Long run is a misleading guide to current affairs. In the long run we are all dead.[213]
John Maynard Keynes
Chapter 4 already discussed certain aspects of economic cycles, making it unnecessary to repeat it here. Economic cycles are a natural phenomenon, occurring even in the absence of pro-cyclical human intervention. Consider sunspots. Their intensity on the sun’s surface fluctuates over an approximately eleven-year cycle.[214] Peak sunspot activity increases the gravitational pull of the sun and disturbs the fragile gravitational balance on the earth’s crust, sparking an increase in volcanic activity. The increased spewing of millions of tons of volcanic ash, smog, and dust into the stratosphere slightly blocks the sun’s rays for a year or two. The haze cools the earth’s atmosphere, perhaps by as much as 1°C, thereby reducing water evaporation and rainfall.[215] The drop in precipitation can range from mild, with only a slight decline in agricultural yields, to drastic, resulting in droughts and even famines. Consequently, agricultural prices could rise moderately or sharply.
Indeed, severe droughts can propel more than spirited inflation. History is replete with examples of droughts causing famines, wars, and mass migrations, including one that reportedly thrusted the Mongol Empire onto the world, to become the largest empire in history.[216] Apparently, a major volcanic eruption in Iceland also preceded the French Revolution; the drought that ensued drove the hungry French farmers to rebel.
In addition, there are manmade cycles. Joseph Schumpeter‘s creative destruction theory attributed major economic cycles to entrepreneurs undertaking large investments to supply products that incorporate new inventions and innovations, thereby spurring economic growth. In addition, changes in tastes, optimism, and pessimism can affect private consumption and investment, and therefore economic cycles. Regrettably, inappropriate government fiscal, monetary, and foreign policies are probably the largest factor in amplifying economic cyclicality, such as a restrictive monetary policy during a contraction, an abrupt cut in military spending at the end of a war without a compensating expansion in civilian public expenditure, or a distant war spiking oil prices.
Economic Cycles as Externalities
The unified theory of macroeconomic failure considers economic contractions negative externalities requiring government intervention. Keynes also treated the Great Depression as a negative externality, but without labeling it as such. The cause of recession or depression is frequently a shortfall in aggregate demand, which the private sector, on its own, cannot offset in a reasonable time, if at all. Given the slack in the economy during a contraction, government expenditure on infrastructure, for example, is much more stimulative than the actual amount spent due to the feedback from the so-called multiplier effect in stimulating consumption, employment, and aggregate demand. Consumption in particular has a large impact on economic activity, given that in the United States, for example, it represents about two thirds of the gross domestic product (GDP). The increase in aggregate demand also improves capacity utilization, and with economies of scale, improves profitability, business confidence, and, therefore, the prospects for new private investments, which together spur the economy to further expansion. A recovery in asset prices also has a wealth effect that prompts a mild increase in consumption.
The public benefits from the fiscal stimulus of investing in infrastructure include the new infrastructure itself, the reduction in unemployment and social security disbursements due to increased employment, the increase in tax revenue due to increased economic activity, as well as all the benefits accruing to the private sector from the economic expansion. Taken together, these far exceed the social cost of the new infrastructure. Accordingly, the slack in the economy during a contraction makes the public benefits from public expenditure, on say infrastructure, exceed its cost, hence, the existence of an externality during a contraction.
The critical element in the foregoing analysis is the presence of economic slack, which implies public expenditure is not displacing or competing with private expenditure but rather stimulating it. It also implies that temporary stimulation that is limited to taking up some of the slack in the economy does not cause the economy to overheat, with only mild inflationary effects, if any. The foregoing also implies that the stimulative element of public expenditure must taper off as the economy recovers, to avoid displacing the private sector and forestalling the potential inflationary effects of excessive aggregate demand. Thus, as the economic slack disappears, so does the cyclical externality.
Similarly, an inflationary expansion is a negative cyclical externality too because excessive aggregate demand exceeds the capacity of the economy to deliver, calling for demand restraint by curtailing monetary expansion and postponing noncritical infrastructure to avoid displacing the private sector.
