see Business Cycles
Accurately forecasting the next boom or bust provides strategic advantages to business firms and can be an easy path to personal riches. (Perhaps you thought fortunetellers were used only for romantic forecasts.) Even though scant and unreliable statistics limited early economists to impressionistic theorizing about swings in economic activity, their thoughts provide important and lasting insights into the nature of macroeconomic fluctuations.
External Shock Theories
Many early business cycle theories focused on such external shocks as wars or weather.
External shocks are economic disturbances that originate outside an economy.
External shocks remain potent disrupters of an economy. For example, shocks from soaring oil prices severely weakened the economies of most oil-importing nations in the 1970s.
And then there is the shock of war. Some sectors of an economy may flourish (e.g., weapons manufacturing), but conflict wreaks havoc on both victorious and vanquished nations. Wars divert output away from capital investment and destroy equipment (e.g., factories), infrastructure (e.g., bridges and roads), and labor (e.g., soldiers). Today, agriculture dominates few economies, but weather cycles—another external shock—are still studied to help predict the effects of erratic crop yields. For example, in 1993, record floods in parts of the U.S. farm belt and severe drought in other areas drove up food prices internationally. Unless crop failures are global, however, countries are now buffered somewhat by increased ability to import from regions blessed by bumper crops.
The sunspot theory is an exotic external shock theory developed in 1875 by W. Stanley Jevons, a pioneering mathematical economist. Jevons reasoned that sunspots (nuclear storms on the sun’s surface) affect weather and, hence, agriculture. Although Jevons’ theory has been discredited (along with reading tea leaves or the entrails of goats), new sunspot theories may develop if we ever depend heavily on solar energy.
Population Dynamics Theories
Early economists often pondered the long-term effects of such events as wars or the opening of new territory. Thomas Malthus (1766–1834) popularized a population dynamics approach, which concludes that bare subsistence is all that people can ultimately expect. A theory from biology illustrates why these early forecasts were pessimistic.
Subsistence and Population S-Curves Suppose that at time = 0 in Figure 3, a few rabbits are set loose in a new territory (as in Australia at the beginning of European colonization). With ample space and food, rabbits prosper and their population growth accelerates. Competi-tion for food and territory mounts, however, when rabbits reproduce excessively (as they will). Malnutrition and a parallel population explosion of predators (packs of wild dingo dogs) eventually depresses the rabbits’ population growth. Survival of the fittest means rabbits that fail to secure territory starve. An equilibrium population entails shorter lifespans. This sequence is called a population S-curve.
Malthus used a similar model to describe the growth of human populations. He viewed our procreative urges as constant, but argued that birth rates depend primarily on maternal health. Favorable events trigger population explosions because birth rates rise while death rates fall. But population pressures against available resources eventually stifle economic activity, leaving only plagues, famine, or war to impede population growth. Booms and then busts, according to this line of reasoning, should alternate across generations.
Early fans of Malthus’s model failed to anticipate technological advances and generally opposed birth control programs. Their speculations now apply more to primitive economies than to modern industrial giants. To this day, however, modernization in less developed countries is often offset by population growth that constrains standards of living to subsistence levels for the majority of the population; starvation is the ultimate population check in Malthus’s theory. Small wonder that the historian Thomas Carlyle, a contemporary of Malthus, characterized economics as “the dismal science.”
Marxian Capitalistic Crises
Contrary to popular stereotypes, Karl Marx was in awe of economic progress under the market system. In The Communist Manifesto (1848) (BBC news on the book 2008) , he marveled that capitalism
has created more massive and more colossal forces than have all preceding generations together.... It has accomplished wonders far surpassing Egyptian pyramids, Roman aqueducts, and Gothic cathedrals; it has conducted expeditions that put in the shade all former migrations of nations and crusades.
Nevertheless, Marx condemned markets as permitting the rich and powerful to exploit workers.3 Describing his views as “scientific socialism,” he predicted that capitalism would spasmodically expand and then contract, with each peak higher than its predecessor and each successive crash deeper than the last.
