Chapter 15

Business Cycles

Business Cycles are Now Less Frequent

From 1789 through 1982, a recession occurred about once every four years. Since then, there have been only 2 mild recessions, in 1990-91 and 2001. During the 2001 recession, final sales i.e., GDP minus inventory investment did not actually decline.

Measuring the Business Cycle

The actual starting and ending dates of each business cycle are determined by the Dating Committee of the National Bureau of Economic Research. These dates are based on the behavior of the indexes of leading, coincident, and lagging indicators. Sometimes the Committee takes a long time to make up its mind. For example, even though the 2001 recession ended in November of that year, this was not officially announced until July 2003, some 20 months later.

Index of Leading Indicators

The index of leading indicators consists of economic data series that usually turn up or down several months before general economic conditions change. The major problem with this index is that it provides too many false signals, indicating that a recession is imminent when in fact no turning point is about to occur. The stock market is often mentioned as an important leading indicator. Yet after the economy recovered in late 2001, the stock market fell almost steadily during the first three quarters of 2002.

Index of Coincident Indicators

This index measures where the economy is right now. It consists of four components: payroll employment, real business sales, industrial production, and real personal income excluding transfer payments. Although not widely followed, this is a very useful index for pinpointing where the economy is right now. It is more accurate than real GDP, and is also available on a monthly rather than a quarterly basis.

Index of Lagging Indicators

This index is supposed to provide verification that the economy has in fact entered a recession or recovery. However, even here the index did not work very well, failing to alert the Dating Committee that the recession had ended in late 2001. As a result, this index is seldom mentioned any more.

What Determines a Recession?

In general, the answer is a decline in real GDP and production and a rise in the unemployment rate. However, sometimes these changes are small enough that the result is a pause in the expansion but not an actual downturn. There is no dictionary definition for a recession, but generally, the unemployment rate must rise at least 2% and industrial production must decline for two consecutive quarters. It was once thought that real GDP also had to decline for two consecutive quarters, but that did not occur in several recessions.

Recessions Recurring but not Regular

The timing of business cycle recessions is quite erratic. There were no recessions from 1961 to 1969, then four of them occurred in the next 12 years. That was followed by only 2 recession in the next 20 years. The causes of recessions are somewhat different, but once the downturn has started, a recurring pattern of economic activity does occur.

What Causes Recessions?

Previously we noted that since 1969, every recession has been preceded by an inverted yield curve, and that there have been no other times that the yield curve became inverted. But what causes the yield curve to become inverted? It would be a serious mistake to say that monetary policy causes recessions. If anything, monetary policy has mitigated the severity of recessions in the post World War II period.

What Causes an Inverted Yield Curve?

Often, the rate of inflation rises, and the Fed tightens in order to keep inflation from spiraling even further. Even if inflation does not rise, though, interest rates may rise because of an overheated economy or a bubble in the stock market. The 2001 recession was caused more by excess capacity rather than the inverted yield curve per se, because credit was not restricted. Nonetheless, the yield curve remained an accurate indicator of the upcoming recession.

Non-monetary factors causing recessions

Besides monetary tightening reflecting overheating, or explicit restraints on credit through legislation, what other factors cause business cycle recessions? End of wartime spending Excessive fiscal restraint Energy or other supply shocks Excess capacity Strikes or other major disturbances International developments

Impulse and Propagation

The impulse, or initial shock causing a recession, may be due to a large variety of figures, as shown on the previous slide. However, once the downturn is under way, a recurring pattern of economic reactions generally occur. Thus even if the impulse is quite different, the propagation as the downturn spreads through the economy is usually quite similar.

The Lower Turning Point

We have suggested several reasons for why recessions start. Why do recoveries start? Monetary easing: lower interest rates and greater availability of credit Fiscal stimulus: usually but not always Workoff of excess capacity, and decline in excessive inventory stocks. Weaker dollar may stimulate net exports in the short run.

Length of Recent Recessions

It usually takes the Fed about three months to recognize a recession and start easing, and about six months before that change in policy takes effect. Thus most recessions including the 2001 downturn last about 9 months. Two postwar recessions have been six months longer, because the Fed initially failed to ease or started to ease but then reversed course when inflation accelerated and tightened again. Other than that, there have been no exceptions in the U.S. economy in the postwar period.

