Depressions. Recessions. Panics. Booms and Busts. Business Cycles. Many names have been given for these events in history, but does anyone understand what truly causes these cycles, and does anyone have a workable idea of how to get out of one or prevent one? Are they “fixable,” or, as according to Marx, are they just a fatal consequence of the capitalist system that we cannot get rid of?
In fact, these processes have been explored for as long as they have been happening. And, despite what you may think, fewer explanations are given than there have been occurrences in history. And this is a good thing, because it indicates that we aren’t as lost on this topic as the media and pundits seem to think we are. Business cycles are understandable and predictable, and while many contradictory theories still exist on the topic, a few are actually able to explain how they form and how to prevent and cure them.
In this series, I will attempt to elaborate on the so-called “Business Cycle,” bringing the reader up to speed on what exactly is meant by the term, a bit of history of business cycles, and the single best theory that, while not the most politically popular, is able to explain the situation and what to do about it.
So, what is a Business Cycle? Focusing on the United States (with parallel occurrences in other parts of the world), over the past couple of hundred years there have been recurring instances of economic chaos that have gripped the nation. For some reason, and as a complete surprise to most of the citizens, the entire economic structure of the country suddenly and completely breaks down. Businesses of all stripes abruptly fail, unemployment skyrockets, banks collapse, construction halts, and asset values plummet. What’s worse is that these sudden failures are spawned during times of great prosperity. The country, overnight, goes from a state of growing asset values, tremendous production, low unemployment, and terrific opportunity to a state of complete meltdown. Witness the stock market crashes of 1929 and 1987 as well as the dot-com debacle and the housing crisis.
The United States has suffered through many such events in its history. There have been the Panic of 1792, the Panic of 1797, the depression of 1807, the Panic of 1819, the Panic of 1825, the Panics of 1837, 1857, 1873, 1893, 1896, 1907, and 1910, the Recession of 1913, the Depression of 1920-1921, The Great Depression (1929-1942, including the recession-in-a-depression of 1937), the Recessions of 1945, 1958-1961, 1973, 1980, and, again, the dot-com bust of 2000, and The Great Recession. And this doesn’t include many of the smaller regional disturbances that have occurred throughout our history. The consistency and regularity of these occurrences in the failures of business is what has in the past led theorists to believe that there is a cyclical nature to the occurrences, and that some innate flaw exists in the free-market system.
Past theorists, in an effort to explain these occurrences, have offered up many theories, some sound, and many quite silly. Some of the most entertaining examples of theories of business cycles are those that rely on sunspots or other astronomical phenomena. Several prominent economists developed these theories in the 19th and early 20th centuries. According to sunspot theories, changes in sunspots caused changes in harvests, which in turn affected the overall performance of the economy. Perhaps the weirdest of these theories was that of Henry L. Moore, an American economist who was an early user of mathematics. Moore, after considerable statistical work, concluded that there was an eight-year cycle and attributed it to the planet Venus that every eight years passes directly between the earth and the sun. In the end, while modern macroeconomics theory has discounted the recurring cyclical nature, the name has stuck.
So, how is it that these events happen, how are they so sudden and unexpected, and, more importantly, why do they continue to happen?
Keynesian Theory
From the Keynesian economic view, fluctuations in aggregate demand cause the economy to come to equilibrium at levels that are different from the full employment rate of output. In the Keynesian view, the “ideal” economy is one where national consumption and national income are equal. Since income can only come from previous people spending their money on production, then all spending in one period automatically becomes the income for people in the next period. Any reduction in spending can only result, therefore, in a reduction of income for the next period, and therefore a reduction in all economic activity is the result. Saving is seen as a bad thing, as it takes away from everyone a certain portion of the economic activity that could be produced. Since the economy doesn’t behave ideally, fiscal manipulation is required in order to nudge the economy into a more “ideal” state.
From the business cycle standpoint, the Keynesian argument is one where some sort of “unease” grips the market. Keynes, himself, terms this unease as “animal spirits” and discusses how it influences human behavior, and can be measured in terms of “consumer confidence.” This unease causes people to cut back on their spending. This decrease, in turn, results in a reduction of production income, which causes businesses to begin to cut back on their production and their need for inputs and labor. The sequence begins to feed on itself, as people cut back their spending further, which results in a further cutback in production. Eventually, the economy crashes.
