Economic Cycles

Often referred to as a ‘business cycle’, an economic cycle can perhaps be thought of as the ride an economy is on over a period of time.

Generally, the GDP of most advanced economies in the world is on an upward trend over time. This is predominantly due to the general rise in population, improvements in technology and the discovery of new resources and business processes. The growth of a country’s economy is not a smooth, linear process however and is generally made up of cycles of expanding and receding growth.

To explain the nature and causes of a business cycle, let’s start at the most logical place – the beginning. This is when the growth of a country’s GDP begins to rise or speed up. Production levels of goods and services increase, so too does the consumer appetite for those goods and services. Demand increases, and supply must follow. People become more and more confident as time goes by during an expending economy, which leads to more spending and borrowing.

However, this eventually leads to a booming economy that is in danger of overheating. At some point, demand will dry up or supply will run out, creating an imbalance that pushes the economy beyond boiling point. Countries then either end up having a lot of production that nobody wants to buy, or they simply aren’t able to keep up with demand and money stops passing through the economy.

This then leads people to become more and more anxious about the state of things. Typically, the closer a country gets to the top of it’s expansion phase of the economic cycle, the more people begin to worry that the next recession can only be around the corner. The good will doesn’t last forever. Eventually, people start to become anxious if certain investments perhaps haven’t gone as well as they thought they would, or there is a sudden slow down in things such as house prices. Companies may have borrowed more than they should have when the going was good, only to find that their forecasts were some way wide of the mark. Humans tend to get a little bit greedy in times of abundance, seemingly unable to register that the good times won’t last forever. Eventually, an economy is undone by this greed and the economy begins to slow down.

This isn’t necessarily the beginning of the end, and a slight slow down in economic growth could simply be a small bump in the road in an economy that continues to expand. However, this change in sentiment can often lead to anxiety and panic amongst those with skin in the game. Investors may begin to sell off shares in fear that a recession is coming, and they want to get out before everything hits the bottom. The herd mentality of humans unfortunately means that others will see the irrational and the foolish selling their investments at the first quiver of a market decline, and blindly follow suit. This then creates more supply of shares available to buy in the stock market, which reduces their price. Remember, when supply outweighs demand, prices tend to go down. If the sentiment of investors is that prices will be lower tomorrow, they tend to wait before buying. This creates a perpetual spiral downwards in share prices, as those panicky investors sell more and more of their shares to nobody looking to buy them.

When stocks and shares (equities) become less attractive for investors, they tend to look towards fixed interest vehicles such as corporate and government bonds. A bond is essentially a loan by an investor to a company or government for a predetermined period of time. Bonds are purchased for a starting price determined by the demand for that particular bond, which is driven by the rate of interest it will pay, which in turn is driven by the risk of default by the company or government issuing the bond and the length of time the bond will be held for. At the end of the bond’s term, e.g. 12 months, the bond issuer buys back their bond from the investor for the same price they sold it for 12 months earlier. Bonds are seen as more secure investments than equities, particularly in the short-term, given that they essentially have a known outcome.

The problem that this rush to more secure investments has for an economy, is that it tends to tie money up for longer periods of time, and the economy itself becomes less ‘liquid’. This means that there is less money being exchanged for goods and services, which is the heartbeat of any modern economy. The economy slows down and growth recedes.

When an economy simply cannot sustain its own level of growth, it begins to slow down. If people have been over-zealous during the good times, this can often lead to a recession. Often, people and companies spend and borrow to excess when an economy is growing due to the availability of affordable goods and services. When this eventually becomes unsustainable however, those high levels of debt often bring an economy crashing back down to earth. Companies can no longer afford to pay their employees and people are left without jobs.

To try and stimulate growth at this point, a government may issue more money into the economy via a process known as Quantitative Easing. The hope is that this injection of cash will stimulate economic growth or stifle a possible recession. Another tactic at this point is to keep interest rates as low as possible, in order to make tying up money in savings accounts less attractive and encourage borrowing at a low cost. This also has the indirect effect of more money flowing into the stock market in the search of returns that are no longer available from lower risk savings vehicles such as cash and bonds.

The economy now begins to recover, as the flow of money speeds up again. Businesses can borrow at a lower rate of interest which encourages investment in the hope of growth. Generally, businesses that grow turn higher profits and more jobs become available. The same is true for general consumers, who begin to feel more confident in spending and borrowing money. There is now more money in flow around the economy, as increased profits and earnings are redistributed to pay for other goods and services. The health of the economy improves, and the economic cycle begins again.

It is difficult to predict the length of an economic cycle and just how volatile it will be. Different economies grow and contract at differing rates over various lengths of time. In the US, research carried out by the National Bureau of Economic Research (NBER) shows that, between 1945 and 2009, the average economic cycle lasted 58.4 months.

However, the current economic cycle has been going since March 2009 (almost 10 years), making this one of the longest periods of growth on on record. As we continue to evolve into a global economy, this has led many people to speculate on whether the nature of economic cycles are changing, or if these cycles will eventually disappear altogether.