Given the foregoing, by implication, any measure that causes or amplifies cyclicality is itself a negative externality, as in the case of debt.[217]The other factors that amplify cyclicality include the withholding of fiscal stimulus during a down turn and the non-curtailment of stimulative measures during an expansion.
Given the present decisive influence of business over government decisions, it is inappropriate to classify government decisions as exogenous. Therefore, to pin down the role of economic actors, including governments, in precipitating or smoothing economic cycles, one needs to define endogenous variables as those generated within a political and economic system, and the truly exogenous as those generated outside that system.
Accordingly, war is an endogenous variable for the country that initiates it, but exogenous for the defending country and the rest of the world. This is a stricter definition than the prevalent one. Economists have traditionally classified all wars and threats of war as exogenous variables, disregarding that it is an endogenous decision to the party that initiates it. Similarly, if a country initiates economic sanctions, boycotts, or other measures that threaten the vital interests of another country, compelling the latter to respond militarily, then war in that case is an endogenous variable for the initiator of such measures, rather than the initiator of actual hostilities.
Thus, war can be either exogenous or endogenous, depending on the initiator of the chain reaction that leads to war. In most cases, making this classification is easy enough, although, at times, as with World War I, the sequence of events is complex, making a clear distinction difficult.
Surges in oil prices since the 1970s have all been associated with war, or the threat of war, in the Middle East.[218] Thus, the Arab-Israeli War (1973), the Iraq-Iran War (1980-1988), the First Gulf War (1990-1991), the September 11 events in 2001 followed by the War on Afghanistan (2001-present), the War on Iraq (2003-2011), and the perceived threat of an American attack on Iran in 2007 all resulted in spikes in oil prices. Since the 1970s, spikes in the oil price have preceded and contributed to all recessions. Thus, the 2007 oil price spike slowed the economy, while the rise in interest rates brought forward the simmering crisis in sub-mortgages, tipping the economy into the Great Recession of 2008. Hence, for most countries around the world, the recessions they experienced were frequently the result of exogenous variables. However, to the extent that the United States encouraged, facilitated, waged, or threatened war, resulting in an oil spike followed by a US recession, it was the result of an endogenous US policy variable. This approach has the advantage of illuminating the impact of foreign policy decisions on economic activity and assigning economic responsibility for its consequences.
The Wall Street crash in 1929 followed by the Great Depression, surprised Irving Fisher (1867-1947) because he had expected the boom to continue. Although Fisher was a neoclassical economist, the Great Depression convinced him that debt creation induces economic expansion and fuels asset bubbles, while credit contraction bursts them, followed by recession or depression. Regrettably, Fisher had not foreseen the Great Depression and, for a while, continued to doubt it was underway although it was becoming self-evident. This undermined his credibility and limited the attention given to his seminal work Debt-deflation theory, published in 1933.[219]
However, since the 1980s, Fisher’s theory has enjoyed a comeback among mainstream post-Keynesian economists like Hyman Minsky, who developed it further, while Steve Keen (b. 1953) modeled Minsky’s financial instability mathematically.[220] Alas, Fisher offered no structural solution to the problem of credit and indebtedness, such as replacing usurious financing to dampen the amplitude of economic cycles.
Clearly, heavy doses of credit expansion fuel speculative asset price bubbles, which ultimately burst to trigger financial crises and painful contractions. Cycles with markedly different degrees of indebtedness have occurred since 1929. The best-publicized debt-driven contractions include the Great Depression, the twin Volker recessions in the early 1980s, the Internet bubble in 2000, and the sub-prime crisis in 2008. It is economically less disruptive and more efficient to have longer and gentler expansions and shallower contractions, along with smoother instead of violent fluctuations in asset prices (e.g., stocks, bonds, properties).
The following presents aspects of Fisher’s credit expansion-contraction cycle with some elaboration:
1. Excessive expansion of housing credit fuels higher house prices. This attracts speculative demand and expands housing construction, employment, and consumption. Ultimately, an excess in housing inventory builds, followed by tumbling house prices, housing credit, housing construction, employment, and consumption.