Suppose Everything Went Wrong

But suppose after a recession was underway, the Fed tightened, credit was restricted, taxes were raised and government spending was cut, and foreign trade plunged because tariffs were raised. Under those circumstances, the recession might continue indefinitely and intensify into a depression. That is what happened to the U.S. economy from 1929 to 1933. Presumably no administration would make those kinds of mistakes any more.

Old and New Business Cycle Theory

From 1959 through 1990, the U.S. economy went through 6 recessions that all showed the same pattern. Inflation increased, productivity growth slackened, the Fed tightened, the yield curve inverted, credit was restricted, and real GDP declined. The 2001 recession was quite different. The core inflation rate did not rise at all and productivity growth accelerated. Yet a recession still occurred and the bursting of the stock market bubble was not the major impact, because most of that happened later.

Business Cycle Theory, Slide 2

We have already mentioned excess capacity as one of the major reasons for the 2001 recession. This is not a new theory. In fact it is a very old theory, one that was common before the Great Depression of the 1930s. It all goes back to the fundamental identity I = S. No matter what theory is used, a recession occurs when ex ante I falls below ex ante S and the decline in interest rates is not sufficient to close the gap.

Business Cycle Theory, Slide 3

Why would ex ante I fall? The fundamental relationship remains the comparison between the cost of capital and the marginal productivity of capital (mpk). When the former is higher than the latter, investment declines. Usually that imbalance occurs because interest rates rise. But suppose they do not. In that case, investment would keep rising. Eventually the capital stock would increase so much that the mpk would decline, and it would no longer pay to invest because of excess capacity. When that occurs, a recession would start even if interest rates and the cost of capital had not risen at all.

Business Cycle Theory, Slide 4

That cycle would caused primarily by a technological boom, which would initially boost the mpk relative to the cost of capital and would keep capital spending rising rapidly much longer than would ordinarily be the case. Hence the expansion phase of the cycle would be longer than usual. That is what happened in the 1990s.

Real Business Cycle Theory

The fact that some business cycles are caused by shifts in technological progress is one of the key elements in what is known as Real Business Cycle Theory. In general, RBC says that most cycles are caused by various shocks, including shifts in technology, but also due to energy shocks, wars, international disturbances, and strikes and other major domestic disruptions. RBC says that changes in monetary and fiscal policy play only a secondary role in causing business cycles.

Fed Does Not Usually Cause Recessions

Sometimes this point is confusing because it seems that recessions invariably occur shortly after the Fed has tightened. However, most economists no longer think if indeed they ever thought that the Fed causes business cycles. It reacts to other factors that cause business cycles, namely an imbalance between the cost of capital and the MPK. The expansion invariably comes to an end when the former exceeds the latter, whether that is due to a rise in interest rates or a decline in the MPK due to excess capacity. The Fed does not cause business cycles; usually it reduces them.

Fiscal Policy Usually Reduces Rather than Magnifies Recessions

The same comment can generally be made about fiscal policy. Automatic stabilizers help reduce the length and severity of recessions. Also, discretionary fiscal stimulus often occurs during recessions, although given the length of time required to pass legislation, sometimes the stimulus does not occur until after the recession has ended. Of course, fiscal policy can cause recessions, especially when market forces are subverted by wage and price controls or other interferences with market-clearing mechanisms.

Errors Have Been Made

It is, of course, possible, for fiscal and monetary policy to contain errors that lengthen and deepen recessions. That happened in the 1930s, and to a lesser extent occurred in 1968 and 1973. Since the end of World War II, though, fiscal and monetary policy in the U.S. have generally worked to ameliorate, rather than exacerbate, business cycle downturns.

Business Cycles: Endogenous or Exogenous?

Without monetary and fiscal stabilizers, regular cyclical fluctuations in the difference between the cost of capital and the MPK would probably cause recessions on a fairly regular basis. In an optimal world, monetary and fiscal policy could regulate the economy well enough that any imbalances would remain minor. However, even if policy makers were unusually capable, that still does not take account of expectations. Suppose everyone believed the business cycle had been conquered and there would never be any more recessions. Many consumers and businesses would leverage their positions, leading to a runaway stock market. Eventually, the excessive optimism would turn on itself, and a recession would develop anyhow.