Boom and bust
|The dismal science|
|The Worldly Philosophers|
Boom and bust is a colloquial term for what is often known as the "regular business cycle." Economies, in general, tend to go through periods of excessive growth followed by retrenchment. In the 1800s these cycles were spectacularly harsh.[note 1] Many modern regulations have helped smooth the edges of the business cycle. The FDIC and Federal Reserve, for example, have helped to prevent widespread bank failures that would plunge the economy into downward spirals and harsh deflationary recessions. Data collected by the NBER shows post-World War II business cycles to be much more moderate than pre-war cycles. In 2002, economist James Stock coined the term "Great Moderation" to describe the relative stability of the business cycle over the previous 20 years. The term was later popularized by Ben Bernanke. This was later seen as poor timing considering the events that followed soon after.
There are many other government actions that help to regulate the "business cycle", despite intentions to the contrary. Income taxes pull in more revenue during a boom, thus tamping down excessive growth, and less during a bust, helping to stimulate it. Unemployment insurance works similarly, pulling in plenty of revenue when unemployment is down and putting stimulative government spending into the economy when the bust strikes. These are known as "automatic stabilizers" in econo-speak.
Explanations for business cycles
There are several reasons proposed by different economics schools for why the business cycle may occur.
Austrian Business Cycle Theory
Austrians believe that the business cycle is caused by fractional reserve banking. In fractional reserve banking, banks can increase the supply of money via loans. This increase in the supply of money will cause bankers and creditors to confuse the supply of hard money and credit and go on an investment spree, leading to a bubble. Eventually, this bubble will pop and lead to a recession. Austrians insist that government and central bank interventions in the economy will make a recession more likely and worsen the effects of a recession. This is because when a government/central bank does monetary or fiscal policy, it will create confusion all at the same time and lead to an even bigger bubble. Austrians therefore recommend Laissez-Faire approaches along with abolishing fractional reserve banking (by returning to the gold standard).
Monetarist Business Cycle Theory
Monetarists believe that the business cycle is caused by an unstable growth in the money supply. Essentially, growth in the money supply causes an increase in aggregate demand, which leads to an increase in prices, employment, and national output. However, prices are sticky, so it takes a while for supply to properly adjust. Eventually the short run aggregate supply will increase due to the increase in prices. On the other hand, if there is a contraction of the money supply, then there will be a decrease in aggregate demand, which leads to a decrease in prices, employment, and national output. Eventually, after prices adjust, the short run aggregate supply will decrease to a decrease in prices. Monetarists therefore advocate for automatic monetary policy to ensure a stable growth in the money supply and a Laissez-Faire approach to fiscal policy.
The Monetarist Business Cycle Theory came under attack when it was unable to explain the Global Financial Crisis, leading to the Keynesian Resurgence. The federal reserve attempted to increase the money supply to take the economy out of the recession, but it didn't work.
Real Business Cycle Theory
The Real Business Cycle Theory is another business cycle theory that comes from the Chicago School. It asserts the business cycle occurs because of shocks in productivity and technology, and so business cycles are only a creation of supply side issues. Increases in productivity and new technological discoveries will lead to a boom. However, decreases in productivity or technology failures can lead to a recession. Real Business Cycle Theory states that since supply is the only factor in the business cycle, the government and monetary authorities are incapable of helping out. Therefore, New Classical Economists (proponents of the Real Business Cycle Theory) advocate for a Laissez Faire approach.
The Real Business Cycle Theory is incapable of explaining the Great Financial Crisis and the Great Depression. These recessions were caused by a decrease in aggregate demand, which the Real Business Cycle says is impossible. So as seen, the Real Business Cycle isn't very real at all.
Neo-Keynesian Business Cycle Theory
Neo-Keynesians say the business cycle occurs due to a lack in effective aggregate demand. Essentially, when investors invest less, interest rates will drop, and an increase in savings. This causes a recession. Theoretically, the decrease in interest rates should cause investors to invest more and save less (since they don't need to pay as much on loan interest). However, this may not happen. One explanation is that investor confidence (Keynes call this "Animal spirits") could drop and cause investors to not invest and continue to save. This can cause a liquidity trap, as now both consumers and investors are too scared to borrow money. This effect of investors and consumers continuing to save more and more is known as the paradox of thrift. Eventually, the whole system collapses. Neo-Keynesians therefore advocate for fiscal policy in a recession. The government should spend money and decrease taxes so people will be less scared to buy goods and take loans. Neo-Keynesians generally reject monetary policy, because it can only affect the supply side, not the demand.
Neo-Keynesian Business Cycle Theory came under attack from Monetarists when stagflation in the 70's occurred. Here, a supply side recession occurred, and according to Keynesian Business Cycle Theory, this could not be forecasted.
New Keynesian Business Cycle Theory
Eventually New Keynesians improved Neo-Keynesian Business Cycle Theory to include both supply and demand reasons for a recession. New Keynesians say recessions happen because of market failures. Agents within markets act rationally, but don't have perfect information, and will allocate resources ineffectively. This is mainly due to a problem in communication. There may be dozens, if not hundreds of different firms in an economy. This creates price stickiness, as firms will not change prices in coordination with other businesses (since it's impossible for them to know what every other firm will do). These inefficiencies will build up and create a recession in which there is a lack of effective demand and a mismanagement of supply side resources. Since markets create recessions in which demand and supply are lacking, New Keynesians advocate for both fiscal and monetary policy to ensure that an economy gets out of a recession.
Post-Keynesian Business Cycle Theory
Like Neo-Keynesians, Post-Keynesians also believe in the paradox of thrift. However, Post-Keynesians have more to their business theory than Neo-Keynesians. Post-Keynesians believe that inflation is a result of class struggle between workers and capitalists. Workers will try to raise their wages and capitalists will try to increase prices so that they maintain high profits. This constant increase in prices is known as cost-push inflation, AKA supply-side inflation. Cost-push inflation can also occur because it may be more expensive to get resources. This was what Post-Keynesians identify as the cause of stagflation in the 1970's. The cost of resources got higher and higher (such as grain and oil), and the abolishment of the Bretton Woods System, also lead to a surge in prices. In order to combat cost-push inflation, Post-Keynesians recommend using buffer stocks of resources (so if there's a shortage, there will still be excess supply) and income policies in order to constrain inflation, as well as fiscal policy tools like Neo-Keynesians.
- NBER business cycle data
- Great Moderation
- Mises Wiki on Australian Business Cycle Theory
- Paul Krugman's takedown of Austrian Business Cycle Theory
- Milton Friedman's takedown of Austrian Business Cycle Theory
- Your Article Library's Explanation of the Monetarist Business Cycle Theory
- Economics Help on the Real Business Cycle
- Economics Help on Keynesian Business Cycle Theory
- Economics Discussion on New Classical vs New Keynesian Economics
- Lord Keynes's (The Blogger) explanation of stagflation