An abstract business cycle
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 alternances "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.
The main types of business cycles enumerated by Joseph Schumpeter and others in this field have been named after their discoverers or proposers:
- the Kitchin inventory cycle (3-5 years) -- after Joseph Kitchin .
- 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.
Ed Dewey, who formed The Foundation for the Study of Cycles, studied cycles in everything -- including economic data. Based on Dewey's periods, the cycles' average periods are: Kondratieff 53.3 years; Kuznets 17.75 years; Juglar 8.88 years; and Kitchen an interaction of 2.96 years, 4.44 years and 3.39 years.
In the Juglar cycle, which is sometimes called "the" business cycle and is the main focus of this entry, 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 moderate the cycle even without conscious action by policy-makers.
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, and until 2001 or so, a comparable period of economic malaise was avoided. 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. This was perhaps because his ideas were uninformed by Keynesian economics.
No-one argues that managing the money supply and fiscal 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.
At least until the 1990s, many business cycles, including the Great Depression, social-democratic and new liberal forms have been introduced, such as the reforms of Franklin D. Roosevelt (the "New Deal"), in the hopes that they would be empowered to reduce the severity of the next cycle. Keynesian economics has been applied, off and on, by most of the "Western democracies". The result of this has been strong centralization of economic power in all Western democracies, and control of money by their central banks, often in alliance with their politically-powerful banking and financial sectors. It is also unclear whether or not the Marxian theses apply: was the U.S. and Western European stagflation of the 1970s a result of a doomed effort to suppress the crisis tendencies that Marx pointed to? Or was the dramatic recession of 2001 a re-assertion of those tendencies?
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 overinvestment.
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 that 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.
In the current era, most business cycle theory follows Keynes to stress the role of fluctuations of aggregate demand, including the multiplier and accelerator effects. On the other hand, real business cycle models associated with blame 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.
While both of the these theories blame the economy for causing cycles, 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. Whatever the validity of this theory, the U.S. Federal Reserve seems to have encouraged most of the recessions in the United States between World War II and the year 2000 by raising interest rates.
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 cashflow 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.
Do business cycles really exist?
Psychological & lead/lag cycles
Exogenous shock-based cycles
Keynesian theories of the cycle:
Endogenous theories of the cycle
Last updated: 05-13-2005 00:54:12