Business Cycle

1. INTRODUCTION  
Business Cycle, term used in economics to designate changes in the economy. Ever since the Industrial Revolution, the level of business activity in industrialized capitalist countries has veered from high to low, taking the economy with it.

2. PHASES OF THE BUSINESS CYCLE  
The timing of a cycle is not predictable, but its phases seem to be. Many economists cite four phases—prosperity, liquidation, depression, and recovery—using the terms originally developed by the American economist Wesley Mitchell, who devoted his career to studying business cycles.

During a period of prosperity a rise in production becomes evident. Employment, wages, and profits increase correspondingly. Business executives express their optimism by investing to expand production. As the upswing continues, however, obstacles begin to occur that impede further expansion. For example, production costs increase; shortages of raw materials may further hamper production; interest rates rise; prices rise; and consumers react to increased prices by buying less.

As consumption starts to lag behind production, inventories accumulate, causing a price decline. Manufacturers begin to retrench; workers are laid off. Such factors lead to a period of liquidation. Business executives become pessimistic as prices and profits drop. Money is hoarded, not invested. Production cutbacks and factory shutdowns occur. Unemployment becomes widespread. A depression is in progress.

Recovery from a depression may be initiated by several factors, including a resurgence in consumer demand, the exhaustion of inventories, or government action to stimulate the economy. Although generally slow and uneven at the start, recovery soon gathers momentum. Prices rise more rapidly than costs. Employment increases, providing some additional purchasing power. Investment in capital-goods industries expands. As optimism pervades the economy, the desire to speculate on new business ventures returns. A new cycle is under way.

In fact, business cycles do not always behave as neatly as the model just given, and no two cycles are alike. Business cycles vary considerably in severity and duration. In the United States the major cycles have lasted slightly longer than eight years, on the average. Minor cycles have a shorter span, generally from two to four years. The American economist Alvin Hansen accounted for 10 major and 23 minor cycles in the U.S. between 1857 and 1937.

The most severe and widespread of all economic depressions occurred in the 1930s. The Great Depression affected the U.S. first but quickly spread to Western Europe. The American economy, however, suffered the most. From 1933 to 1937 the U.S. began to recover from the depression, but the economy declined again from 1937 to 1938, before regaining its normal level. This decline was called a recession, a term that is now used in preference to liquidation. Real economic recovery was not evident until early 1941.

Since then, the U.S. has been spared another severe depression. Recessions have, however, occurred repeatedly. In addition, the general pace of economic growth has slowed.

3. SPECIAL CYCLES  
Apart from the traditional business cycle, specialized cycles sometimes occur in particular industries. The building construction trade, for example, is believed to have cycles ranging from 16 to 20 years in length. Prolonged building slumps made two of the most severe American depressions worse (in 1872-73 and in the 1930s). On the other hand, an upswing in building construction has often helped to stimulate recovery from a depression.

Some economists believe that a long-range cycle, lasting for about half a century, also occurs. It has been shown that a periodic shift in wholesale prices recurred in the U.S. throughout the 19th and early part of the 20th centuries. The pattern went as follows: From about 1790 to the early 1800s, wholesale prices rose; about 1815 this trend was reversed, and prices declined until the middle of the century; after another rise, prices again declined following the American Civil War and continued into the 1890s; a rising-price trend took over until 1920; thereafter prices fell until 1933. These rise-and-fall cycles averaged about 50 years each.

Studies of economic trends during the same period were made by the Russian economist Nikolay Kondratieff. He examined the behavior of wages, raw materials, production and consumption, exports, imports, and other economic quantities in Great Britain and France. The data he collected and analyzed seemed to establish the existence of long-range cycles similar to those just described for wholesale prices. His "waves" of expansion and contraction fell into three periods averaging 50 years each: 1792-1850, 1850-96, and 1896-1940. Such studies, however, are not conclusive.

4. CAUSES OF CYCLES  
Economists did not try to determine the causes of business cycles until the increasing severity of economic depressions became a major concern in the late 19th and early 20th centuries. Two external factors that have been suggested as possible causes are sunspots and psychological trends. The sunspot theory of the British economist William Jevons was once widely accepted. According to Jevons, sunspots affect meteorological conditions. That is, during periods of sunspots, weather conditions are often more severe. Jevons felt that sunspots affected the quantity and quality of harvested crops; thus, they affected the economy.

