The Economic Cycle
What is the Cycle??
Over history, there have occured cyclical patterns of high economic growth to low or negative economic growth following a pendulum like swing. This pattern is perpetual and is readily illustratable over the past years in US and UK economic data, and appears an analogous trait of human behaviour; ‘everybody has their ups and downs’ whether it be relative prosperity and unprosperity in a career or a relationship.
Note: The Economic Cycle may also be named as the trade or business cycle.
Stages of the Cycle
The economic cycle is drafted in its simplest format above, typically evolving from boom to bust.
Boom: Period of high economic growth and rising asset prices, characterised by excessive optimism often lasting for a few years.
Recession/Downturn: When the ‘irrational exuberance’ is replaced by unjustifyable pessimism. Typically crashing asset prices and slow or negative economic growth lasting from a few months to several years. The official definition of a ‘recession’, is two successive quarters of negative growth.
Notice the periodic, pendulum swing behaviour of the US data, datinjg back to the 1850′s: Ponder over the idea that policy intervention (Federal Reserve introduction in 1913 and post Depression Keynesian fiscal ac) appears to have prolonged economic cycles rather than smoothed or eliminated them.
Explanations of Cycles…
For years, economists have pondered why these cycles happen, what causes them? Many explanations have come about why activity can be volatile:
Due to some conflicting opinions Keynes v Hayek has become the biggest thang since Tupac v Biggie
Using the Keynesian-Cross framework, firms scale their levels of employment and subsequent output based on changes is unsold stock, or ‘inventory’.
Where firms are moving in lockstep in doing this, a cycle results: Overproduction in a boom and a lack of corresponding aggregate demand shall result in firms cutting back and firing people, increasing unemployment and reducing total incomes to the point of an equilibrium of supply and demand. Vice versa of course applies.
Taking the level of investment to be characterised by the expected marginal efficiency of capital and the accelerator effect, this model rationalises the exaggerated and correlated relationship between net investment and GDP:
In periods of high economic growth, an optimistic expected MEC explained by the irrational ‘animal spirits’ behaviour of firms causes over-investment and excess capacity. At the point where it is realised they may have over-invested, business decision makers cut back on replacement investment and employment of labour; factoring in the multiplier effect leads to less income in the circular flow, the accelerator turning this to less investment and etc.
Replacement investment, of capital which remains operating in the midst of the downturn is said to jump-start the lumbering economy back into growth through the same principle. Albert Aftalion therefore said that the lifetime of capital is important in defining the length of the downturn: How long will it take before mass, almost unison replacement investment reverses this economic destruction? Keynes et al built on Aftalion’s endogenous business cycle theory.
Asset Price Cycles
Rising asset prices through a rising stockmarket or housing market can elicit higher aggregate demand
- Consumption rises through the wealth effect
- Investment rises through rising consumption and equity values
The 19th century economist William Stanley Jevons devised a theory in the days when agricultural output comprised a significant proportion of the economy, and thus GDP depended a lot on the quality of the yearly harvest. As the behaviour of the Sun strongly affects the quality of harvest, Jevons correlated sunspot cycles with cyclical economic behaviour. This may still be applicable in less developed, agriculture oriented economies.
Monetarist Theory of Cycles
Milton Friedman and Anna Schwartz brought Monetarism to the front line, and rejected the idea of neutrality of money with the theory of business cycles corresponding to central bank’s altering the money supply. Friedman went further with the hypothesis that the 2 worst periods of economic performance in recent history, the Great Depression and the Long Depression of the 1870′s were prolonged by a significant contraction in the money supply prior to and during the period.
The theory underlines the importance of money in it’s function as a medium of exchange and store of value. When eradicated, money becomes more scarce and interest rates rise as the economy chokes up, as there is not enough grease for the wheels. This real effect is illustrated in the Monetary Transmission Mechanism model.
Long Run Cycles
The Kondratiev Cycle
The Russian economist suggested that economic cycles oscillate about an underlying, very long run cycle which reaps every 50-70 years, coinciding with ground-breaking advances in technology. I shall offer an explanation as to how this is a causal factor of these very long run cycles.
Initial slowdown When we find new, more cost efficient ways to produce, it usually occupies a large offloading of labour which become replaced with machines, or whose skills are no longer needed. The huge rise in structural unemployment, aswell as lossmaking strikes causes a slowdown in output.
Boom Over time, the unemployed may be retrained, young people go into productive careers, reducing structural unemployment over time. Not to mention to millions of extra jobs that are created due to the technology, like software engineers and googleplex workers due to the internet. Workers become very productive with the technology, especially younger, who have trained with it all their lives. Hence the tech causes huge expansion of jobs, output and wealth, after structural effects have reduced.
The Economic Cycle in the UK…..
Here we can see similarities between UK growth and the ideal model. Cycles following a fairly regular period in recent years.
Boom and Bust
1973-74 The Barber Boom Named after the Chancellor of the Exchequer at the time, the first period of a huge government spending led growth project caused a rapid rise in growth, and inflation.
1974-76 The Oil Crises. OPEC(oil exporting countries) rapidly increased the price of crude due to surges in global demand and a collusive agreement. Costs of production rose, seeing firms offloading their workers and rise the prices of their goods. First notable period of stagflation, causing problems with Keynesian policies.
1980-82 Bad Monetary Policy An excessly high rate of interest, over 15% in the UK and US, caused a severe recession by depressing entreprenuer spirit and consumption, something Thatcher wanted to expand via free markets.
1986-88 The Lawson Boom. Chancellor Nigel Lawson prompted the second period of huge government driven growth. Again, this was unsustainable, caused by large borrowing, creating very high inflation in goods aswell as asset prices. An 18% rate of interest followed and so did a large recession when the bubble ‘burst’.
1990-92 Burst of Leverage Bubble. The huge rise in asset(mainly house) prices caused by the Lawson Boom saw a rise in borrowing on the back of securities. The housing crash followed, leaving many in negative equity, bankrupting people and business.
1997-2000 Stockmarket Boom.
The revelation of the internet led to a huge excitement over internet stocks, which caused the greatest bubble in stockmarket history. Some funds and share prices returned over 100% 1998-99, leading to many overhyped dot coms to get into £millions debt setting up and relying on share capital to keep them afloat. Price/Earning ratios reached as high as 60 in some cases.
Corruption over figures to juice up share prices(Enron, Worldcom, aswell as other factors) eventually led to firms with huge public investments going bankrupt, leading to mass pessimism and falls in 2001 (also discussed Individual Firms Behavior). Although most of this happened in the US, it certainly had it’s effects in the UK
2001-2003 Slight Slump and Switch to Housing.
A combination of the Wall Street crash and the collapse of the World Trade Centre caused a slowdown of trade. Housing markets were still rising, however, and they offered the hope that shares had promised earlier to investors.
2004-07 Financial Sector Driven Boom
The extreme confidence that house prices could only go up caused many to borrow to the extreme. The financial sector lapped up the confidence, with major banks offering sub prime(high chance of default) loans to anybody to exceed performance targets, and often selling those loans on to others giving them a AAA rating.
Major funds and investment banks also took a high risk of leveraged investments in financial markets, giving huge returns when the times were good.
2008-10 Financial System Crash
The banks found themselves in difficulty when those sub prime loans just could not be repaid, and the government had to step in to save peoples savings from going under. Collapse of Lehman Brothers in Sept 2008 created huge panic, and the funds suddenly found their AAA rated Mortgage Backed Securities were toxic assets.
The US and UK’s comparative advantage caused a global recession, due to the animal spirits of ‘corruption’ and ‘confidence’ throughout. ‘The Economy was placed on life support’ says George Soros.