LeoGlossary: Business Cycle
The business cycle is fluctuation in the aggregate demand for a nation. Economies go through periods of expansion and contraction, led by the demand of the consumers. These are long term moves that play out over years.
Many equate this to boom/bust cycles. While that tends to be attributed more to markets, there is a degree of validity when placing that upon the economy. When it is in a period of expansion, excess tends to take place. Companies will over hire due to the demand for its products/services. As this occurs, what is needed to enable those employees to operate also sees an increase. This can include real estate (office space), IT spending, and other services. When the economy shows signs of reversing, much of this has to be unwound.
From a macro standpoint, the metric used is Gross Domestic Product (GDP).
There tend to be 6 generally accepted stages to the business cycle.
Revenues and profits of companies start to increase. This requires more labor to handle the increase in business. The velocity of money is high as borrowers are able to pay off their debts. Banks are lending since the risk of default is lowered. The debt markets also see an increase in activities as larger, public corporations seek expansion of operations. Returns are fairly strong allowing for the use of leverage to work out.
During this period sentiment is high.
Here is where an economic top is realized. Customers find they are getting "tapped" out financially. Revenues of companies are leveling off as adjustments in consumption are made. This is often driven by an increase in essential costs, such as with commodities. As budgets are altered, some companies start to see a hit to their numbers. The next phase is only a matter of time as this spreads throughout the economy.
This is where the decent begins. Many are not aware of the reversal that took place so companies are still ordering like before. This results in a buildup of inventories. Economic indicators start to turn negative although many justify that is a temporary condition. Certain industries might start laying off but it is not widespread. Prices start to fall as companies are forced to slash to move inventory.
Markets can often reverse. Commodities are highly susceptible to demand. As recession takes hold, demand wanes. This is an area that many look forward signs of what is to come.
As the economic indicators keep worsening, companies start to wake up. This is the stage where unemployment takes off. The excess that was present during the expansion stage is eliminated. Money gets very tight as lenders start to increase the standards. Defaults result with banks taking a hit. Companies start to find their way into bankruptcy because they cannot keep up with servicing the debt under the new economic conditions.
The end is near.
This is the nadir. Sentiment is at its worst. Unemployment his high, company profits low, and GDP is negative. Contraction is at its peak. Declines in many areas are still felt as this stage is a leveling off period. Consumption is at its lowest with companies suffering from prolonged inventory problems. Manufacturing numbers are also at an unbearable point.
The final stage of the business cycle is the ascent upwards. Whereas the trip down is often fast and hard, the recovery stage can take years. Companies are still smarting for the beating they took as are customers. The early stages are slow as uncertainty still reigns.
Once a significant number of companies see improvement, things start to spread. While still trailing where things were earlier in the cycle, revenues are adding more cash to balance sheets. This leads to more hiring. Ultimately, unemployment starts to drop which helps households. Here we see spending fed with people willing to indulge more.
There is great debate about what causes the different phases to occur. Why does an economy suddenly go from expansion to contraction?
This is something the field of Economics theorized about. Some believe that pricing is a major factor in this since expansion tends to be accompanied with an increase in prices. Another view is that monetary policy leads to the point where tightening occurs.
One of the more popular views is that economic shocks are the reason. Throughout history we saw example where commodities such as oil sent economies reeling. The Great Financial Crisis was a bank run whereby banks were rushing around trying to be made good on their collateral. The most recent example was caused by the lockdowns associated with the COVID-19 pandemic.
There is still another line of thinking that the business cycle is simply a natural economic phenomenon. Whatever the event that people point to, the underlying conditions are such that reversal (from the expansion/peak stages) is bound to occur. In other words, while the instigator might change, the only reason it was able to have the impact was due to the conditions explained in the different stages.
If the economy was not filled with excess, labor, debt, leverage, etc..., the event itself would not create a contraction.
Problems With The Business Cycle
There is a growing field that believes the business cycle is no longer relevant. This stems from the fact that we see a country like China go decades without having negative GDP. Instead, the idea is to look for growth cycles and how they are slowing.
Obviously, if contraction does not take place, there is no business cycle.
It is hard to think this line of thinking will be substantiated long term. One of the first issues is that, while one can point to China, that is not true for everyone. During China's run up, most countries faced periods of economic contraction. China appears to be an outlier to the norm.
We also have to wait to see if there is a point where China does encounter negative GDP. If this happens, then this claim about the business cycle will be proven false.
There are a number of indicators or metrics that economists and others use to determine what is happening with the business cycle.
- unemployment figures
- workforce participation rate
- inventory growth rates
- consumer confidence indexes
- retail trade index
- manufacturing surveys
Over time, fluctuations along with shocks will cause some indicators to have less value. Macroeconomists try to make their analysis as broad as possible to derive what is taking place.
The stock and bond markets also can be forward looking indicators according to many. While they can be driven by sentiment, they usually process the data long before the economic numbers appear. Markets are designed to take in relevant information and provide an outlook going forward. For this reason, moves in markets tend to precede the business cycle.
For example, it is common for the economy to still be contracting while the bond and equity markets already bottomed out and starting to reverse course. This is often referred to as "markets already pricing it in".
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