Chapter 26
Business Cycle Theory: It’s Wrong and Slow

Business cycles are dead. Well, if not dead inexorably changed. If new companies can grow more quickly than they could a decade ago, if technology continues to get adopted more quickly, if information can be found and shared at speeds not even thought of a few years ago, and if trade in goods and securities happens much faster, then why would business cycles still follow the same pace as they did decades ago? It is logical that if the pace of everything else has increased so has the business cycle, and it needs to get measured differently. Business cycles still can happen but, like everything else in business, they just start and finish much faster.

The traditional framework of the business cycle has five phases. The economy goes from a peak, into a recessionary decline, hits a trough, then starts to recovery, and shifts into an expansion and then a new peak. In the United States the National Bureau of Economic Research (NBER) defines expansions, contractions, and recessions. It traces business cycles back to 1854.86 The traditional definition of a recession is usually two consecutive quarters of gross domestic product (GDP) decline, but the NBER states that it uses several indicators including jobs, income and, even, industrial production to determine a recession.

Since World War II through 2018 the NBER measured eleven recessions, with the typical length of about eleven months. The great recession was measured at eighteen months. Keep in mind that typically final GDP numbers are not available until about six months after a quarter ends, on average recessions could be more than half way done before they are declared. Expansionary periods typically lasted fifty-nine months. Clearly there is more expansion than contraction in the trend lines.

Note that recessions and expansions are usually measured in time. This measurement has validity as extended economic downturns can cause more damage to businesses and the social fabric of economies. However, the extent of the impact on the overall economy should also be considered, measuring the compounded growth during the recessions can put downturns in perspective, too. The compounded growth impact on GDP during the 2001 recession was not much worse than the weakness in the economy in 2011, when no recession was declared.

The expansion after the great recession has been very shallow. Perhaps this should not be looked at all as one part of a cycle. Figure 26.1 shows that there have been at least three quarterly periods of negative GDP since the great recession in the United States. There were two periods in 2011 and one in early 2014. Perhaps these were full economic cycles that were simply more shallow and recovered more quickly than traditional measures, maybe this is the new economic cycle in the technology era. In the third quarter of 2011 stock levels dropped and the S&P 500 was within 4% of the Great Recession average, this was during a time of economic uncertainty as the United States government looked like it was in gridlock and might shut down and the country’s debt quality was downgraded by a credit rating agency. The Chicago Fed National Activity Index (CFNAI), that measures business activity, is very broad in scope and more volatile and responsive than GDP and during this period it had contractionary indications. Similarly, when oil prices collapsed in mid-2014, large parts of the economy acted and smelled like they were in a recession through 2015 and very early 2016. This was not an official recession by current definitions using measures such as GDP, but “soft” economic data like the CFNAI and the Purchasing Managers Indexes (PMI) trended weaker and the S&P 500 Index posted some very poor results. This bump-in-the-road business cycle may prove to be more common as greater efficiencies keep the overall economic trends positive for a longer time period than in the past.

So-called soft indexes, such as the CFNAI and PMIs, respond much quicker to changes in the economy than larger government driven macro measures. This is due in large part because they were designed with different purposes in mind, the soft indexes are supposed to be more responsive. While these survey-based indexes may give more false signals, the overall trends of these indexes, such as the CFNAI, is probably more telling of how modern rapid business trends are moving than slow moving data sources like GDP. This can be especially true when some of the most followed data may be undercounting the most dynamic and rapidly changing parts of the economy.

There are many theories about the causes of business cycles. None of them are right all the time, because while many periods have similarities the context of the economy, the excesses, and the mistakes are very different each time. Therefore, it is most likely that the various theories have their time and place and none of them are right for every country, industry, or event. One of the larger historical economic debates has been the view on the business cycle of the Austrian School of Economics, generally associated with Ludwig von Mises and Friedrich Hayek, and the Keynesian school. A brief, over simplified and probably flawed synopsis of the two theories follows:

The basic theory laid out by Mr. Keynes is focused on recessions caused by shocks to the aggregate demand in an economy. Generally, the argument is focused on investors and suppliers responding to aggregate demand. Once a change in that demand happens, due to a shock of some kind, the anticipated returns on investment realign changing the climate for business reinvestment and this further exacerbates the downward cycle. The Austrian theory focuses more on supply and points to artificially low-cost credit being made available to businesses and entrepreneurs. This leads to a boom in investment. However, too much cheap capital drives more supply into the market and bad investment decisions are made because of the abundance of capital. This then creates a credit crunch as these “malinvestments” fail, capital is lost, and a recession occurs.

Both theories have been picked apart for flaws and both have been altered, improved, and rearranged by subsequent generations of economists. However, these two views have been the seeds from which most strains of business cycle research have grown. Not surprisingly, the solutions offered by the two schools of thought differ, too. The Keynesian model follows on that government stimulus spending can trigger demand and smooth out business cycles. Meanwhile, the Austrian school calls for more market-based solutions with less interest rate intervention to create a natural supply and demand for goods and products rather than allowing the recovery to be dictated by artificial government-induced demand.

A recent research paper about the Great Recession and the investment hangover (Rognlie, Shleifer, and Simsek, 2018) discusses the real estate boom and bust that contaminated the financial sectors and household values. However, in a surprising move, in an era that seems to have forgotten compromise, the paper built a model that utilized both the Austrian theories of overbuilding and investment and the Keynesian ideas of demand shortages.87 Business cycles will always be caused by different things because business and the economy evolve. The cycle in 2011 was triggered by a frozen government in the United States, but at that same time there was a crisis in Europe due to profligate spending by a member of the currency union. The next cycle may be caused by overly aggressive interest rate hikes, over-regulation, government deficits or trade wars, it is hard to tell.

The obsession with pundits that are always calling for the next economic collapse damages the market. Looking at triggers from the past is valuable, but the data is not always useful for the current situation, it is like a goalie thinking of the last penalty shoot-out while a striker bears down on him at full speed. The situations are loosely related but not really relevant. False calls for the next crisis happen all the time and even the best signals are hard to time. An opportunity for capital appreciation can be lost by leaving a trend too early. False negatives have hurt more than false positives as the average expansion to recession ratios show.

Do not think that there is a timer running that rings loudly and reminds you when an economic expansion is fully baked and about to end. Recessionary bumps will still happen but should not last as long or be as extreme. They may even occur more often, but have less impact. More economic and financial flexibility in the economy will mean that cycles should look more like trend lines with a few bumps. The time and depth of those bumps should be smaller than in the past given increased technology-driven flexibility of capital flows, supply chains, and company formation. One of the major risks to such a scenario is that government interference could disrupt these self-correcting measures in the broad economy. However, even though economic flexibility creates an environment of longer positive trends and quicker recoveries it does not mean that volatility disappears.

There will also be “pocket” recessions that hit an industry or a region. Pocket recessions will occur more often because of the rampant changes in competition and capital flows. Pocket recessions will get noticed, some investors will lose meaningful money when they happen. Sometimes they may be large enough to impact asset valuations in other areas for a period of time. However, pocket recessions will be relatively contained and problems inside of the pocket will not be such a large burden that it will cause the economy’s pants to fall down.