Marxists view business cycles as driven by increasing concentrations of wealth in the hands of capitalists. Underconsumption is inevitable when, because rapid investment and growth distribute income inequitably, workers lack income to buy all the goods they produce. Glutted markets then plunge capitalism into depressions or imperialistic wars. An upswing emerges when new markets open, new raw materials are discovered, or a successful war yields plunder for capitalists to exploit. This plants the seeds for the next downswing, and so on. Finally, the working class overthrows its exploiters, the spark of a revolution igniting during the abyss of a deep depression.
Marx’s ideas inspired generations of radical critics of capitalism, and he provided a number of predictions about the course of history. Most have proven wrong. The recent collapse of most communist governments and their replacement by market-oriented systems, for example, is absolutely contrary to Marx’s predictions.
Long Waves and Innovations
The resurgence of entrepreneurial instincts in former Eastern bloc nations might also have surprised Joseph Schumpeter, whose writings celebrated the creative vigor of capitalism. In 1911, he proposed a long-wave theory of business cycles in which development is fueled when entrepreneurs initiate such innovations as (a) discoveries of raw materials, (b) new goods or new quality in familiar products, (c) technological advances, (d) the opening of new markets, or (e) major reorganizations of industries.
Major innovations generate spinoffs, which are related inventions, mimicries of an original innovation, or the births of new industries. Such advances as microelectronics, Teflon, and laser surgery, for example, were spinoffs of the space program. Economic growth peaks by the time society fully adapts to a major innovation; saturated markets cannot absorb further supply increases or emulation of the new technology. When firms retrench, the economy slumps while awaiting fresh innovations. The next long-wave process is sparked (but only after a delay) by a new wave of innovation. Of course, minor innovations might explain shorter cycles.
Schumpeter identified certain institutional features in a society as essential for innovation and economic vitality. First, entrepreneurs must have broad discretion about how to operate. Second, well-developed financial markets must channel credit to entrepreneurs, allowing investment in new capital and R&D even before they actually contribute anything to national income.
Schumpeter used railroads to illustrate major innovations.4 Cars, planes, and advances in agriculture have also driven U.S. economic development. More recently, computers have enabled some firms to grow to sizes that were impossible when information processing was primitive, and microprocessors have thrust an array of new consumer goods (e.g., garage door openers, electronic toys, and microwave ovens) into the realm of necessities for many Americans. Perhaps the most underrated innovation of the past century is the supermarket, which reduces transaction costs for an incredible variety of goods. Supermarkets provide outlets for specialized firms that would have been denied shelf space in old-fashioned general stores.
In the past few decades, economically less developed areas such as Japan, Taiwan, Hong Kong, South Korea, Malaysia, Mexico, and, most recently, China and India, have experienced dramatic growth, largely through the implementation of market incentives.5 Schumpeter would not have been surprised by the progress made possible by competition among ambitious entrepreneurs. One major prediction extended beyond even Schumpeter’s own long-wave theory (30 to 60 years). It seems strange, but Schumpeter, a devotee of capitalism, was almost as convinced as Marx that capitalism might ultimately self-destruct. However, he hypothesized a very different mechanism.
Schumpeter thought that prosperity created by capitalism (and not, as Marx thought, a capitalist depression) would ultimately create irresistible pressure for redistribution of income from the haves to the have-nots. This, in turn, would diminish entrepreneurial incentives, draining capitalism’s creative vigor. Thus, in essence, his most sweeping forecast was that capitalism would fall victim to its own success. Many modern economists who share Schumpeter’s enthusiasm for entrepreneurs as innovative heroes also see governmental growth in developed countries as an omen that Schumpeter’s worst fears are being realized.
Predictions of collapse or expectations of prosperity can be self-fulfilling. Psychological theories of cycles focus on how human herd instincts make prolonged optimism or pessimism contagious. These theories help explain the momentum of swings initiated by such external shocks as wars and natural disasters, or by changes in the expected profitability of investment or in the availability of natural resources.