2. Credit expansion also amplifies the cycle in stock prices. For example, a 50 percent margin policy permits the doubling of the size of stock portfolios on credit, lifting stock prices. Higher stock prices increase the equity of stock accounts with brokers, providing more margin borrowing and purchasing power, which feeds the cycle of stock purchases followed by higher stock prices and a further boost to margin availability. At some point, the market tops and begins to decline, inducing the cycle to work in reverse as a price-credit contraction cycle. Lower stock prices diminish the market value of the stock portfolios, triggering margin maintenance calls, which require investors to liquidate stocks to maintain credit margins, pushing prices lower and so on. Thus, borrowing on margin exaggerates the rise and fall of stock prices.
3. The availability of credit induces speculative, herd behavior, which exacerbates investment performance. Credit availability increases as stock prices rise, facilitating more purchases at higher prices. As a result, margin availability and maximum portfolio positions peak near market tops. On the other hand, credit availability contracts as stock prices fall, inducing stock selling at lower prices. Hence, minimum stock positions coincide with minimum credit availability near market bottoms.
In other words, margin finance results in the worst investment strategy imaginable because it violates the cardinal rule of shrewd investing: buy low and sell high. Instead, it finances and, subsequently, enforces an irrational investment strategy: buy high and sell low. Record stock turnover around market peaks and bottoms supports this conclusion. Moreover, this naïve investment strategy, enforced by credit availability, gives astute investors the opportunity to act as counterparties, by selling at high prices and buying at low prices, thereby significantly increasing their return. The credit cycle has a similar negative effect on the performance of many investors in other asset classes as well.
To protect the investing public, regulators should ban margin credit for stocks. Failing that, regulators should require margin availability to peak at say 50 percent after a market correction of 40 percent or more and for the margin availability to decline gradually to zero as the market recovers to say 90 percent of its previous high. This mechanical rule would permit purchasing more stocks at lower prices and enforce credit repayment and progressive selling at higher prices, thereby harnessing the markets’ speculative tendency to rise and fall to improve the public’s investment performance. Such a policy also has the added advantage of making stock cycles gentler.
4. Debt artificially inflates asset prices and investors’ wealth, inducing them to boost their consumption as markets rise. When the bubble bursts, debt works in reverse, excessively reducing wealth and consumption. Thus, the credit cycle amplifies the wealth effect on consumption, thereby indirectly amplifying cyclical fluctuation.
5. Bankers tend to relax credit standards during an expansion, thereby accelerating the pace of expansion, as well as its premature end. In contrast, during a recession, when credit is dear, bankers become cautious and raise their credit standards, making a recession deeper than it would be otherwise. These pro-cyclical credit policies increase the amplitude of cycles.
6. Easy credit finances excessive business investment during the expansion phase, resulting—during the contraction phase—in greater excess capacity, larger investment cutbacks, heavy indebtedness, and increased business failures.
7. Monetary authorities tend to misjudge the state of the economy. During an upturn, they tend to delay raising interest rates and then raise it too high and too fast. During a downturn, they tend to delay cutting interest rates and then cut them but not enough. Both effects tend to amplify cyclical swings.
8. National debt is also pro-cyclical. During an expansion, national debt facilitates more government spending than is available based on its tax revenue, thereby exaggerating the expansion. During a recession, the deficit becomes too big, inducing banks to lobby the government to adopt austerity, consequently making the recession deeper.
The heavy indebtedness of other countries further amplifies this effect. Thus, after decades of debt-financed overspending, excessive national debts have prompted the governments of Greece, Italy, Portugal, Spain, Ireland, Hungary, Britain, France, and other nations to cut their budgets in the depth of contractions. As a result, they are facing widespread unemployment, unrest, deteriorating social services, and larger budget deficits, while their national debts continue to spiral out of control.
9. When the debt burden becomes too heavy, it seeds public unrest and prompts governments to resort to the printing press. Inflation torches debt denominated in domestic currencies, which adds another source of economic and political instability. On the other hand, the repudiation of debt denominated in foreign currencies can reduce the debt burden as well as potentially trigger threats to national sovereignty by powerful foreign creditor nations.
