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The Death of a Business Cycle

How do business cycles end? In the US, conventional wisdom is that they are murdered by the Federal Reserve. It is too slow to raise rates and then goes too quickly. This view is espoused by numerous well-respected economists and policymakers. President Trump’s criticism of the Federal Reserve is anchored by such views.

America’s ambivalence toward a central bank is around 200-year old. It was the Panic of 1893 that swung the banking community around to support a modern central bank. It is notable that the economic crisis of 1893 was called a panic. The jargon changed in the late 1920s with the Great Depression. Subsequently, the word recession was used to denote the end of a business cycle to avoid the connotation of the word depression, which was associated with the calamity of the 1920s and 1930s.

The business cycle existed before the Federal Reserve. Therefore it seems incongruous to blame it for the business cycle, though that does not prevent it from making policy mistakes that could exacerbate the downturn. Earlier business cycles seemed to reflect the agriculture cycle. However, by the start of the 20th century, economists and policymakers had begun recognizing an industrial business cycle.

Some, for example, linked it to the lag time between breaking ground for a new factory and the time that factory came on-line. Others saw the rise of fixed costs relative to variable costs as posing new challenges. It provided an incentive to continue to produce even at a loss rather than cease production, like the abstract models of the day suggested. There are also some that saw the problem as a function of the creation of national markets. The US, Germany, Italy, for example, were united around the middle of the 19th century.

In the US, after the Civil War, a shoe manufacturer in Boston now would compete with a shoemaker in Chicago. The birth of national economy exposed excess capacity and redundant investment, and what many at the time called “ruinous competition.” It is not coincidental then that the US experienced its first large-scale merger wave after 1893 Panic.  Mergers and acquisitions (horizontal) are industry’s attempt to self-regulate and get rid excess capacity. Think of US Steel, which when created out of ultimately nearly a dozen steel companies, early in the 20th century. Indeed, the “Trust Question” was one of the issues that dominated national politics for around a quarter of a century before WWI.

Like the game of Clue, if Colonel Mustard Mustard did not kill Mr. Boddy, who did?  If the Federal Reserve does not murder the business cycle, who does? The alternative hypothesis is that the business cycle is not murdered; it is a case of suicide. The growth and expansion phase of the business cycle plant the seeds for the downturn. During the upside, a virtuous cycle ensues, demand encourages business to expand output and hire more people, which underwrites demand.

A couple of other things are happening. First, pent-up demand for durable goods, such as cars and household goods whose purchases have been deferred, is expressed. The same logic holds for businesses and some modernization of plant and equipment. Note that the new equipment is often not only labor-saving but also capital-saving. Aggregate demand, due to the division of the social product (GDP) between wages and profits, cannot be sustained at levels that place sufficient demand on the capacity.  

Second, following Minksy, who Wall Street seemed to discover during the Great Financial Crisis, only to cast him aside once again during the expansion, the upswing creates excesses. He was concerned with the financial excesses that result simply from steadily rising asset prices. These excesses eventually come home to roost. An extended period of stability leads to instability.

The popular beer distribution game (created by MIT professors in the early 1960s, see here for an online version), which among other things, illustrates in a very concrete way, how the business cycle arises by the economic agents themselves. The lack of perfect information and coordination issues complicate the situation. Even now the inventory cycle is one of the key elements of the business cycle itself.

In addition to this explanation grounded in history and theory, consider the end of recent business cycles. Beginning with the late-1970s, the US has experienced four economic downturns. The only one that the Fed’s fingerprints are all over the murder weapon was the one that Paul Volcker engineered to squeeze out the inflation of the 1970s (free from the constraints of Bretton Wood and the oil embargo). In fact, Volcker had to not only shoot it but drive a stake through its heart, creating a double-dip downturn and marked the beginning of what turned into a nearly 40-year decline in long-term US rates. 

The last three, the 1991-92 (S&L Crisis), 2000-2002 (Tech bubble) and the 2008-2009 (Great Financial Crisis) were not sparked by too aggressive of Fed policy, but financial excesses. These were not questions of interest rates, money supply or inflation. Some of the managers of the large pools of capital took lethal doses of a powerful drug–other people’s money, highly leveraged, with great risks. Competition is as much a driver, arguably, as greed, which in any case Adam Smith assured us that the private vice is transformed into a public virtue by the Invisible Hand. If the Fed assisted in the suicide it is through its regulatory function rather than as lender of last resort.

Capitalism has a history. As it emerged from its agrarian and small-business roots, new challenges emerged. The business cycle’s nature changed. After the convulsions of the world economy beginning in the late 1970s in China and India, and later the UK and US ushered in the contemporary era. Ironically and perhaps paradoxically, the Great Moderation that began at the end of the Reagan-Volcker downturn continues despite the Great Financial Crisis. It is characterized by flatter and longer business cycles, modest price pressures, and a weakening of those institutions whose raison d’etre is to boost wages and household demand.  

The exogenous theory of economic crisis (that the Fed kills it) is ahistorical and colored by hubris. It serves policymakers interest, exaggerating their power. It serves politicians’ interest because they can point to a culprit. It leaves unaddressed the real threat, self-induced financial excesses. But to appreciate that requires a different stance toward markets and regulation.

Full story here
Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.
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