When a real disturbance occurs in the form, say, of some external shock (e.g., a hike in energy costs), decision-makers’ reactions set off secondary shock waves, the psychological part of a cycle. Information is costly, so decisions often rely on educated guesses (much as you sometimes answer multiple-choice questions). Most business managers operate from the same forecasts and information bases, which include government and market research data; thus it is not surprising that firms often move in the same directions.
Business cycles unfold when firms adapt their plans to similar expectations. Once set off, waves of pessimism or optimism seem to have lives of their own. For example, pessimistic firms might slash output, lay off workers, and postpone investments. If workers then curb their own spending, firms with shrinking sales lay off even more workers. Thus, expectations of economic collapse may be self-fulfilling. (With psychology involved, is there any wonder at the term “depression”?)
A wave of optimism operates in the opposite direction. Recoveries commence when firms begin expanding output. More labor is hired, bolstering household optimism and spending, creating more employment, and so on. Psychological theories help explain inertia in a recovery or downturn, but cannot predict turning points in business cycles.
The emphasis on shared expectations from psychological theories has become central to modern business cycle theories. But how are expectations formed? One possibility is that investors and other interest groups often closely monitor government policies for signs about future events. For example, some analysts have nightmares that policy errors from the 1930s will be repeated. This group blames the Great Depression on a trade war set off by the Smoot-Hawley Tariff of 1930. In their view, the 1929 stock market crash was precipitated when it became apparent that Smoot-Hawley, the highest set of U.S. tariffs ever, would be enacted.6 Expectations that international trade would break down in the 1930s triggered a worldwide depression that began in 1929. This group views sentiment for governmental protection against international trade as a threat that could collapse economies everywhere.
Classical Macroeconomic Theory
The preceding theories provide important insights into economic fluctuations, but most modern economists now focus on two general theories that compete in explaining broad cyclic activity: classical theory and Keynesian theory. Classical economics was not the creation of a single mind. Instead, it melds the thoughts of mainstream economists dating back to Adam Smith.
Classical macroeconomic theory stresses coping with scarcity from the supply side as the key to macroeconomic vitality and supports (a) market solutions to problems and (b) laissez-faire (minimal) government policies.
Classical economics relies heavily on the self-correcting power of automatic market adjustments (Smith’s “invisible hand”) to cure macroeconomic instability, including excessive unemployment. Recessions create pressures for wages and prices to fall, which in turn, leads to growth of sales and expanding demands for labor. Opposite adjustments help prevent a rapid boom from overheating the economy.
Persistent high unemployment during the Great Depression of the 1930s clashed with classical predictions. Might decades pass before an economy self-corrected? Or was classical reasoning flawed? John Maynard Keynes (1883–1946), the most influential economist of this century, concluded that capitalism might neither automatically nor quickly recover from a depression.
Keynesian theory views inadequate demand as the cause of cyclic downturns and recommends actively adjusting government policies to combat instability.
The demand-oriented model in Keynes’s The General Theory of Employment, Interest, and Money (1936) dominated macroeconomics from the 1940s through the 1960s, but classical theory bounced back when Keynesian policies failed to cure the economic stagnation of the 1970s.
Some modern economists still stress demand-oriented Keynesian analysis; others view the supply-side orientation of new classical macroeconomics as the major recent advance in economic knowledge. However, most economists of either persuasion now recognize that an appropriate mix of both market forces and government policies is a key to economic stability. Disagreements abound, however, about what constitutes an appropriate mix.
Economists inspired by classical reasoning would rely primarily on market forces, with changes in government policies being used only as a last resort to cure an economy in tumult. On the other hand, economists who follow in the footsteps of Keynes tend to advocate activist government policies, with less reliance on market forces. Virtually all economists agree, however, that Aggregate Supply and Aggregate Demand are both important in explaining the course of economic growth, unemployment, and inflation.