Econ 101: Business Cycles

Posted: April 3, 2014 by davishipps in Economics

The last basic topic of Economics that I want to cover is this idea of “business cycles.” That’s the term economists use for when the “boom” times (periods of prosperity and rapid economic growth) are followed by the “bust” times (recessions/depressions). I need hardly point out that we’re experiencing the “bust” part of one of these cycles right now, though some economists are hopeful that we’re at the tail end, or even that we may be finally recovering.

A large part of why I decided to write this Econ 101 series was to be able to explain and discuss business cycles. You really have to understand all of the concepts covered so far before you can make sense of what happened, how to recover, and how to prevent it from happening again. And so, without further ado, here’s my attempt to put it all together:

Generally, the scenario runs as follows. The central bank starts increasing the amount of money in circulation, which has the effect of lowering interest rates to a point below the rate that would occur on the free market. These low rates lead to an increased use of credit, particularly in any industries that are being incentivized by the government. In the late 1990s, this took the form of investment in tech startups; in the early and mid 2000s, it took the forms of investment in housing through construction loans but also through greatly relaxed lending standards for homebuyers. The lower lending standards had the effect of increasing the demand for housing, driving up prices quickly and far beyond what the market would have set without all this excess credit. To get back to the general case, as the increased use of credit spreads throughout the economy, demand for the goods and services of the incentivized industries creates more jobs in those industries and causes wages in those industries to increase. People perceive that they are more prosperous, even though another result of the increased supply of money will have been an increase in prices, first in the favored industries, then in related fields, and so on until the increase becomes general throughout the economy. But who cares if prices go up a bit? Everybody’s working, everybody’s making more money, everybody’s better off, right?

At some point in this process, reality is restored. This happens when the money-issuing governmental authority (i.e., central bank) determines that it has been inflating the money supply too quickly and begins to scale back. It does not have to decrease the money supply nor even to halt expansion. All that is required is that the expansion of credit slows, which spooks investors into thinking that projects they’ve taken on with the expectation of freely available credit may not be able to be completed. Investors will cease to invest, lest they lose even more money on projects that cannot be completed, and just like that, the boom ends and the bust begins.

Projects taken on during the boom are now seen to be untenable, and the producers’ perception of a growing demand in their industry is now shown to have been an illusion based on easy credit, without which the demand is greatly reduced. These companies, which had hired workers and increased wages (to attract or retain workers for those projects), begin laying off those workers in large numbers. Prices stagnate or decline as the producers try to recoup whatever money they can with increasing desperation. Many simply go out of business. This trend continues until the resources in the economy can be reallocated to more productive uses in companies or industries for which there is an actual, non-credit-based, demand.

And that’s the business cycle. The only thing I’ve left out at this point is what the central banks or the government should be doing to help us get out of the bust period. The answer is: nothing. As you may have guessed if you have read the posts on Government Interventions and on Central Banking, any steps that the authorities take will, in the words of Sir Topham Hatt, “cause confusion and delay” in getting the economy back on track.


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