Sunday, April 20, 2008

The Business "Cycle"

I want to correct one particularly glaring misperception that has been increasingly rearing its head in the debate over what the government should do, if anything, in response to the ongoing housing/credit crisis. A growing number of the "let the market be" advocates have been arguing that government action isn't required because this is just a "normal business cycle." For example:

What is scary is the degree to which the Fed assimilated the alarmism on the Street: “These guys are so afraid of an economic cycle,” a hedge-fund manager remarked.
Let's be clear: the business cycle is not a "cycle." Just because recessions are normally part of the business cycle doesn't mean that recessions are predetermined or predictable, and most importantly, a full recovery is not predetermined (see e.g., Japan, Great Depression). The "business cycle" is just the short-run fluctuations in economic activity. For those of you who don't have time to take a refresher Intro to Macroeconomics course, here's what you would have read in Greg Mankiw's basic Principles of Economics textbook:
"The term business cycle is somewhat misleading, however, because it seems to suggest that economic fluctuations follow a regular, predictable pattern. In fact, economic fluctuations are not at all regular, and they are almost impossible to predict with much accuracy." (pg. 724)
Aggregate demand doesn't always increase itself; most of the time, in fact, it requires monetary stimulus via Fed rate cuts, and other times it requires fiscal stimulus. Government intervention is thus part of the "normal business cycle" every bit as much as recessions. My intuition is that some Wall Streeters and hedge fund managers adopt the deterministic "this is just a business cycle" argument because it allows them to excuse their own malfeasance. That is, they can say to themselves, "It wasn't my actions that led to this recession, it was the unstoppable forces of the normal business cycle. I had no choice." I've always thought that the simple act of replacing the term "business cycle" with "fluctuations in economic activity" in economics textbooks would produce substantial social benefits in the long-run. I'm looking at you, Professor Mankiw!


Gabriel M said...

Impulse and propagation. Sing it brother!

Still, that Fed action is or is not required doesn't follow from that alone.

Anonymous said...

You're right, and I personally would like to see the Fed stop cutting rates. I just can't stand the people who condemn anything the Fed does as an "overreaction to a normal business cycle," as if there's some immutable law that recessions are predetermined and self-curing.

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