The progressive replacement of Keynesianism by neoclassical macroeconomics made monetary policy the primary macroeconomic instrument and relegated fiscal policy to a secondary role. Hence, business cycles have undergone significant changes since the early 1980s. Cycles share many common characteristics, nevertheless, each has its own unique fingerprints. In practice, the stages of a cycle tend to overlap, blurring the transition from one stage to the next and only becoming clear in retrospect. Moreover, depending on the cycle, some developments might appear sooner and others later than usual. On average, the recovery and expansion phases last approximately four times as long as the crisis and recession phases, although this too varies considerably from one cycle to the next. The following is a general outline of the stages of a business cycle that is not overwhelmed by a dramatic event such as an oil crisis, a financial crisis, or war:
(a) Recovery: The stock market, consumer confidence, production, profits, and investments rise while inventory-to-sales ratio, unemployment, and bankruptcies fall, and inflation and interest rates remain low.
(b) Expansion: The stock market, consumer confidence, production, investments, profits, and employment peak while inventory-to-sales ratio, inflation, and interest rates continue to rise and bankruptcies hit bottom.
(c) Crisis: The stock market crashes and consumer confidence, production, investments, and profits fall while unemployment and bankruptcies rise and inventory-to-sales ratio, inflation, and interest rates peak.
(d) Recession: The stock prices, consumer confidence, production, investment, profits, inflation, and interest rates hit bottom, inventory-to-sales ratio stops deteriorating while unemployment and bankruptcies peak.
The following paragraphs provide a more detailed presentation of the stages of a business cycle, starting with the recovery phase.
The impetus to a recovery could be a fiscal stimulus. The private sector begins to feel it when inventories prove too low to meet demand, with the loss of sales inducing managements to expand production to raise their inventory-to-sales ratio to a more customary level. Incremental expansions in production encourage managements to increase working hours, followed by rehiring. Exogenous stimulative factors may also come into play, such as falling prices of imported raw materials, including oil, due to a fall in international demand or an increase in supply.[221]
As sales improve, a sense that the worst of the economic crisis is past gradually replaces the gloom, followed by guarded optimism and then a budding cheerfulness. Previously cautious consumers, who worried about becoming unemployed and postponed the purchase of durable goods, begin to spend, taking advantage of discounted prices and low interest rates. Revived business confidence encourages businesses that had earmarked funds for fixed investments, but had been waiting for a sign of an uptick in the economy, to begin replacing obsolete plants and equipment. In parallel, the multiplier effect generates a virtuous cycle, whereby rising consumption prompts production expansion, increasing employment, incomes, profits, and business investments, leading to further increases in consumption.
Gradually, the economy moves to the second stage of the cycle, the expansion phase. Certainty about a brighter tomorrow replaces hesitancy. Cheerful sentiments become contagious. Stock prices register big jumps, delighting investors, and they begin to throw caution to the wind. Margin borrowing provides further fuel to the rise in the stock market. In turn, higher stock prices make more margin debt possible, driving stock prices higher still, in euphoric cycles of self-realized expectations that sow the seeds of a speculative bubble. At the same time, rising asset prices increase wealth, which stimulates consumption (the wealth effect). Firm demand develops for housing and durable goods, such as furniture, white goods, and cars. The economic expansion gathers momentum and continues for two to three years, or longer. Plant utilization approaches its capacity limits, prompting new investments; unemployment falls, the labor market tightens, and wages rise.
With the faster tempo of the economy, inflation picks up, prompting the central bank to tighten monetary policy and raise interest rates. As monetary policy becomes tighter, the business outlook dims. Stock prices peak and then begin to slide.
When the economy slides into the third stage of a cycle, the crisis phase, doubt steadily replaces optimism, until the public mood turns cautious. Some enterprises, in anticipation of a slowing economy, begin to conserve cash by postponing investments and hiring, and reducing inventories. The rise in interest rates produces crashes in asset prices, including stocks, bonds, houses, and commercial property. Falling asset prices and shrinking wealth induce cutbacks in consumption. The sale of houses and durable goods falters. A generalized weakness in demand triggers falls in production, profits, and employment. In parallel, the multiplier works in reverse, turning the initial fall in economic activity into a self-feeding process.
