Abacus: The Economics of Business Cycles

As the United States tries to recover from one of its worst economic periods in modern history, the concept is known as the “business cycle” that is becoming comparatively plain to many not entirely familiar with macroeconomics. That is, the cycle that revolves around the inevitable expansions and recessions of any developed country is perhaps more evident than it has been since the global financial crisis of 2008.

These economic cycles refer to the short-term changes in output that contribute to long-term growth. Historically, most countries, rich or poor, tend to see an upward trend in growth; their Gross Domestic Product rises over the course of several decades.

Despite the long-run successes experienced by most countries, economists hardly view developed societies as risk-free for a downturn. Even during times of strong growth, analysts and business people are typically wary of how long the prosperous times can last.

On the other side of the economic spectrum, however, are those who can get caught up in the heat of the moment; individuals who believe that stretches of economic and financial success can never cease. Such misapprehension of the way humans interact in an economy, combined with the ability to overlook events out of people’s control, can lead to bewilderment during any swift downturn.

The events of the past year best encapsulate both of these perceptions. Only last August, months before anyone pondered the probability of a disease ravaging the international economy, economists and investors took keen notice of an inversion in the yield curve. Such a scenario occurs in the rare situation in which the interest rates on long-term bonds are lower than the rates on short-term bonds.

Due to the risks that come with storing money in securities for a long period of time, such as the possibility of missing out on gains on other assets or forgoing the opportunity to hold cash in a more liquid account, yields on long-term bonds are usually higher than yields on short-term bonds, other factors considered.

When rates on long-term bonds fall below those on short-term securities, this inversion of the yield curve is created. Its cause is typically rooted out of investors’ fears that the economy will soon enter a recession, and that as a result, their money should be placed in short-term assets so that it could be used for more immediate purposes.

Investors witnessed the yield on 10-year Treasury notes (1.469%) fall below that of 2-year security (1.504%) in late August 2019. One possible explanation for the yield curve inversion and concerns over a recession was partly due to the actions of the Federal Reserve, the central bank.

Namely, the Fed had incrementally increased its benchmark interest rate, the federal funds rate, numerous times since 2017 to try to prevent the economy from “overheating” and achieve an inflation rate of close to 2%. Through early 2019, the federal funds rate had been at its highest since it was cut close to 0% in late 2008, with the rate coming close to 2.5%.

Many economists contend that the actions taken by the Fed, steps taken to ensure a balance between promoting growth and strong employment while limiting high inflation, can be one of the causes of business cycles: expansions occur during periods when interest rates are lowered to stimulate the economy, and contractions take place soon after rates have reached a level high enough to discourage activity on the part of consumers and firms.

Many economists contend that the actions taken by the Fed, steps taken to ensure a balance between promoting growth and strong employment while limiting high inflation

In actuality, the origins of economic cycles are more complicated and can occur based on a number of causes. The principal reason that explains the buildup of any recession, and thus the reality of booms and busts in the economy, is that some event transpires that delivers a shock to aggregate demand.

These shocks can be artificially created by a government or regulatory institution, but they can also, develop naturally.

Perhaps the best example of a natural shock to an economy is COVID-19; a disease that offers little discrimination of where it spreads, and which forces businesses to close and people to curb the amount of time they spend near others outside.

The way certain individuals displayed their mentality of the economy just prior to the start of the pandemic and during it offers lessons for what we could learn about business cycles. Firstly, no matter the extent that certain key indicators seem to point to a strong economy, a government should always prepare for an imminent recession: even if inflation is kept at normal measures and unemployment has fallen to historically low levels, policies must always remain in place that sustain the general welfare of society.

In particular, this point of view on how to best manage an economy became especially noticeable late last year, when the Fed, out of fears that the economy could be slowing in part due to sluggish global growth, decided to cut rates. Rates were lowered three different times, decreasing to as low as 1.5% in October.

Some were critical of the moves because, if a recession were to occur in the near future, the Fed could decrease rates only so much before they reached 0%. Some economists argued that rates should have remained at their higher levels so that if a downturn did occur, the central bank would be able to conduct a more effective monetary policy.

Analysts that agreed with the Fed’s moves were partly enthusiastic over the effect lower interest rates could have on financial markets. Indeed, these market enthusiasts had good reason to be ardent about the Fed’s actions: the S&P 500, the benchmark stock index in the US, was in the midst of its best year since 2013, rising nearly 29%.

With financial markets trending upward and the US holding off a recession, the excessively eager individuals were delighted by the moment: in late December, Goldman Sachs, one of the most prestigious investment banks in the world, hinted that the economy could be recession-proof.

Obviously, the fanatics were proven wrong; the economy resumed its process of alternating between advancement and shrinkage. If anything, the sudden turn to economic devastation should teach nearly everyone who participates in society, from consumers to entrepreneurs, investors to regulators, that dark times are nearly unavoidable.

Consequently, policies should be implemented that, even if they seem unjust at the moment, or disrupt the flow of fortune, help minimize long-term damage. Making a profitable investment for everyone.