Trade Cycles and Their Phases

Its features, listed for an answer. Rising national income; full or near full employment; rising prices and wages; high profits; heavy investment in plant and machinery; expansion of bank credit; rising share prices; a shortage of skilled labour and of some materials; and an increase in imports as domestic demand runs ahead of domestic supply.

Why it cannot last. Because the very conditions of a boom destroy it. Costs rise as materials and skilled labour become scarce. Interest rates rise. New capacity built during the boom comes into production and adds supply just as costs are highest. And somewhere the most optimistic investment turns out to be a mistake.

The upper turning point

The moment prosperity turns into recession. Some investment fails to earn what was expected; a lender contracts credit; confidence, which was self reinforcing on the way up, begins working the other way.

Phase two: recession

What it looks like. The turning point is now visible. Orders fall, unsold stocks rise, firms cut production and stop new investment. Employment falls. Prices and profits fall. Banks, seeing higher risk, restrict credit, which makes the contraction worse. Share prices fall. Failures begin among the weakest firms.

Its features. Falling output and employment; falling prices and profits; cancellation of investment plans; rising inventories, at first involuntarily and then deliberately run down; contraction of bank credit; falling share prices; and, crucially, a collapse of business confidence, which is the mechanism that turns a downturn into something worse.

Recession has a working definition used in reporting, though not a law of economics: two consecutive quarters of falling real gross domestic product.

Phase three: depression

What it looks like. The extreme of the downswing. Output and employment are at their lowest. Prices are at their lowest and may be falling still, which is deflation. Many firms have closed. Investment has stopped almost entirely, and there is heavy excess capacity, so a fall in the interest rate does little, because nobody wants to borrow to build what is already standing idle. Bank failures are possible.

Its features. Mass unemployment; general fall in prices, wages and incomes; heavy excess capacity; near zero investment; low interest rates that do not revive borrowing; contraction of world trade; and a deep pessimism that is itself part of the problem.

The historical reference every answer should have. The Great Depression that began in 1929 is the standard example, and it is the reason macroeconomics exists as a separate branch, as [Microeconomics and Macroeconomics] explains.

The lower turning point

The point at which the fall stops. Two things usually cause it. Plant and equipment wear out and eventually have to be replaced whether or not anybody feels optimistic, so replacement investment revives. And costs, wages, interest rates, material prices, have fallen far enough that an investment which was unprofitable at boom costs becomes profitable again.

Phase four: recovery or revival

What it looks like. Replacement orders reach the capital goods industries, which take on workers. Those workers spend, which raises demand for consumer goods. Firms find stocks running down, so they produce more. Employment, income, prices and profits all begin to rise. Credit expands. Confidence returns and the process becomes cumulative again, carrying the economy back into prosperity.

A caution to state. Recovery may be slow and false starts are common. That is why policy intervenes at this point rather than waiting.

The four phases compared

Other kinds of cycle, named

Economists distinguish cycles by length, and naming them is worth a line.

• Kitchin cycles, about three to five years, driven by inventory adjustment.
• Juglar cycles, about seven to eleven years, driven by investment in plant and equipment. This is the classic trade cycle and the one this chapter describes.
• Kuznets swings, about fifteen to twenty five years, associated with building and infrastructure.
• Kondratieff long waves, about fifty years, associated with major technological change.

A worked example: a cycle in one industry town

The town. A district whose economy rests on a cluster of auto component units supplying vehicle makers.

Prosperity. Vehicle sales are strong. The units run double shifts, hire 400 extra workers, and two proprietors order new presses on borrowed money. Shops in the town do well, land prices rise, and a new hospital and two schools open. Bank branches lend freely.

Upper turning point. Fuel prices rise sharply and interest rates on vehicle loans go up. Vehicle sales slow. The presses ordered eighteen months ago are delivered now, into a falling market.

Recession. Orders to the component units fall by a third. Overtime stops, then the second shift. The 400 extra workers go first. Unsold stock accumulates. The two proprietors cannot service their loans. Shops in the town see takings fall, and they in turn stop hiring.

Depression. Two of the seven units close. Half the town's workers are unemployed or on short time. Rents and land prices fall. The bank stops lending against local property. The new presses stand idle, so even at a lower interest rate nobody will buy machinery.

Lower turning point. After two years the surviving units' older machines fail and must be replaced. Wages and rents in the town are now much lower than in the neighbouring district, so a vehicle maker places a trial order there because it is cheap.

Recovery. The trial order becomes a standing one. A unit reopens under new ownership. Workers are recalled, the shops see takings rise, and the cumulative process begins again.

What the example teaches. Notice how the swing was violent in capital goods, the presses, and mild in the town's grocery trade; how confidence amplified both directions; and how the turning points came from replacement and from cost, not from anybody's decision to end the slump.

What beginners get wrong

"Trade cycles are regular, so the next slump can be dated." They are recurrent and not periodic. Nobody can date the next turning point, and an answer that implies otherwise is wrong.

"Recession and depression are the same." Recession is the downswing; depression is its extreme and prolonged form, with mass unemployment and falling prices. Every depression begins as a recession; most recessions do not become depressions.

"A cycle is the same as inflation." Inflation is a rise in the general price level. It typically accompanies a boom, but an economy can have inflation with stagnant output, which was called stagflation when it occurred in the 1970s and which the simple cycle does not describe.

