Until recently, the very existence of business (trade) cycles was called into question by the devotees of the New Economy. It took a looming global recession to convince wild-eyed optimists that old cycles are more reliable guides than any new paradigm. Even now, three years later and still in the throes of a meltdown of capital and real markets on both sides of the Atlantic, the voguish belief in the demise of pre-1990s economics is alive and well.
Even conservative voices, such as The Economist reassure us that consumer price inflation is dead and that policymakers should concentrate on the risk of deflation brought on by asset disinflation. Central bankers - particularly Alan Greenspan the mythical Chairman of the Federal Reserve - are castigated for adhering to outmoded schools of thought and for fighting the last war (against inflation), or the wrong one (artificially perking up the stock markets).
The Economist was among the most consistent and persistent critics of the New Economy. Yet, by preaching that certain economic phenomena - notably inflation - are "over" it has joined, unwittingly, a growing camp of "revisionist" economists who spot the demise of the business cycle.
As recapped by Victor Zarnowitz, the research director of the Foundation for International Business and Economic Research in New-York, the optimists believed that downsizing, new technologies, inventory control, the predominance of the services sector, deregulation, better government and globalization have rendered boom and bust a thing of the past.
They tended to tone down the roles of earnings, inventories, investment and credit, the drivers of the "now defunct" classical business cycle. They also largely ignored the interplay between different sectors of the economy and between entwined national economies - continuous interactions which determines inventory planning, the level of wages and pricing. The purported connection between the money supply and output was largely discounted as unproven.
The consensus now, though, is that the cycle is alive and well, though it is less volatile and more subdued. Economies spend less time in recession than they used to until 1980. The cycle is still susceptible, though, to exogenous shocks, such as war, or an abrupt increase in the price of oil. Bursting asset bubbles, if they become more frequent in the future due to financial liberalization, globalization and unbridled credit growth, may restore past volatility, though.
Another ominous phenomenon is the synchronization of recessions and expansions across continents. According to the International Monetary Fund, gross capital flows has exceeded $7.5 trillion globally in 2000 - four times the amount of money sloshing around in 1990. Foreign portfolio assets doubled as a percentage of household assets.
The ratio of merchandise exports to world output has long exceeded its 1913 level, the previous record year. Such unhindered exchange exerts similar influences on countries as far apart as Germany, the United states, Argentina and Singapore - all in the throes of a concurrent recession.
Still, expansions continue to be restricted by the increase in population, net investment and, importantly, technological innovation. The downside is also limited by population increase, government policy on income support and investment. The economy fluctuates to adjust itself to these constraints. The business cycle is a symptom of this process of adaptation.
The waxing and waning of credit made available by alternately over-optimistic and over-cautious financial intermediaries plays a crucial part. Fiscal policy - which affects investment and employment - also matters as do foreign trade, monetary policies and the reaction of the financial markets.
The business cycle typically passes through seven phases correlated with the fluctuations in the output gap - the difference between an economy's actual and potential gross domestic product. Cycles are self-perpetuating, though they can be hastened by exogenous shocks, such as a precipitous rise in oil prices or a protracted military campaign. They can also be smoothed or ameliorated by the operation of automatic fiscal stabilizers and appropriate counter-cyclical government policies.
Centuries of cumulative experience allow us to identify these stages better than ever before, though timing them with any accuracy is still impossible. They are based on the shifting balance between the emotions of greed and fear - as immutable as human nature itself.
Every economic cycle invariably starts with inflation. The previous sequence having ended - and the new one just begun - the environment is mired in uncertainty. In the wake of a recession, often coupled with deflation, goods and services are (absolutely) scarce and money is (relatively) abundant.
When too much money chases few products, the general price level rises. But this constant and ubiquitous increase (known as "inflation") is also the outcome of mass psychology. Households and firms compensate for the aforementioned high degree of uncertainty (that is, of risk) by raising the prices they charge. Market signals are thus garbled by psychological noise and uncertainty increases. It is a vicious cycle: inflation brought on by uncertainty only serves to enhance it.
Ignorant of the appropriate or optimal equilibrium price level, everyone is trying to stay ahead of perceived economic threats and instabilities by increasing the risk premiums that they demand from their customers. On their part, consumers are willing to pay more today to avoid even higher prices tomorrow.
Inflation appears to be a kind of market pathology, or a market failure. But the psychological underpinnings of inflation have been thoroughly dissected in the last few decades. It is the source and dynamics of economic uncertainty that remain obscure.
Inflation disguises the suboptimal and inefficient economic performance of firms and of the economy as a whole. "Paper" profits make up for operational losses. The incentives to innovate, modernize, and enhance productivity suffer. Economic yardsticks and benchmarks are distorted and prevent meaningful analyses and well-founded decision making.
Inflation leads to technological and economic stagnation. Pecuniary aspects are emphasized while industrial and operational ones are neglected. Financial assets are preferred to investments in machinery, infrastructure, research and development, or marketing. This often yields stagflation - zero or negative growth, coupled with inflation.
In an effort to overcome the pernicious effects of inflation, governments liberalize, deregulate and open their economies to competition. This forces firms to innovate and streamline. Efficiency, innovation, entrepreneurship, productivity and competitiveness are the buzzwords of this phase.
