Its a cycle stupid!

The biggest mistake in macro-economics is to forget that there is an economic cycle. Yet recessions follow upswings and recoveries follow recessions. And my research suggests it is not just random. It is not that the economy normally grows nicely but just periodically gets knocked off course by an oil shock price or an over-aggressive Fed. Thats what a lot academic textbooks suggest. But I think the older economists had it right - a cycle is something natural, with each stage arising out of the earlier stage. I go back to Schumpeter in particular and his magisterial two-volume study Business Cycles published in 1939. It may be hopelessly out of fashion now but I think studying macro-economics through the framework of a business cycle is much more fruitful than thinking in terms of equilibria or equilibrium paths.

I have set up this website and blog to showcase this research. The business cycle framework used here has been developed over years of studying and writing about the US economy. It identifies 5 stages of the cycle and 6 main drivers. By first identifying which stage of the cycle we are in we have a better idea of what to expect next. Then we can analyse the drivers to see how they are unfolding which gives us a sense for when the next stage might begin.

And the typical US cycle on my reckoning lasts 7-11 years. That isnt what the NBER says, (the official daters of the business cycle) because they calculate the average length of the cycle. The problem is that the average is distorted by a couple of short cycles, caused by special factors like the credit controls in 1980. Take out those non-typical cycles and you find that the US has had cycles in the 7-11 year range in the 60s, 80s, 90s, 2000s, and 2010s.

So why does it last 7 years or more 'normally'? Because it takes that long for the 6 drivers to play out. Inflation, my first driver, ends the Recession stage on the ropes and usually doesn't pick up again during the Recovery or Early Upswing stage. Only in the Late Upswing stage does a strong economy with low unemployment typically push inflation higher. And monetary policy, the second driver, responds to that, pushing up rates, which eventually (often) chokes the upswing in one way or another and leads to the Peak or Slowdown stage and then, inevitably into the next Recession.

The third driver is pent-up demand. In the Recovery and Early Upswing stage there is plenty of pent-up demand. Think of the way US car sales surged upwards for years from 2009 onwards before topping out in 2017. The fourth driver is business investment. That usually picks up in the Early Upswing stage but often only gets motoring in the Late Upswing stage so it helps to keep the economy going along in the second half of the cycle when consumers' pent-up demands may be fading and the Fed is often tightening.

The fifth driver is financial fragility. The point here is that because of the financial fragility revealed by the Recession, banks and borrowers are cautious in the Recovery and Early Upswing period. So risk is contained which means that if there is an outside shock, the risk of it throwing the whole economy back into recession is limited. Only later, during the Late Upswing phase does credit and leverage really take off. That also keeps the economy going for a while, though stores up trouble for the future.

The sixth driver, inventories is on a cycle of its own, typically 2-3 years. The importance of this driver is its role in the turning points of the main cycle. Typically it plays a major role in swinging the economy into recession and swinging it out again.

And why does the cycle usually not last more than 11 years? Because these drivers eventually create the conditions for high inflation, high rates, satiated consumers, over-investment and financial fragility. At that point the Late Upswing stage reaches the Peak or Slowdown stage and soon into Recession.

Of course all this is a typical cycle but each cycle is different. For a start the current cycle already threatens to go on longer than any previous US cycle and breach my 7-11 year range. That will be the topic of a future post.