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Business & Investment Cycles

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (expansion or boom), and periods of relative stagnation or decline (contraction or recession)

These fluctuations are often measured using the growth rate of real gross domestic product. Despite being termed cycles, these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern.
 

History of Economic Waves Series

Cycle/Wave Name Years
In 1860, French economist Clement Juglar identified the presence of economic cycles 8 to 11 years long, although he was cautious not to claim any rigid regularity.

Later, Austrian economist Joseph Schumpeter argued that a Juglar cycle has four stages: (i) expansion (increase in production and prices, low interests rates); (ii) crisis (stock exchanges crash and multiple bankruptcies of firms occur); (iii) recession (drops in prices and in output, high interests rates); (iv) recovery (stocks recover because of the fall in prices and incomes). In this model, recovery and prosperity are associated with increases in productivity, consumer confidence, aggregate demand, and prices.

In the mid-20th century, Schumpeter and others proposed a typology of business cycles according to its periodicity, so that a number of particular cycles were named after their discoverers or proposers:

Interest in these different typologies of cycles has waned since the development of modern macroeconomics, which gives little support to the idea of regular periodic cycles.

Business cycles after World War II were generally more restrained than the earlier business cycles. Economic stabilization policy using fiscal policy and monetary policy appeared to have dampened the worse excesses of business cycles. Automatic stabilization due to the aspects of the government's budget also helped defeat the cycle even without conscious action by policy-makers.

Identifying the Business Cycle
In 1946, economists Arthur F. Burns and Wesley C. Mitchell provided the now standard definition of business cycles in their book Measuring Business Cycles.

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 into the expansion phase of the next cycle; in duration, business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar characteristics with amplitudes approximating their own.

According to A. F. Burns, Business cycles are not merely fluctuations in aggregate economic activity. The critical feature that distinguishes them from the commercial convulsions of earlier centuries or from the seasonal and other short term variations of our own age is that the fluctuations are widely diffused over the economy--its industry, its commercial dealings, and its tangles of finance. The economy of the western world is a system of closely interrelated parts. He who would understand business cycles must master the workings of an economic system organized largely in a network of free enterprises searching for profit. The problem of how business cycles come about is therefore inseparable from the problem of how a capitalist economy functions.

In the United States, it is generally accepted that the National Bureau of Economic Research (NBER) is the final arbiter of the dates of the peaks and troughs of the business cycle. An expansion is the period from a trough to a peak, and a recession as the period from a peak to a trough. The NBER identifies a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production".
 

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. For Milton Friedman calling the business cycle a "cycle" is a misnomer, because of its non-cyclical nature. Friedman 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 modeled as shocks to a system.

In the tradition of Slutsky, business cycles can be viewed as the result of stochastic shocks that on aggregate form a moving average series.

Explaining the Business Cycle
The explanation of fluctuations in aggregate economic activity is one of the primary concerns of macroeconomics. The most commonly used 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, then in theory monetary policy and fiscal policy can have a positive role to play rather than simply causing inflation or diverting funds to inefficient uses.

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. Paul Samuelson's "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 determines the level of aggregate output (multiplier), and is determined by aggregate demand (accelerator).

In the Keynesian tradition, Richard Goodwin accounts for cycles in output by the distribution of income between business profits and workers 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 periods of high unemployment, wages tend to fall. According to Goodwin, when unemployment and business profits rise, the output rises.

Keynesian economist Hyman Minski has proposed a explanation of cycles founded on fluctuations in credit, interest rates and financial frailty. 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.

Keynesian views have been challenged by real business cycle models in which fluctuations are due to technology shocks. This theory is most associated with Finn E. Kydland and Edward C. Prescott. They consider that economic crisis and fluctuations cannot stem from a monetary shock, only from an external shock, such as an innovation.

Following the tradition of Adam Smith and David Ricardo mainstream economists have usually viewed the departures of the harmonic working of the market economy as due to exogenous influences, such as the State or its regulations, labor unions, business monopolies, or shocks due to technology or natural causes (e.g. sunspots for S. Jevons, planet Venus movements for H. L. Moore). Contrarily, in the heterodox tradition of Sismondi, Juglar, and Marx the recurrent upturns and downturns of the market system are an endogenous characteristic of it.

