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September 21st 2009 print

Steven Kates

Understanding the Business Cycle

Cycles are cyclical. An upturn follows a downturn, and relatively quickly unless something is done to hold the economy down.

What one does is typically built around what one believes. This is as true of economic policy as of anything else. 

If it is believed that Keynesian economics is valid, and that it provides sound guidance on what to do when recessions occur, then during recessions high levels of public spending and deficit finance make perfect sense. If, however, one takes the view that such deficit spending will create lasting debts whose repayment costs will be a burden on the recovery process, then something else would be done instead. 

In recent discussions the statement is often made that the opposite to demand stimulation is to do nothing. It is put that either governments increase spending on their own list of projects and go into deficit, or they do nothing at all while the economy burns to the ground around us. Increased demand is, in the view of many, the only viable option. And so it is if the only theory you know is Keynesian. 

There was a time when economists understood that an economy at the macro level was based on exchange and that the cause of recession was related to the exchange mechanism breaking down. 

The reasons why such breakdowns might happen were many and varied, but the essence of such explanations were mistaken market-based decisions – often caused by badly designed market regulations and government decisions. These are, for example, the kinds of things that have caused the actual recession we are in the midst of today. 

The crucial issue was this. Keynes argued that when an economy went into recession, unless government action was taken, an underemployment equilibrium would be reached. The economy would remain locked into high rates of unemployment from which it would emerge either slowly or not at all unless some kind of public spending stimulus was applied aimed at raising the level of aggregate demand. 

The theory of the cycle, by contrast, was built around the recognition that economies from time to time go into recessions and then, sooner rather than later, those recessions come to an end. 

Cycles are cyclical. An upturn follows a downturn, and relatively quickly unless something is done to hold the economy down. 

Business cycle theory revolved around a recognition that all business decisions are aimed at a future that is profoundly unknowable. The goods and services sold today are the product of past decisions to produce, often being decisions made many years before. 

Such decisions, when they were made, seemed like a good idea at the time. They were made by individuals or business concerns because the expectation was that the results of those decisions would make them money. That is why the costs were incurred, almost always in advance of the payments that would cover their outlays. 

Within such an economic structure, with the future so uncertain, the potential for things to go wrong are obviously large. And every year, even in strongly growing economies, there are business decisions that lead to closure and loss. Some decisions will just go wrong. 

Recessions, however, occur when there are wholesale mistakes made across the economy that go well beyond the normal. Moreover, starting from these mistaken decisions, the major transmission mechanism is often a loss of business confidence that causes firms across the economy to slow their expansion plans, diminish their orders from others and reduce the number of people they employ. 

The cumulative effects are experienced as a recession which shows up in our national statistical collections as a fall in the level of output and a rise in the rate of unemployment. 

In a Keynesian model, as soon as an economy enters recession, a new under-employment equilibrium is reached from which the economy will not emerge without government action. 

In the classical theory of the cycle, there are continuous changes that take place automatically that move the economy towards recovery. The owners of every income-earning asset within the economy are individually and collectively taking whatever actions they can think of to ensure that what they own – their capital equipment or their labour, for example – is used in ways that will earn the highest return. 

Once the crisis has passed, when the dust has settled and the initial panic has subsided, the opportunities to use one’s resources productively become more apparent. The rise in business confidence occurs naturally as the rhythm of economic activity again gathers momentum. With rising confidence comes rising activity and a return to higher rates of employment. 

Crucially, the improvement is based on decisions on which forms of production will increase value adding activity to the greatest extent. Each business, acting in its own best interests, will ensure that higher growth is the result. 

To think that the judgement of governments can be substituted for the judgements made by business may be the largest single mistake that Keynesian economists make.