During the recession phase, pessimism, gloom, and negative business news dominate. Corporate profits shrink or turn to losses, unemployment peaks, bankruptcies abound, and mortgage repossessions become commonplace. Lower interest rates fail to stimulate new investment. Oddly, in the midst of the deep gloom, and before any noticeable recovery in economic activity, stock prices stabilize and begin to crawl higher.
United States Cyclical Contractions (1785-2009)
With the proviso that early statistical data was less reliable and less detailed, in the 224 years between 1785 and 2009, the United States experienced forty-nine economic cycles. The data shows that US cycles underwent major change after 1941. Accordingly, it was logical to split US economic cycles into two groups, with January 1, 1942, for a cutoff date, as follows:
1. Table 11.1 covers the period from 1785 to 1941
2. Table 11.2 covers the period from 1942 to 2009
The final row of each table is important because it provides a summary about the cycles and their contractions during the period concerned. Table 11.1 shows that during the first period there were thirty-seven cycles. Of these, twenty-three were credit crises, with at least some of the following characteristics: rising interest rate, credit contraction, the burst of a speculative bubble, a market crash, panic, bank failures, and deflation. This confirms Fisher’s diagnosis that credit contractions were a major cause of recessions and depressions. The remaining fourteen contractions had various causes including falls in aggregate demand, peace recessions following the end of hostilities, and trade restrictions imposed by Great Britain. The final row of Table 11.1 also reveals that during the era of classical and neoclassical macroeconomics and laissez-faire, cycles were shorter and contractions were longer and deeper.
Table 11.2 (1942 to 2009) illustrates the structural change to the US economy, starting in 1942. The final row of Table 11.2 shows that on average cycles became longer, lasting 5.7 years compared to 4.2 years, contractions became shorter, lasting only 0.9 years compared to 2.0 years, and shallower at -2.2 percent instead of -22.7 percent of GDP.
The interesting question is what brought about this structural change in the business cycle? The Federal Reserve was not the reason because between its establishment in 1913 and 1942, there were three very severe financial crises, including the Great Depression, as Table 1.1 reveals. Moreover, since 1942, there have been twelve contractions. Nine resulted from tight monetary policy (including the Great Recession in 2008, brought about by monetary tightening and a spike in the oil price); a sharp spike in the oil price triggered two recessions, and one was due to the end of World War II hostilities. Thus, the roots of most economic contractions remained monetary, despite the Federal Reserve. Therefore, we can safely conclude that the Federal Reserve did not engineer the milder cycles.
Indeed, the structural change points to two factors. The adoption of Keynesian countercyclical aggregate demand management made contractions briefer and shallower. The other factor was the increased share of US government in GDP, following the adoption of the welfare state. This diminished the effect of the cyclical fluctuations in private demand on the overall economy, thereby dampening overall cyclical fluctuations. Hence, the neoclassical rallying cry for a smaller government is misplaced and inconsistent with economic facts because shrinking the public sector would increase economic volatility, prolong and deepen contractions, and make them more frequent; the severity and frequency of the pre-1942 cycles attest to this.
Moreover, the reversion to neoclassical policies since 1979 shrank the role of fiscal policy and increased the role of monetary policy. Predictably, it amplified economic fluctuations. This countertrend began with the launch of very tight monetary policy of Fed Chairman Paul Volker, producing two grim recessions in quick succession. During the second recession in 1981-1982, peak unemployment exceeded that reached in the first oil crises of 1973-1975. This tendency for magnified cyclicality culminated in the Great Recession.
Neoclassical economic policies increased economic instability further by deregulating banking, spawning financial bubbles and financial crises, including the savings-and-loan debacle in the early 1990s, the Internet bubble in 2001, and the sub-prime crisis in 2007-2009, with unemployment rising to very high levels in the latest contraction. In fact, these crises were probably far worse than the official statistics suggest because in the 1980s the US government changed the statistical definitions of unemployment and inflation, thereby understating their levels compared to earlier definitions.
In conclusion, for one-and-a-half centuries, until 1942, economic contractions—particularly financial crises—gravely disrupted US economic life. The situation improved markedly following the adoption of Keynesian economics and the welfare state. Economic cycles and the state of Western economies began to deteriorate again starting in 1980, mirroring the progressive reintroduction of neoclassical policies.