Business Cycles

Stephen King: The murky mysteries of the economic cycle
It wouldn't be a bad idea to open up the assumptions made by the Chancellor to greater scrutiny

15 November 2004

Economics is the science of the vaguely knowable rather than the precisely predictable. Many economic theories, particularly big picture theories at the macro-economic level, make an awful lot of sense in theory - as, indeed, they should - but they're not always quite so helpful in practice. And, even when they do make sense individually, they don't always hang together terribly well collectively.

Take business cycles. All of us think we know something about the evolution of business cycles. The language of business itself is full of it: upswings and downswings, booms and busts, recessions or, even worse, depressions. Yet, when it comes to understanding why cycles happen at all, and where we are in the current economic cycle, it all begins to get a little murky.

Part of the problem lies in understanding why cycles occur in the first place. Some people think there is a natural cyclical path established by movements in inventories. Final demand appears to be stronger than it really is when companies are rebuilding their inventories, leading people to overestimate future growth. When growth turns out to be not so strong, inventories are reduced, leading to final demand appearing to be weaker than it actually is.

Others focus more on exogenous shocks. Would the mid-1970s economic crisis have been possible without the quadrupling of oil prices in 1973? Would the 1930s depression have been quite so bad had the US not imposed the Smoot-Hawley tariff in 1930? The exogenous approach argues that cycles wouldn't be there at all in the absence of these essentially unpredictable events.

Then there are those who focus on the "political" element of economic cycles. Policymakers, particularly politicians, create cycles because their preferences don't equal the preferences of society. A politician focused on the electoral cycle may make economic policy decisions that suit re-election more than the good governance of the economy over the medium term. Mercifully, the increasing independence of central banks has gone some way to reducing this particular problem but, on the fiscal side, the incentive is still very much there.

Above all of this, though, are the unfathomable "animal spirits" of businesses and households. As Keynes put it: "Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities".

Of course, this doesn't mean to say that animal spirits are entirely unpredictable. My cat, for example, has regular eating habits and regular toilet habits (although his visits to the litter tray are disturbingly hit and miss). Nevertheless, it's fairly clear that Keynes regarded the business cycle as in one sense a mysterious thing, rather difficult to predict because markets weren't always capable of settling down to a nice equilibrium. In Keynes's world, disequilibria were both possible and persistent, even if unpredictable.

All of which creates problems for Gordon Brown. Last week, the Treasury announced that the Chancellor would be delivering his Pre-Budget Report on 2 December. In that report, he will have to come up with his latest views about the economy and its relationship with the public finances. As part of this process, he will have to tell us about the size of the output gap.

The output gap is, conceptually, a simple idea. It's a measure of the degree to which the actual economy has strayed away from its long-term "sustainable" path. If output is above this sustainable path, there will be a tendency for inflation to rise. If output is below this path, there will be a tendency for inflation to fall (or, in a world of sticky prices, unemployment to rise). In

PACKERSOLDKIDNEY, I think business cycles are easy to explain. We all have the herd instinct. The sheep follow the goats because they are convinced that the goats must know what they are doing. To get the sheep to run where you want them train a goat to show them the way. The market works exactly the same way, we follow behind, but are inclined to run to far in both directions that to a thinking person does not make sense. the market reacts to extremes. Never follow the herd, work out where the goat will be next, and wait until the herd play catchup. Look to buy when its out of favour and sell when it is. Farmers are the very worst example of this [hense the sheep and goats bit]. They rush from one extreme to the other.
The ones that make the money are the ones that get there first, and wait for the herd to buy them out. That is why we have money managers and prediters feeding off the flock.

In other words, Macdunk is saying that markets are more volatile than business cycles would dictate they should be because of the human factor. Correct me if I'm wrong MacD.

Good article POK... another "cyclical" explanation is that we're at the tail end of one of Joseph Schumpeter's "Industrial waves" or "cycles of creative destruction" (I have made those terms up because I can't remember the correct terms and can't be bothered searching for them)... The basic idea is that every so often a technological revolution comes along which increases the productivity of the inputs (ie capital, labour). These include such time periods as those which saw transport productivity improvements (ie rail, steamships) Industrial Revolution, and more recently the IT improvements (communication etc) which increase Factor Productivity.

Anyway... we're meant to be on the tail end of one of these waves, and therefore the "zing" that the innovation has created in terms of increased productivity for a fixed amount of input has decreased. We're waiting on the next one (my guess is robotics who can feed the cat/pat the dog/put out the rubbish/argue pointlessly with the "significant other") before we see another productivity boom.

Wouldn't want to subject the idea to empirical testing but it does make sense and people who believe in the idea could very easily point to the last decade as an example of one of these "waves of innovative productivity" (made that one up too). It would also explain the damp growth in the Western world compared to the 90's.

But getting back to the topic, we all know cycles happen but it's a losing proposition trying to pick exactly where we are on the damn things. Therefore politicians will and can spin as much as they like (even if most nations have foiled the attempts of Pol's to lessen the amount of influence available for the "political" influence in business cycles).

I could literally go on for hours on this topic, bit of a speciality of mine, I have stuff published in some not too bad journals [:I]

Anyways, Mr. King is being a bit disingenious to say that the Chancellor has all the wiggle room in the world over measurement of the cycle. There is a loose consensus of what the 'right' methods are and other policy agencies (e.g. the Bank of England, European Commission, ECB, OECD, IMF etc) and academics calculate and publish them too. So if the UK Treasury were to do anything outrageously fishy the estimates would stand out like a sore thumb and would be commented on at all sorts of levels...

And BTW measurement is easy compared to understanding the drivers of the cycle! If it were all understood most macro economists would be out of a job for a start ;)

Business cycles and the reasons for them thats what i concentrate on.
To get in first before the cycle starts trending. Pick your companies first in each business division. Power generators i choose Trustpower ahead of contact energy. Farm service i choose pgg ahead of WRI. Ports i choose POT ahead of POA. Those are the three areas that i see coming good in the next round. Power producers are a dead certainty, trust power is the small company with the big potential. The dollar is going the wrong way, for our farmers in the very short term,but on the other side of the coin another mad cow scare in america, plus a free trade deal looming with china, pick this is a sector on the rise. Three companies one company i wouldnt touch with a 2c piece, because of a name on the board. the other two WRI, or PGG, i pick PGG, good divi, uptrending, good management,whatever happens will not lose. The port sector, I expect a downturn in imports as our dollar starts going the other way, but i really do think forestry will recover in a big way, and POT will make a killing. They are so far in front at the moment. I would never consider the opposition. The energy sector is the one to watch, NOG with all the hype, i picked that wrong cashed out after 4wks for a 12pc profit under estimated the herd, A lot of fingers will get burned here. Pure speculation buy a lotto ticket sell out what you have and go for more thrill and drill. Then i was wrong with poisiden and history hopefully wont repeat. 50c to $230-00 and back again so go with the flo. I do notice and bring it to the attention of investors that most of that type of company loses more than they win. throw it back if i am wrong. macdunk