What is the Business Cycle?

The business cycle is like riding a bike on a hilly road…

Gravity pulls you down the hill, and when you reach the bottom, momentum helps you up the first part of the next one. Climbing higher requires a lot of effort, and eventually there’s nowhere to go but down. From there, you do it all again.

There are four stages to the business cycle:

1. Growth

The default direction of an economy is up. Growth occurs for two reasons. First, as a population gets bigger, it buys more goods and services. Second, businesses have an incentive to reduce costs (which increases profit), so they invest in improving efficiency and increasing productivity. In other words, we get more economic activity out of the same amount of resources.

But as the economy grows, workers get harder to find. Wages begin to rise. With more money circulating, prices begin to go up as well, causing inflation.

The longest expansion stage on record began in June 2009 and lasted until February 2020, when economic instability ensued as a result of the COVID-19 pandemic. The previous longest growth phase occurred between March 1991 and March 2001 (120 months). Those two periods of sustained growth are unusual. On average, an expansion in the US has lasted 38.7 months.

2. Peak

Eventually, the economic engine reaches an upper limit. When all your friends are making money, you tend to want to join them. But when everyone has a job, a new business must pay premium wages to entice employees to come on board. And when most real estate is occupied, rent shoots through the roof. These increasing costs of business make growth difficult. As a result, the economy stops growing — It reaches a peak.

3. Contraction

After the peak, companies that took out loans assuming they’d be able to pay them back thanks to continued growth may start missing payments. They lay off employees and pull back on their plans. People losing their jobs lose their incomes, so they cut back on household spending. Businesses see sales decline, which means they need to reduce payroll, too. The process feeds back on itself in a vicious circle of contraction.

As the economy stumbles, workers become easier to find. Companies don’t need to offer the same compensation and benefits to attract them anymore, so wages begin to fall. Likewise, businesses find it more difficult to find customers. They begin slashing prices to attract business and inflation rates may even turn negative (called deflation).

The average length of a contraction in US business cycle has been 17.5 months since 1854. The recession that began in December 2007 officially ended in June 2009 (18 months). The US also experienced recessions that started in 2001 (8 months), 1990 (8 months), and 1981 (16 months). The COVID-19-induced recession began in June of 2020 and resulted in a broad decline in economic activity as a result of stay-at-home orders, quarantines, and significant job layoffs.

If a contraction is severe enough, it might get classified as a depression. There has only been one contraction that received this label: The Great Depression, which started in 1929 and lasted 3.5 years.

3. Trough

Eventually, the unemployment pool gets deeper. Rather than companies competing for workers by increasing salaries, the unemployed compete against each other for whatever work they can find. Wages fall. Property values fall. The price of everything goes down. Finally, the economy hits rock bottom – The trough. On average, a US recession has hit its trough every 56 months since 1854.

The low-cost environment makes for fertile ground from which new businesses can grow. Once some companies achieve success, others join in. As people begin receiving paychecks again, they buy more stuff, which means companies need to hire more employees to handle the increase in business. The virtuous cycle kicks in and pushes the economy into recovery, and eventually to new heights. Then the loop starts all over again.

Economists measure changes in the economy and define the point at which it enters different stages of the business cycle. The National Bureau of Economic Research (NBER), a non-profit, non-partisan research group, is the entity that officially declares the start and end of a recession in the US. Data is collected after the fact, so it’s not uncommon for a downturn to be over before the organization officially declares a recession. The recession that officially began in December 2007 was announced in December 2008 — a full year after it started and just six months before it was over.

NBER has identified 33 defined business cycles in the United States since 1854. To determine when a recession (the portion of the business cycle in which the economy is contracting) begins, economists define a recession as two consecutive quarters (or six months) of decline in gross domestic product (the value of all goods and services produced in a country over a certain time period).

However, GDP is only one measure of economic health. Sometimes unemployment rates, wages, household income, real estate values, foreclosure rates, bankruptcies, and other statistics can point toward a weakening economy without the GDP statistic picking up on it (that usually occurs due to inflation). Other times, GDP might signal something is wrong, but the rest of the indicators don’t. Because there are complex factors to consider beyond the textbook definition of a recession, NBER takes into account not only GDP growth but also statistics like wage growth and unemployment.

Once GDP growth returns to positive territory, the recession is deemed to be over, and a recovery period begins. However, people who lost their jobs may have a hard time finding work long after economists say a recession is over. And it may take a long time before the economy gets back to where it was. But technically, a recession is over when GDP begins to grow again.

There are two economic schools of thought on the business cycle. One says, “leave it alone, and let it self-correct.” The other says, “smooth out the cycle by using the good times to lift the bad times.”

Laissez-Faire

The first school of thought is called laissez-faire, which loosely translates to “let it be” or “hands-off.” This approach holds that the natural forces of an economic system push things back to where they should be. By this logic, no government intervention is required to right the economy. Opponents of this view believe the government’s job is to help the public and that sitting on the sidelines while people need aid is immoral.

Keynesian

The second school of thought is called Keynesian economics (named after the famous British economist John Maynard Keynes). This school believes the government should intervene to support the economy when it needs help. The most common intervention is increasing government spending to stimulate the economy, even if that means issuing debt. Debts are supposed to be paid back with the increased tax revenue that comes with a stronger economy. Other options include decreasing taxes during a recession to motivate investment.

Types of Government Intervention

Collectively, government interventions like adjusting spending or taxes are known as “fiscal policy.” Critics of fiscal policy point out that it can be hard for decision makers to time the strategy. Since a recession may be over before Congress passes a budget, the intervention might not be necessary at that point. Also, it tends to be easier to cut taxes and increase spending than the opposite, making it difficult to reverse these actions once the recession ends. Critics point to the rising national debt in the US as evidence that the strategy doesn’t work as planned.

A nation’s central bank, such as the Federal Reserve in the US, also plays a role in smoothing out the business cycle. During recessionary times, it can expand the money supply by reducing interest rates and purchasing bonds. That tends to encourage spending and helps unfreeze credit markets. During an expansionary period, the bank can fight inflation by increasing interest rates and selling bonds. These efforts reduce the supply of money and slow things down. Collectively, these actions by the central bank are known as “monetary policy.”

People often think the stock market is a measure of the economy. In reality, the stock market reflects the value of the companies operating within an economic system. The best indication of an economy’s health is the value of all the things it produces (known as gross domestic product, or GDP).

Market cycles (the tendency for the stock market to go through periods of increasing and decreasing values) and business cycles are related. How much a company reaps in sales helps determine its earnings, and those earnings help establish a company’s value (reflected in its stock price). But there can be bull and bear markets (periods of growing and falling stock values respectively) without the whole economy moving through a business cycle.

It’s best to think about movements in the stock market as a gauge of how investors expect the economy to progress. It’s a measure of how investors and consumers feel things are heading and an indication of how well businesses are doing — But it’s not an official measure of the economy, and you shouldn’t confuse a market correction with a recession. Still, paying attention to the stock market might provide some useful insight into which stage of the business cycle is coming.