There is no such thing as a ‘business cycle’

There is no such thing as a ‘business cycle’

By Lars Christensen, Founder & CEO Markets & Money Advisory, LC@mamoadvisory.com.

It says in the Bible (Genesis 41:27) that “the seven lean, ugly cows that came up afterward are seven years, and so are the seven worthless heads of grain scorched by the east wind: They are seven years of famine.”

This is essentially a description of what economists normally call the ‘business cycle’, and commentators often talk about the business cycle as if it were nearly as regular or God-given as the seven lean years and seven fat years in the Bible. If we look at macroeconomic developments, we can also observe that there are periods of high growth and periods of low growth in the global economy. Furthermore, we can observe that there seems to be what statisticians and economists call an “autocorrelation” in the GDP growth numbers. If growth is high one year, then it is likely that it will also be high during subsequent years. In that sense, we can observe ‘cycles’ in macroeconomic activity.

This causes some to conclude that the ‘business cycle’ follows some kind of regularity, which is unrelated to macroeconomic policies and economic institutions. The world-famous economist John Maynard Keynes even talked about ‘animal spirits’ – that there are periods of excessive optimism and excessive pessimism, which generate alternating booms and busts in investment and consumption.

I would venture to suggest, however, that we are fooling ourselves if we think there is a ‘business cycle,’ in the sense of a ‘natural law’ that dictates we must go through booms and busts. Those who believe in such a natural law are apt to make policy mistakes.

My view of the business cycle, or should I rather say the non-business cycle, is inspired by two of my favourite economists: Irving Fisher (1867-1947) and Milton Friedman (1912-2006). Both fundamentally believed that without policy shocks – or some other kind of external circumstance such as changes in the weather – there would be no booms or busts. In economic lingo, we would say that the business cycle, or the economy’s downturns and upturns, is the product of exogenous shocks rather than an inbuilt characteristic of a free market economy. Hence, the ‘business cycle’ is not a natural phenomenon – it is derived from external conditions.

This caused Milton Friedman to suggest that we should think of the economy within a framework of what he called his ‘plucking model’. He meant that we should think of the economy as taut string – a straight line. We can pull on the string until it is no longer straight, but once we let go, it reverts to its former condition.

A free market economy works in much the same way. Imagine, for example, that suddenly, the European Central Bank hiked interest rates out of the blue. That would be like pulling the string – the euro zone would go into recession, but gradually prices and wages would start to adjust and the economy would ‘straighten’ itself out again. Friedman didn’t say the recovery would happen fast, and he conceded that it would depend on how flexible wages and prices were, but nonetheless, it would gradually happen.

This understanding is at the core of Milton Friedman’s advice to central bankers – don’t pull the string. Keep it so it won’t disturb the economic system with erratic changes in monetary policy. Stick to clear and transparent rules, and it is likely that the market system will keep the economy stable.



WORLD LEADING ADVISORY SPECIALISING IN THIS TOPIC

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