Business Cycles – How They Work and Why

Why do we swing from good times to bad times to good times again? Why can't the economy just go straight up without ever falling? The economic swings up and down are largely caused by business cycles. Let's take an economy that is emerging from weak to strong slowly. When the economy was weak, many people were out of work thus dampening consumer spending – the main driver of the economy. With consumer demand down, the laws of supply and demand kick in. Less demand for products and services, in addition to causing layoffs and even bankruptcies, also leads to cheaper prices for goods and service as it is better for businesses to at least get something for their products and services. Often their own costs for products and labor have gone down, enabling them to mostly survive the bad times. Over time the cheaper prices for goods and services causes demand to rise for them as they have now become more affordable. The higher demand eventually causes business to increase production and hire more employees. This result has a multiplier effect, especially as the people who have been hired were either unemployed or making less money in the job they quit. So now they can afford more goods and service and there is pent up demand for these goods and services. The improving economy will cause some of these employees to start their own business, hiring more employees to meet the growing demand for goods and services both large (such as homes, cars) and small. So why doesn't this process go up forever?

At some point, the increased production of goods and services will have fulfilled the pent up demand from the previous economic low point. Purchases will decline. Layoffs and/or reduced working hours will increase, and some bankruptcies will occur. This too has a multiplier effect to the negative. Once enough damage has been done to the economy, prices for many goods and services will fall again, and the process of trending toward better times as described previously will begin again.

What about government – can't they help? Yes sometimes they can, but they may not do it right and multiply the problem. For example, after the 1929 stock market crash and the resultant Recession, with less people working, government revenues went down. So to balance the budget, government raised taxes during a Recession. Consumers, with less disposable income/take home pay due to the increased taxes, bought less goods and services, resulting in further layoffs, less taxes collected due to less people working, and the 10 year long Great Depression that took a World War to get out of.

The government has two major tools to speed up or slow down the economy. The most often utilized is the control of the money supply and interest rates through the Federal Reserve. This is called Monetary Policy. In a down economy, lowering interest rates makes borrowing cheaper. That enables more people to afford buying homes, cars, etc.. That drives up demand for goods and services and starts an economic uptrend. Raising interest rates in an over heated economy can likewise slow an economic boom down hopefully before severe inflation topples the economy. However, people don't rush out and buy new cars and homes in big quantites just because interest rates have been lowered. This is a slow process. Thus Monetary policy is the weakest tool that the government has, but can be very useful when the business cycle is not very volatile.

The more powerful tool in the government's economic arsenal is called Fiscal Policy. Fiscal policy is the lowering and/or raising of taxes. These type of changes are felt immediately by consumers as their take home pay increases or falls.When it increases, since most people typically spend all or nearly all of what they earn, demand for consumer goods and services rises much faster than under Monetary Policy. Thus the impact on the economy is much faster.

Also, raising taxes in an over heated economy has a much quicker impact on cooling off the economy than monetary policy. However, it is also easy for such dampening fiscal policy to be too dangerous because too many people, including much of the middle class, live paycheck to paycheck with little or no savings. Cutting their take home pay could easily make them unable to pay their rent, mortgage, car payment, or other important bills. Therefore, it is normally better to utilize more slowly acting monetary policy to dampen over heated economies.

There's nothing stopping government from utilizing both fiscal and monetary policies at the same time, though control rests “independently” with Congress and the federal Reserve. Sometimes they can help each other; but sometimes they actually fight each other.

It needs to be pointed out that even in strong economies, when businesses and jobs are growing nicely, there will be some businesses and jobs lost due to inefficiencies compared to competitors and/or obsolescence of such goods and services. For an easy to understand example – the making of horse drawn wagons was once the largest industry in the U.S.. However, this industry went out of business when the car was invented and caught on as the preferred transportation means. That's a good thing and something that Capitalism does best – rooting out “waste” (it would have been a waste of both human and material resources to continue to build horse drawn wagons in large quantities since no one would have been buying them). By more efficiently rooting out “waste” than any other economic system, Capitalism has become the most successful economic system ever, and the only economic system that has raised billions of people throughout the world out of poverty. The reason that Communism never worked and was the most failed economic system ever is that it has no mechanism to efficiently root out waste in a non-market driven economy. You met the production goal and you were a success despite the fact that much of it became surplus that no one bought, thus not raising the standard of living of anyone. Also, Communism gives no incentive for people to take risks and develop new products, services, and very importantly, new technology. My hope for the future is for American schools to offer and require more Economic classes so that future voters are wiser on Economics - normally the most important issues for voters in any government besides freedom.