued that if the "natural" rate of interest rose above the "bank" rate of interest, the level of economic activity would begin to increase. In contemporary terms, the natural rate of interest is what businesses expect to earn on real investment. The bank rate is the return on financial assets in general and commercial bank loans in particular. The boom begins when, for whatever reason, the cost of borrowing falls significantly below expected returns on investment. This difference between the rate of return on real and financial assets generates a demand for bank loans by investors seeking to exploit the opportunity for profit. The economy booms.

At some point the bank rate will start to rise and/or the real rate will start to fall. When the expected rate of return on investment falls below the rate at which funds can be borrowed, the process will begin to reverse itselfnd the recession is on. As bank loans are paid off (or defaulted on), bank credit is reduced, and the economy slows accordingly.

In recent years, business cycles theory has centered on the argument about the source of cyclical instability. The question of the root causes of ups and downs in the level of economic activity received a lot of attention in the 1980s and 1990s.

Figure 1 shows how the parties to the debate are divided up. First, there is the question of whether the private sector of the economy is inherently stable or unstablehich is to say, do the observed fluctuations originate in the government or private sector? On one side are what might be called classical economists, who are convinced that the economy is inherently stable. They contend that, historically, government policy has destabilized it in a perverse fashion. On the other side are what might be called Keynesians, named after the famous British economist John Maynard Keynes (1883946). Keynesians think that psychological shifts in consumers' purchasing and savings preferences and in businesses' confidence are a substantial source of instability.

There is a whole body of literature on political business cycles. As a contemporary economist, William D. Nordhaus, noted in 1989, "The theory of the political business cycle, which analyzes the interaction of political and economic systems, arose from the obvious facts of life that voters care about the economy while politicians care about power" (p. 1). The idea is that politicians in power will tend to follow policies to promote short-term prosperity around election time and allow recessions to occur at other times. The evidence that the state of the economy influences voting patterns is strong, as is the apparent desire of incumbent politicians to influence the economy; but it is difficult to make a case that the overwhelming determinant of the level and timing of business fluctuations is politically determined. At some points in recent history, politically determined policies were apparently a determining factor and at other times not.

With respect to the impact of governmental policies, there is a dispute as to the relative importance of monetary policy (controlling the money supply) and fiscal policy (government expenditures and taxes). Those who believe that monetary policies have had a generally destabilizing effect on the economy are known as monetarists. Most economists accept the fact that fiscal policy, especially in wartime, has been a source of cyclical instability.

As noted above, it is the so-called Keynesian economists who think that the private sector is inherently unstable. While noting the historical instability of investment in tangible assets, they have also emphasized shifts in liquidity preference (demand for money) as an independent

Figure 1

source of instability. As a counter to the standard Keynesian position, there has in recent years arisen a school of thought emphasizing real business cycles. This school contends that nonmonetary variables in the private sector are a major source of cyclical instability. They contend that the observed sympathetic movements between monetary variables and the level of economic activity result from a flow of causation from the latter to the former. The changes in real factors cause the monetary factors to change, not vice versa. In this way they are somewhat like Wicksell, discussed earlier.