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The business 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 total national production or the real gross domestic product.

To call those shifts "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.

Business Cycles

In the typical "business cycle" 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 defeat the cycle even without conscious action by policy-makers.

Traditional Business Cycle models

The main types of business cycles enumerated by Karl Marx, Joseph Schumpeter and others in this field have been named as follows:

1. the Seasonal transitional cycle (annual)
2. the Kitchen investment cycle (3-5 years)
3. the Juglar infrastructural cycle (7-11 years)
4. the Kondratiev wave or technological cycle (45-60 years)

TABLE 1
Business Cycle Peaks and Troughs in the United States 1890-1992
Peak	Trough		Peak	Trough
July 1890	May 1891		Aug. 1929	Mar. 1933
Jan. 1893	June 1894		May 1937	June 1938
Dec. 1895	June 1897		Feb. 1945	Oct. 1945
June 1899	Dec. 1900		Nov. 1948	Oct. 1949
Sep. 1902	Aug. 1904		July 1953	May 1954
May 1907	June 1908		Aug. 1957	Apr. 1958
Jan. 1910	Jan. 1912		Apr. 1960	Feb. 1961
Jan. 1913	Dec. 1914		Dec. 1969	Nov. 1970
Aug. 1918	Mar. 1919		Nov. 1973	Mar. 1975
Jan. 1920	July 1921		Jan. 1980	July 1980
May 1923	July 1924		July 1981	Nov. 1982
Oct. 1926	Nov. 1927		July 1990	Mar. 1991

Preventing Business Cycles

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 cycles through fiscal and monetary policies. 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.

Classical economic theory---as explained by Schumpeter and others--states that no deterministic cycle can persist because it would consistently create arbitrage opportunities, and holds that the economy always moves back to long-run equilibrium at full employment.  This view holds to the idea that observed economic fluctuations can be modeled as short-term periods of disequilibrium which serve as necessary adjustments in a dynamic economic system, and that these periods of disequilibrium would be naturally corrected through changes in prices, wages, and interest rates.  In this theory, any government involvement would actually be detrimental to the efficient functioning of the free market.

In Keynesian theory, however, general trends can overwhelm the behavior of individuals. Instead of the economic process being based on continuous improvements in potential output, as most classical economists believed, Keynes asserted the importance of aggregate demand for goods as the driving factor of the economy, especially in periods of downturn. From this he argued that government policies could be used to promote demand at a macro level in order to fight high unemployment and deflation of the sort seen during the 1930s.

A central conclusion of Keynesian economics is that there is no strong automatic tendency for output and employment to move toward full employment levels. This idea conflicts with the general assumption of classical economics that predicts a general tendency towards equilibrium in an efficient economy. Keynes's theory suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what are called counter-cyclical fiscal policies, that is policies which act against the tide of the business cycle: deficit spending when a nation's economy suffers from recession or when recovery is long-delayed and unemployment is persistently high—and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. He argued that governments should solve short-term problems rather than waiting for market forces to do it, because "in the long run, we are all dead."

No one argues that managing economic policy to even out the cycle is not an easy job in a society with a complex economy. 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.

Politically-based business cycle models

Classical and Neo-classical theorists also believe that government stabilization efforts through monetary and fiscal policy are difficult to use with any precision. There are long lags in the implementation and effect of changes in spending, taxes, and monetary stance. There is also significant uncertainty about how much of a monetary or fiscal stimulus is needed to end a recession of a particular severity. Finally, policymakers also often have conflicting goals. Because inflation tends to slow down in recessions and speed up in booms, policymakers cannot cure the dual problems of inflation and unemployment with the same policy tools. As a result they often seem to adopt the strategy of fighting inflation with tight policy and then reducing unemployment with a switch to loose policy.

While government policy may not have cured the business cycle, the effects of cycles on individuals in the United States and other industrialized countries almost surely have been lessened in recent decades. The advent of unemployment insurance and other social welfare programs means that recessions no longer wreak the havoc on individuals' standards of living that they once did.

However, another set of models tries to derive the business cycle from political decisions designed to solve the problem of business cycles:

The partisan business cycle suggests that cycles result from the successive elections of administrations with different policy regimes. A government adopts expansionary policies, resulting in growth and inflation, but is voted out of office when inflation becomes unacceptably high. The replacement government 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 another government.

The political business cycle is an alternative theory stating that when an administration 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.

Copyright: Design and coding ©: 2004, Liberty Fund, Inc.
Content ©: 1993, 2002 David R. Henderson. All rights reserved.

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