As trade barriers fall, cross border capital flows and investments increase, productivity gains and new products are introduced. The upward price spiral is halted and contained. The same amount of money buys better, more reliable products, with added functionality.
The rise in real incomes results in increased demand. The same dose of working capital generates more production. This is technological deflation. It is beneficial to the economy in that it frees economic resources and encourages their efficient allocation.
Increased consumption (both public and private) coupled with a moderate asset price inflation prevent an outright downward spiral in the general price level (monetary deflation). Moreover, as Jeffrey Miron demonstrated in his book, "The Economics of Seasonal Cycles", output growth causes a surge in money supply.
These conflicting influences allow inflation to remain within a sustainable "band". This transitory phase - from hyperinflation or high inflation to a more supportable plateau - is known as "disinflation". It usually lasts one or two decades.
Various studies have shown that the revolutions in knowledge, communications and transportation technologies have shortened both the cycle and every stage in it. This is attributed to the more rapid dissemination and all-pervasive character of contemporary information.
The values of important parameters such as the equilibrium general price level and other gauges of expectations (such as equity prices) are all determined by data. The more information is available more readily - the more efficient the markets and the shorter and the speedier the business cycles. This enhances the false perception that modern markets are inherently unstable. Yet, rapid cycling does not necessarily imply instability. On the contrary, the faster the adjustments in the marketplace - the more efficient the mechanism is.
The psychological wellbeing and reassurance brought on by disinflation generate demand for assets, especially yielding ones (such as real estate or equities). The more certain the future value of streams of income, the more frequently people transact and the more valuable assets become.
Assets store expectations regarding future values. An assets bubble is created when the current value (i.e. price) of money is low compared to its certain future value. This is the case when prices are stable or decreasing. Stock exchanges and real estate then balloon in irrational exuberance out of proportion to their intrinsic (or book) value.
All asset bubbles burst in the end. This is the fifth phase. It signifies the termination of the bull part of the cycle. Asset prices collapse precipitously. There are no buyers - only sellers. Firms find it impossible to raise money because their obligations (commercial paper and bonds) are not in demand. A credit crunch ensues. Investment halts.
The bursting of an assets bubble generates asset price deflation. The "wealth effect" is replaced with a "thrift effect". This adversely affects consumption, inventories, sales, employment and other important angles of the real economy.
The deflationary phase, on the other hand, is usually much shorter. People do not expect it to last. They fully anticipate inflation. But though not assured of low prices, they are so preoccupied with economic survival that they become strongly risk averse. While in times of inflation people are looking for ways to protect the value of their money - in times of deflation people are in pursuit of mere livelihood. A dangerous "stability" sets in. People invest in land, cash and, the more daring, in bonds. Banks do the same. Growth grinds to a halt and then reverses.
If not countered by monetary and fiscal means - a lowering of interest rates, a fiscal Keynesian stimulus, an increase in money supply targets - a monetary deflation might set in.
Full-fledged deflations are rare. Outright or growth recessions, business slumps, credit crunches, slowdowns - are more common. But a differentiated or discriminatory deflation is more common. It strikes only certain sectors of the economy or certain territories.
A monetary deflation - whether systemic or specific to certain industries - is pernicious. Due to reversed expectations (that prices will continue to go down), people postpone their consumption and spending. Real interest rates skyrocket because in an environment of negative inflation, even a zero interest rate is high in real terms. This is known as a "liquidity trap".
Investment and production slump and inventories shoot up, further depressing prices. The decline in output is accompanied by widespread bankruptcies and by a steep increase in unemployment. The real value of debt increases ("debt deflation"). Coupled with declining asset prices, deflation leads to bank failures as a result of multiple debts gone sour. It is a self- perpetuating state of affairs and it calls for the implementation of the seventh and last phase of the cycle: reflation.
The market's failure, at this stage, is so rampant that all the mechanisms of self-balancing and allocation are rendered dysfunctional. State intervention is needed in order to restart the economy. The authorities need to inject money through a fiscal stimulus, to embark on a monetary expansion, to lower interest rates, to firmly support the financial system and to provide tax and other incentives to consume and to import.
Unfortunately, these goals are best achieved militarily. War reflates the economy, re-ignites the economic engine, generates employment, increases consumption, innovation and modernization.
Still, with or without war, people sense the demise of an old cycle and the imminent commencement of a new one, fraught with uncertainty. They rush to buy things. Because the recessionary economy is just recovering from deflation - there aren't usually many things to buy. A lot of money chasing few goods - this is the recipe for inflation. Back to phase one.
But the various phases of the cycle are not only affected by psychology - they affect it.
During periods of inflation people are willing to hazard. They demand to be compensated for the risk of inflation through higher yields (returns, profits) on financial instruments. Yet, higher returns inevitably and invariably imply higher risks. Thus, people are forced to offset or mitigate one type of risk (inflation) with another (credit or investment risk).
Paradoxically, the inflationary segment of the business cycle is an interval of certainty. That inflation will persist is a safe bet. People tend to adhere to doctrinaire schools of economics. Based on the underlying and undeniable certainty of ever-worsening conditions, the intellectual elite and decision-makers resort to peremptory, radical, rigid and sometimes coercive solutions backed by ideologies disguised as "scientific knowledge". Communism is a prime example, of course - but so is the "Free Market" variant of capitalism, known as the "Washington Consensus", practiced by the IMF and by central bankers in the West.