Causes behind business cycles

Earlier, we learned about the four stages of a business cycle. But what are the causes behind such business cycles? So, let us understand. 

What are the causes behind business cycles?

1) Monetary policy -The interest rate cycle is very closely linked to the economic cycle. 

• If the economy is on a strong footing and inflationary pressures persist- Central banks will increase interest rates to slow down the pace of growth and keep inflation in check.
• If the economy enters into recession mode coupled with rising unemployment- Central banks will decrease interest rates to spur lending and boost economic growth.

Interest Rates Vs Stock Market

India Story

Changes in the level of interest rates are negatively correlated to consumer spending and economic growth. Empirical evidence shows that many bubbles burst when central banks raised interest rates in order to prevent the economy from ' overheating'.

Things were a little different before 1971 when the US Dollar was pegged to the Gold Standard. The gold standard was a monetary system in which each country's currency was valued against a fixed amount of gold. One could simply walk into any bank and convert their gold for US Dollars at a fixed rate. During the early 20th century, one ounce of gold cost $20.67 in the USA. The gold standard provided stability to currency values and hence promoted trade and investment. President Richard Nixon abolished the Gold Standard in 1971 and since then major currencies began freely trading on exchanges.

Today, fiat currency is backed by nothing more than belief. The belief that the currency note can be traded for goods and services. Yes, you heard it right!

The USA has Gold Reserves of 8000 metric tons approximating $500bn dollars in value stored safely at Fort Knox, Kentucky. The number of outstanding dollar bills amounts to $2.02 trillion. That's roughly 4 times. And wait, this number does not include bank deposits or other forms of wealth such as equities, real estate, and so on. Simply put, there are not enough gold reserves to honor every currency note in circulation.

In essence, there is no upper ceiling to the amount of currency a central bank can print.

The modern monetary theory is directly held responsible for significantly reducing the length of economic cycles. Two crisis periods in recent memory - The Lehman Crisis and the Coronavirus crash reiterated the role of central banks in reviving the battered economy. The Federal Reserve cut interest rates to near-zero on both occasions. The Fed responded to the 2008 crisis with emergency measures such as Primary Dealers Credit Facility (PDCF), Troubled Asset Relief Program (TARP), Bailouts of Fannie Mae, Freddie Mac, and AIG, and so on. In totality, it was a $1 trillion-dollar relief package.

It still took more than 2 years to get the economy on its feet

In 2020, this process was even more swift. In less than six months of the crisis, both Nasdaq and Nifty had well surpassed their previous peaks. Although we do not have the final stimulus figures as of yet, A $900 billion dollar stimulus plan has already been approved and a $1.9 trillion dollar package has been announced by President Joe Biden. Such unprecedented Liquidity has propelled asset prices to skyrocket.

A fictional ' fed put' has been created to arrest every single percentage drop in prices. It's the same story everywhere- BoJ, BoE, ECB, SNB, and our very own RBI as well.

Notice how Central Bank balance sheets have swelled post-March 2020. Money is sloshing around and as a result, we had the shortest bear market on record lasting less than 33 days precisely. The jury unanimously declares that central banks have maximum firepower to influence the length, depth, and quality of market cycles.

2) Supply & Demand- The increase/decrease in supply & demand is both a cause and an effect of economic cycles. Let us view this point against the backdrop of the 2008 Financial Crisis. Housing prices were on a tear since the early 2000's fuelled primarily by low-interest rates and subprime lending. The economy expanded at an average pace of 3% between 2002-06 Next in line-  housing prices peaked, demand fell, customers started to default, increasing foreclosures, huge supply glut and the rest is history.

3) Government spending & Macro-economic policies - Tax cuts along with increased government spending boost aggregate demand.  Similarly, an increase in taxes with reduced government expenditure will lead to a fall in aggregate demand. Also, the government can artificially influence demand in a particular sector by increasing/decreasing taxes, announcing favorable policies, providing various incentives, giving subsidies, etc.

Export-oriented industries are also prone to macro-economic policies announced by other countries. For instance, a protectionist regime in the USA might deal a significant blow to the Indian Pharma Industry.

4) Technology shocks - Hot news today is stale news tomorrow. Companies that do not make a constant effort to redevelop themselves become a thing of the past in no time. These companies were the poster-boys of revolution at one point in time but today intense competition has left them battered and bruised- Yahoo Inc, Nokia, Blackberry, Xerox, Walkman, Compaq, Polaroid, Canon, Kodak, and so on. The list of such market stalwarts is endless. Moserbaer is one company I recall in the Indian context.

5) Human Behavior- One cannot truly understand market cycles without studying the many psychological elements at play in behavioral economics. Greed and fear are two sides of the same coin and have been known to aggravate economic cycles. Market participants behave in a pro-cyclical manner due to human nature and other cognitive biases that fed the booms and intensified the busts. 

Having learned about the different causes behind the business cycle, it remains unclear how we can predict the peaks and valleys of an economic cycle. In the next unit, We will be talking about the different indicators that help us to predict.