Mitigation
Most social indicators (mental health, crimes, suicides) worsen during economic recessions. As periods of economic stagnation are painful for the many who lose their jobs, there is often political pressure for governments to mitigate recessions. Since the 1940's, most governments of developed nations have seen the mitigation of the business cycle as part of the responsibility of government.

Since in the Keynesian view, recessions are caused by inadequate aggregate demand, when a recession occurs the government should increase the amount of aggregate demand and bring the economy back into equilibrium. This the government can do in two ways, firstly by increasing the money supply (expansionary monetary policy) and secondly by increasing government spending or cutting taxes (expansionary fiscal policy).

However, even according to Keynesian theory, managing economic policy to smooth out the cycle is a difficult task in a society with a complex economy. Some theorists, notably those who believe in Marxist economics, believe that this difficulty is insurmountable. Karl Marx claimed that recurrent business cycle crises were an inevitable result of the operations of the capitalistic system. 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, since the 1960's neoclassical economists have played down the ability of Keynesian policies to manage an economy. Since the 1960s, economists like Nobel Laureates Milton Friedman and Edmund Phelps have made ground in their arguments that inflationary expectations negate the Phillips Curve in the long run. The stagflation of the 1970's provided striking support for their theories, defying the simple Keynesian prediction that recessions and inflation cannot occur together. Friedman has gone so far as to argue that all the central bank of a country should 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.

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 Michal Kalecki who 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.

Marxian Economics
For Marx the economy based on production of commodities to be sold in the market is intrinsically prone to crisis. In the Marxian view profit is the major engine of the market economy, but business (capital) profitability has a tendency to fall that recurrently creates crises, in which mass unemployment occurs, businesses fail, remaining capital is centralized and concentrated and profitability is recovered. In the long run these crises tend to be more severe and the system will eventually fail.

Some Marxist authors such as Rosa Luxemburg viewed the lack of purchasing power of workers as a cause of a tendency of supply to be larger than demand, creating crisis, in a model that has similarities with the Keynesian one. Indeed a number of modern authors have tried to combine Marx's and Keynes's views. Others have contrarily emphasized basic differences between the Marxian and the Keynesian perspective: while Keynes saw capitalism as a system worth maintaining and susceptible to efficient regulation, Marx viewed capitalism as a historically doomed system that cannot be put under societal control.

Anarcho-syndicalist and Libertarian Socialist
According to anarcho-syndicalism and related anarchist-libertarian socialist economic theories, the key to understanding the workings of the business cycle is the workers' erosion of income as capital investment "pulls" money towards it over time, eventually resulting in a collapse of demand for the goods the system produces.

In this theory, the fact that profit-seeking capitalists plan not with respect of demand at the present moment, but with respect to future demand also drives the cycle. The need to maximise profits results in more and more investment in order to improve the productivity of the workforce (i.e. to increase the amount of surplus value produced). A rise in productivity, however, means that whatever profit is produced is spread over an increasing number of commodities. This profit still needs to be realised on the market but this may prove difficult as capitalists produce not for existing markets but for expected ones. As individual firms cannot predict what their competitors will do, it is rational for them to try to maximise their market share by increasing production (by increasing investment). As the market does not provide the necessary information to co-ordinate their actions, this leads to supply exceeding demand and difficulties realising sufficient profits. In other words, a period of over-production occurs due to the over-accumulation of capital.

Anarcho-syndicalist theory holds that there are means by which capitalism can postpone (but not stop) a general crisis developing as a result of the business cycle. The extension of credit by banks to both investors and consumers is the traditional, and most common, way. Imperialism, by which markets are increased and profits are extracted from less developed countries and used to boost the imperialist countries profits, is another method. Another is state intervention in the economy (such as minimum wages, the incorporation of trades unions into the system, arms production, manipulating interest rates to maintain a "natural" rate of unemployment to keep workers on their toes, etc.). Another is state spending to increase aggregate demand, which can increase consumption and so lessen the dangers of over-production. However, these are considered to have (objective and subjective) limits and can never succeed in stopping depressions from occurring as they ultimately flow from capitalist production and the need to make profits.

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.

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 capital 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 modern examples of artificially abundant credit subsidizing unsustainable malinvestment.

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