A psychological theory of business cycles, formulated by the British economist Arthur Pigou, states that the optimism or pessimism of business leaders may influence an economic trend. Some politicians have clearly subscribed to this theory. During the early years of the Great Depression, for instance, President Herbert Hoover tried to appear publicly optimistic about the inherent vigor of the American economy, thus hoping to stimulate an upsurge.

Several economic theories of the causes of business cycles have been developed. According to the underconsumption theory, identified particularly with the British economist John Hobson, inequality of income causes economic declines. The market becomes glutted with goods because the poor cannot afford to buy, and the rich cannot consume all they can afford. Consequently, the rich accumulate savings that are not reinvested in production, because of insufficient demand for goods. This savings accumulation disrupts economic equilibrium and begins a cycle of production cutbacks.

The Austrian-American economist Joseph Schumpeter, a proponent of the innovation theory, related upswings of the business cycle to new inventions, which stimulate investment in capital-goods industries. Because new inventions are developed unevenly, business conditions must alternately be expansive and recessive.

The Austrian-born economists Friedrich von Hayek and Ludwig von Mises subscribed to the overinvestment theory. They suggested that instability is the logical consequence of expanding production to the point where less efficient resources are drawn upon. Production costs then rise, and, if these costs cannot be passed on to the consumer, the producer cuts back production and lays off workers.

A monetary theory of business cycles stresses the importance of the supply of money in the economic system. Since many businesses must borrow money to operate or expand production, the availability and cost of money influence their decisions. Sir Ralph George Hawtrey suggested that changes in interest rates determine whether executives decrease or increase their capital investments, thus affecting the cycle.

5.ACCELERATOR AND MULTIPLIER EFFECTS  
Basic to all theories of business-cycle fluctuations and their causes is the relationship between investment and consumption. New investments have what is called a multiplier effect: that is, investment money paid to wage earners and suppliers becomes income to them and then, in turn, becomes income to others as the wage earners or suppliers spend most of their earnings. An expanding ripple effect is thus set into motion.

Similarly, an increasing level of income spent by consumers has an accelerating influence on investment. Higher demand creates greater incentive to increase investment in production, in order to meet that demand. Both of these factors also can work in a negative way, with reduced investment greatly diminishing aggregate income, and reduced consumer demand decelerating the amount of investment spending.

6. REGULATING THE CYCLE  
Since the Great Depression, devices have been built into the U.S. economy to help prevent severe business declines. For instance, unemployment insurance provides most workers with some income when they are laid off. Social security and pensions paid by many organizations furnish some income to the increasing number of retired people. Although not as powerful as they once were, labor unions remain an obstacle against the cumulative wage drop that aggravated previous depressions. Government support of crop prices shields farmers from disastrous loss of income. The securities markets are now regulated by the Securities and Exchange Commission and the Federal Reserve System in order to prevent a recurrence of the 1929 financial collapse.

The government can also attempt direct intervention to counter a recession. There are three major techniques available: monetary policy, fiscal policy, and incomes policy. Economists differ sharply in their choice of technique.

Monetary policy is preferred by some economists, including the American Milton Friedman, and is followed by most conservative governments. Monetary policy involves controlling, via the central Federal Reserve Bank, the money supply and interest rates. These determine the availability and costs of loans to businesses. Tightening the money supply theoretically helps to counteract inflation; loosening the supply helps recovery from a recession. When inflation and recession occur simultaneously—a phenomenon often called stagflation—it is difficult to know which monetary policy to apply.

Considered more effective by American economist John Kenneth Galbraith are fiscal measures, such as increased taxation of the wealthy, and an incomes policy, which seeks to hold wages and prices down to a level that reflects productivity growth. This policy has not had much success in the post-World War II period.

The United States has not experienced a major depression since the 1930s, in part because of the federal government's use of anticyclical measures, including wage and price controls, and deficit spending. After a period of economic stagflation in the United States during the 1970s, inflation and unemployment were brought under control in the 1980s. The national debt, however, almost quadrupled in that decade. Thus, the federal government's response to the recession that began in 1990 did not include major new spending programs because of a reluctance to increase the deficit. In fact, an important concern in dealing with the problems of the business cycle is the fear that inappropriate measures might precipitate a severe recession or even a depression.