"A falling growth rate is a recession." Growth falling from eight per cent to six is a slowdown. A recession requires output to fall, not merely to grow more slowly. The distinction matters in India, where the economy has continued to grow through periods described in the newspapers as slumps.

Limits of the analysis

The four phase description is a stylisation. Real cycles are irregular in length and depth, and some have no clear depression at all.

It does not explain what causes the cycle. That is the subject of the next chapter, and the four phase description is compatible with several competing explanations.

Modern policy has changed the shape. Deposit insurance, automatic stabilisers such as unemployment benefit and progressive taxation, active monetary policy and coordinated fiscal action have made deep depressions rarer than they were before 1945, though not impossible.

A developing economy's fluctuations have different causes. In India, the monsoon, world commodity prices and capital flows have historically mattered more than the classic investment cycle.

Quick revision

1. Trade cycle: recurrent but not periodic fluctuation in aggregate economic activity, general across sectors, cumulative and wave like, felt most in capital and durable goods, and international in transmission.
2. Four phases: prosperity, recession, depression, recovery, joined by an upper turning point and a lower turning point.
3. Prosperity: rising output, employment, prices, profits, investment and credit; optimism; ends because costs and interest rates rise and new capacity arrives.
4. Recession: falling orders, rising unsold stock, cancelled investment, contracting credit, collapsing confidence. Working definition: two consecutive quarters of falling real GDP.
5. Depression: mass unemployment, lowest prices, heavy excess capacity, investment near zero, low interest rates ineffective. The Great Depression from 1929 is the standard example.
6. Recovery: driven by replacement investment and by costs having fallen far enough, then cumulative.
7. By length: Kitchin three to five years, Juglar seven to eleven, Kuznets fifteen to twenty five, Kondratieff about fifty.
8. Recession is not depression, and a fall in the growth rate is not a recession.

Test yourself

1. Define a trade cycle and state its characteristics. A trade cycle is the recurrent fluctuation in the level of aggregate economic activity of a country, in which periods of expansion in output, income, employment, prices and profits alternate with periods of contraction. Its characteristics are that it is recurrent but not periodic, so no fixed interval can be stated; that it is general and synchronised across sectors rather than confined to one industry; that it is cumulative and self reinforcing in both directions; that it strikes capital goods and durable consumer goods industries far harder than the industries producing necessities; and that it is transmitted internationally through trade and capital flows.

2. Describe the four phases of a trade cycle. In prosperity, output, employment, income, prices and profits are high and rising, investment is heavy, bank credit expands and optimism is general. At the upper turning point some investment disappoints and confidence begins to fall. In recession, orders decline, unsold stocks accumulate, investment plans are cancelled, employment and prices fall, credit contracts and confidence collapses. In depression, output and employment are at their lowest, prices may still be falling, excess capacity is heavy and investment nearly ceases, so that even low interest rates fail to revive borrowing. At the lower turning point worn out equipment must be replaced and costs have fallen far enough to make investment profitable again, and in recovery replacement orders reach the capital goods industries, employment and incomes rise, stocks run down and the cumulative process carries the economy back to prosperity.

3. Distinguish recession from depression. Recession is the downward phase of the cycle, in which output, employment, prices and profits are falling from the peak; it is often identified in practice by two consecutive quarters of falling real gross domestic product. Depression is the extreme and prolonged form of that downswing, marked by mass unemployment, a general fall in prices and wages, heavy excess capacity, near cessation of investment and widespread business failure. Every depression begins as a recession, but most recessions do not deepen into a depression.

4. Why do capital goods industries suffer more in a trade cycle than consumer goods industries? Because the purchase of a capital good or a consumer durable can be postponed, while the purchase of food, fuel and other necessities cannot. When incomes fall or the future looks uncertain, households defer a car or a house and firms defer new machinery altogether, so demand for those goods falls sharply. Demand for necessities is inelastic and changes little. The result is that fluctuations in aggregate activity are magnified in the industries producing machinery, construction materials and durables, and muted in those producing everyday consumption goods.

5. What brings a depression to an end? Two forces, neither of which depends on a return of confidence. First, plant, machinery and equipment continue to wear out during the depression and must eventually be replaced if production is to continue at all, so replacement investment revives and orders reach the capital goods industries. Second, costs fall during the downswing: wages, rents, material prices and interest rates are all far lower than at the peak, so an investment that was unprofitable at boom costs becomes profitable again. Once the first orders are placed, employment and incomes rise and the process becomes cumulative.

6. Name the four types of cycle distinguished by length. Kitchin cycles of roughly three to five years, associated with the adjustment of inventories; Juglar cycles of roughly seven to eleven years, associated with investment in plant and equipment, which is the classic trade cycle; Kuznets swings of roughly fifteen to twenty five years, associated with building and infrastructure; and Kondratieff long waves of about fifty years, associated with major clusters of technological change.

7. "India's growth rate fell from 8 per cent to 6 per cent, so India was in recession." Comment. The statement is wrong. A recession requires the level of output to fall, not merely to grow more slowly. A decline in the growth rate from eight to six per cent is a slowdown in which the economy is still expanding, and both output and employment are higher at the end of the year than at the beginning. The practical test used in reporting is two consecutive quarters of falling real gross domestic product, which is a fall in the level. The distinction matters particularly in India, where periods described in public discussion as slumps have generally been periods of slower positive growth.