The solution, according to the Keynesian model, is to “prop up” the national income through fiscal stimulus. Increased spending (particularly by government) attempts to replace the spending lost because of the “animal spirits,” keeping the national income at its optimal levels, and encouraging people to return to their “optimal” spending habits.
The Keynesian system is a simple, but powerful one. However, its simplicity is also its fatal flaw. Keynesian macroeconomic theory relies on a tremendous amount of aggregation. This means that the Keynesian presumes that all goods are “equivalent” in the economy. It doesn’t matter to the economy whether or not steel is produced or shoes. All of it can be grouped together in one great big lump to be used in their theory. In addition, all capital is aggregated in one lump sum. Which means that they presume equivalence between the steel plant and the convenience store. They (almost) completely ignore the capital structure and the flows of goods between stages in production and the factors that influence them. They also ignore, by giving equality to them, the differences between production goods and consumption goods. To the Keynesian theorist, they are essentially the same. Interest rates are also completely ignored in the Keynesian business cycle theory, and must be accounted for because the increased government spending can drastically affect the interest rates in the economy and these rates drastically affect how the consumer and producer both allocate their money.
Keynesian business cycle theory can be seen as a possible explanation for the causes of the business cycle, but the theoretical flaws are too numerous for anything more. Keynesian economic theory, in general, has, over the years, suffered tremendous setbacks by being unable to predict, explain, or fix any of the major economic downturns since its inception in the 1930’s. In fact, there are many good cases to explain how Keynesian theory actually aggravated existing conditions, rather than making them better (but more on that later).
Monetarist Theory
Another popular economic theory is that of the Monetarists, most notably that of Milton Friedman and Robert Lucas. According to them, an unexpected growth of the money supply and the higher posted prices and wages that go with it make producers and wage earners overestimate the real prices and wages for their products and services. An increase in the money supply means that more money chases the same amount of goods. As a result, prices will increase. But the increased wages and charged prices don’t actually buy more goods. However, the overestimated prices and wages make everyone “think” they are earning more, and this induces an increase in demand and a sequential increase in both production and required labor, thus creating an economic boom.
In the reverse situation, when the money supply unexpectedly declines, or fails to “keep up with” production, real prices and wages are underestimated. A fall in the money supply means that fewer dollars are available to buy goods. Each dollar is then able to go farther, so posted prices fall. The resulting decline in “actual” wages causes people to pull back their spending (even though they can continue to buy the same amount of goods), and a production slump occurs, along with a decrease in employment.
The Monetarist Business Cycle theory contends that the money supply needs to be maintained to prevent economic disturbance. Too much money growth, and inflation will occur. Too little growth, or contraction, and a downturn will result. They contend that in many economic downturns, a previous contraction of the money supply is what caused downturn to occur. A Federal Reserve response to a rise in inflation by decreasing the money supply prompting a major downturn is what is pointed to in explaining the Great Depression and the recession of the 1970’s.
However, the Monetarist explanation suffers from many weaknesses It is much more difficult to control the economy through money supply than the theory implies. In addition, the question of which measure of money supply that needs to be controlled cannot be adequately explained. Further, the monetarist attempt to steer the course between inflation and depression ended up not being able to explain what to do with the stagflation of the 1970’s, where an economic downturn ended up being coupled with high inflation, something that shouldn’t be able to happen in their model. Finally, Monetarist injections of money stimulus to the economy, in the form of Federal Reserve rate targeting, has been unable effectively to spur on the economy since the dot-com boom and bust, and it has, in fact, made the situation worse.
The Alternative
So, what can explain the boom-bust cycle, and can suggest a course of action to get out of a bust, and what can be done to prevent a cycle from occurring in the first place?
To get there, we need to look at some economic basics.
To start with, one of the biggest factors in each economic downturn, has been the influence of banks and the banking system on creating unsustainable money and credit in the system. A quick review of some of the causes of many of the Panics in the US can be found here.
Next, we will cover some of the basics of money, its origins, and its role in the economy.
Shade Tree Economist 