• Bye-bye, business cycle?


    WASHINGTON, DC: As a tool for analyzing and influencing the economy, is the business cycle outdated? Yes, says the Bank for International Settlements (BIS) in Basel, Switzerland. Unless you’re deep into today’s economic debates, you’ve probably never heard of the BIS. But its annual reports—the latest is just out—are eagerly awaited, because the BIS plays an informal role as loyal opposition to mainstream economics. This year is no different.

    For the mainstream, smoothing the business cycle is job one. The aim is to prolong its expansions and avoid or minimize its recessions. Until the Great Recession—and excluding the inflation-caused recessions of the 1970s and early 1980s—America’s post-World War II record looked good. Deft shifts in interest rates by the Federal Reserve and the economy’s natural recuperative powers sustained growth. The longest US expansions lasted a decade (1991-2001) and nearly nine years (1961-69).

    The record doesn’t impress anymore. Economists’ confidence has been shaken; so has the public’s. As the BIS says in its report:

    “The crisis that erupted in August 2007 and peaked roughly one year later marked a defining moment in economic history. It was a watershed, both economically and intellectually: we now naturally divide developments into pre- and post-crisis.”

    We need a shift in thinking, argues the BIS. Pay less attention to the business cycle and more attention to what BIS economist Claudio Borio calls “the financial cycle.” It typically lasts 15 to 20 years and may straddle several traditional business cycles. In its early years, the debt levels of households and businesses gradually increase. This strengthens economic growth, drives up asset prices—especially of real estate—and makes debtors feel richer. With credit plentiful, homes, stocks and businesses are worth more. This is the cycle’s expansive phase. But “when financial booms turn to busts,” the depressing phase has devastating consequences. Defaults multiply. Asset prices collapse. The fallout lingers.

    This contrasts starkly with typical post-World War II recessions, whose causes and effects have usually been temporary. One common cause has been an increase in interest rates from the Federal Reserve to quash inflation. Another familiar cause involves surplus inventories — unsold goods. When inventories are too high, companies reduce purchases and production.

    But these sorts of recessions can be reversed. When inflation falls, the Fed can cut interest rates. After firms have sold surplus inventories, they can resume more normal buying and producing levels. The recession’s losses in jobs, output and incomes are gradually erased.

    Not this time. The Great Recession has inflicted enduring economic damage. Business investment has lagged; many workers have dropped out of the labor force. By early 2014, calculates the BIS, US gross domestic product—the economy’s output —was 13 percent below where it would have been if pre-crisis growth trends had continued. In Britain, the gap was 19 percent; in France, 12 percent; even Germany had a shortfall, 3 percent.

    Conventional business-cycle analysis didn’t anticipate these steep losses. It also missed other features of the post-crisis economy. Unlike earlier recessions, countercyclical policies—especially low interest rates by the Fed and other government central banks—have only modestly helped recovery. Low rates fail if borrowers don’t want to borrow or lenders don’t want to lend.

    Given the financial cycle’s ugly climax, governments should shift their focus from smoothing business cycles to preventing excessive debt, counsels the BIS. They shouldn’t try to cure every economic slowdown with easy credit and government budget deficits.

    “Good policy is less a question of seeking to pump up growth at all costs than of removing the obstacles that hold it back,” says the report. It’s not just the United States and Europe.

    The BIS also worries that China and Brazil have too much private debt. They could face financial crises.

    All this will prompt pushback. Mainstream economics still commands the intellectual heights. How can we ignore the business cycle? Optimism—consumers’ and firms’ willingness to spend—presumes that governments respond to economic weakness. This seems especially relevant now with a fragile global economy. Even if we agree with the BIS, do we have the tools to adopt its advice? Within limits, debt is desirable. It aids economic expansion and allows families and firms to invest in the future. Do we know when debt is “excessive”?

    Fair enough. The many failures of economics before, during and after the financial crisis have left an intellectual vacuum. There’s a scramble for policy ideas. But we ought to distinguish between the past and the future. The story sketched by the BIS is rich in irony: Governments’ past success in stabilizing the economy in the short run created, by encouraging too much debt, larger and more stubborn long-term instability.

    © 2014, The Washington Post Writers Group


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    1. Bernardo Carpio on

      This review ignores the fact that the Elite of the Elite of the world call the shots. By the dismantling of the safeguards for such excesses using “Tools” they had in the U.S. Congress the gates were open for unbridled accumulation of debt. It was not only the rich who wanted it, the people in charge of steering the U.S. hegemony over the world wanted it too. The U.S. wasn’t producing any “Real Stuff” anymore. They have outsurced almost everything. To maintain their dominance they had to invent this psuedo products in the likes of CDOs – Collaterized Debt instruments – which were all sold worldwide. This was the No.1 U.S. export. They also promoted debt consumption in other countries including the 3rd world. Now the U.S. medicine for this universal headache is more of the same – more debt !!!. Like anthing else in the Real world too much of anything is bad for you. Same goes with debt. It will come crushing down. But I hope before that happens I would be rid of all bank debt/loans. And surely that fine rice farm with the chickens & hogs up in the mountains and cases of guns & ammo will ensure I will survive the Great Calamity.

    2. victor m. hernandez on

      Cash is king. Without cash, which is the lifeblood of a household, a business, and the economy, progress will be on standstill, if not retrogress.Fundamental to all these is one’s own savings, each and everyone’s savings. Without savings, there is no leverage to borrow for business to expand, to take advantage of market opportunities.The world standard is 80:20 debt equity ratio as benchmark for one to borrow for an identified and existing market, without which no loan should be given, otherwise new projects should be funded by euity from other stockholders. Indeed financial cycle makes for a conservative, steady, and lesser risk growth. We should not hurry to our perdition. Haste is only fueled by lack of due diligence, fraud, and greed.

    3. Many thanks for this interesting article. Can you further elaborate in a very simple language that a simple layman would be able to understand ,probably by citing easily comprehendable illustrations?
      Ben Guerra