Modern economies have alternated between periods of boom and bust. There are times of economic expansion and prosperity followed by economic downturns. Such periods of economic expansion followed by a contraction are called business cycles. During periods of expansion, employment remains high, incomes rise and prices remain fairly stable. In new products or new technologies, this expansion leads to prices falling too. This is due to increasing competition with a sudden rush of new players. Unfortunately, these new players have no clue of Economics or Finance and do not realize that such expansion is not long lasting and the bubble would burst in a short time. This happened recently in high technology industries like computers, telecommunications, satellite broadcasting and dotcoms.
In a downturn, or recession, unemployment will rise, companies may be forced out of business, and prices tend to fall. Such economic cycles must not be confused with business fluctuations. A fluctuation of supply and demand, or of prices, may occur in a specific segment of the economy (or in several segments) without severely damaging the whole economy. In a business cycle the whole economy is affected simultaneously, in both its upswing and its downturn. Some geographic areas of a country may be more affected than others, depending on the types of local industries or agriculture.
A business cycle usually takes several years to complete itself. When the economy as a whole is slowing down, a recession is under way. Economists, politicians, and others have been puzzled by business cycles since at least the early 19th century. One of the more unusual explanations was proposed by English economist William Stanley Jevons in the 19th century. He believed the ups and downs of an economy were caused by sunspot cycles, which affected agriculture and caused cycles of bad and good harvests. This hypothesis is not taken seriously today. Another Russian Economist Kondratieff came out with a fifty year cycle theory which resembled the Jovian 60 year cycle used by astronomers /astrologers in India for making economic forecasts.
Most business cycle theories fall into one of two categories. Some economists assert that economies have basic flaws which, for some reason, lead to cycles. Other economists insist that only some form of outside interference can cause swings from high to low unemployment. Unemployment and business failures are the most visible and characteristic signs of a recession .Those who accept the flawed economy theory usually insist that economies are far too large and complex to operate without a significant degree of government guidance and regulation. Those who hold the opposite view believe that economies are not inherently flawed and that there will be no business cycles as long as there is no outside interference from governments, banks, or other sources.
All economies undergo stress and shock from time to time. Natural disasters, such as hurricanes, tornadoes, floods, and earthquakes, can do serious economic damage, but the damage tends to be localized. If a severe freeze wipes out the Florida orange and grapefruit crops, the growers lose money; and the consumers are forced to pay more for these goods, since there are fewer of them. A more severe shock, such as the increases in oil prices during the 1970s, can have far-reaching consequences. But economies adjust to the new situation in a few years.Shifts, changes, and temporary fluctuations do not constitute business cycles. They are adjustments that economies have always endured. The question that must be answered is what causes a widespread build-up of prosperity followed by a sudden decline? Since money is the connecting link between all economic activities, the answer must be sought there.
Economies exist because people exchange goods and services for money. This means that economies are consumer driven. Everyone is a consumer, though not everyone is a producer. Producers spend money for land, buildings, machinery, resources, and workers. Money circulates through the economy as producers pay owners of land, builders of buildings, makers of machinery, sellers of resources, and a labor force. Products, when they are sold, circulate money back to the producers to keep production going.
The money that producers use to start a business comes from investment. Investors believe that a product or service will have a good chance of success, so they want to put money into a business. Some people invest by buying stock, which is ownership in a company. Others invest by making loans or buying bonds issued by the company. Once a business is operating, it gets the bulk of its funds for future growth and continued operations from borrowing.
Getting investment money together is the start of a process called capital formation. Investment money is the initial capital. It is used to pay for capital goods: the land, buildings, machinery, and labor force. The source of investment money is savings. A large number of consumers do not spend all of their money in the present. They save part of it. Saving is postponed consumption. Instead of spending today to consume now, some people save in order to be able to consume later. Money set aside in savings earns interest. Both the interest and the original investment can be used for consumption in the future.
The money available for investment, especially for loans to business, comes from the savings of all economic units, individuals and organizations. It may be a very large amount, but it is a fairly stable amount. This means there is competition for it. Money, like any commodity, has a price because it is scarce. The price is called interest. If savings exceed demand, interest rates will be low. If demand exceeds savings, interest rates rise. But there is generally a balance between savings and investment in the normal course of economic activity. In other words, supply and demand always tend toward equilibrium.
Businesses borrow money to expand their enterprises based on the money available for loans. They take it for granted that the money available for lending represents an overall consumer preference for future consumption. Guided by this preference, business operators adjust their plans for the future. If an outside agency interferes with the money supply, the equilibrium between savings and investment is disturbed. This happens in the United States when the Federal Reserve System increases the money supply. In the language of Economists this is referred to as M3. Banks have more money to lend, but this extra money does not come from the original stock of savings.
Unfortunately, the businesses that are borrowing do not know this. A loan is a loan, as far as the borrower is concerned. Business expansion, using the new larger supply of money, is no longer being guided by consumer time preferences. But businesses do not know that. Instead of realistic expansion for future needs, they are making Malinvestments--a term coined by Austrian economist Ludwig von Mises. These are investments that will not pay off, somewhat like borrowing to build a factory to make a product no one wants or is ready to buy.
The process of Malinvestments can take several years, as an inflated supply of money courses through the economy and borrowing is easy. New office buildings are constructed, factories are expanded, machinery is purchased, and workers are hired--all to be ready for a great surge of consumer buying power. Meanwhile, prices rise. But the explosion of consumerism never happens. Consumers never voted with their money, by means of savings, to underwrite an excessive expansion. The expansion was due to an inflated money supply.
The awareness of this fact gradually works its way through the economy. Businesses realize they are in trouble. They have too many workers, too much machinery, too large inventories, and too much debt. It is time to wind down. So the economy, which has grown like a balloon, begins to contract. People lose their jobs, businesses fail or are sold. Inventories are unloaded at bargain prices. A great inventory adjustment, called a recession, takes place. This progress from Money inflation to Malinvestments to collapse is the business cycle.
Note: This is an abridged version of the article published by www.madgopes.com on June 29, 1999.
Copyright. September 2007. www.madgopes.com. All rights reserved.
What is a business cycle? - To learn more about this author, visit Madhavan T Gopalachary's Website.
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Madhavan T Gopalachary
(Visit Madhavan's Website)
Madhavan Gopalachary, nick name "madgopes"
(g pronounced as in go) given by IIT
classmates, is a Mechanical Engineer and
an alumnus of Indian Institute of
Technology, Madras having passed out
specializing in IC Engines &
Thermodynamics.
He has nearly 35 years of experience in
the Corporate World. He started off as a
trainee and handled sales, marketing,
manufacturing, product management, profit
center management, strategic planning and
corporate development including R & D in
various organizations and at various
levels before becoming a CEO. His last two
professional assignments were at CEO level
before embarking to start management
consultancy business on January 01, 1998.
He has worked for British, Swedish MNCs as
well as very large Indian business houses.
He has spent a large portion of his time
from June 1998 till date in East African
Countries practicing as an independent
Management Consultant.
More details can be obtained at the
following web sites:
mmg.name/
mtg.html
mmgconsu
lting.biz/
Madhavan's articles can be accessed at www.madgopes.com
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