Business Cycles and the US Economy

Posted: December 2, 2008 in Uncategorized

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By Joseph Thavaraja

“In good times, financial markets embrace capitalism. In bad times, financial markets

re-discover socialism.” – An Economic Quote Now Regaining Its Popularity

As the US economy went to recession in the middle of the financial crisis the US House Speaker Nancy Pelosi, at a recent Capitol Hill news conference announced triumphantly that a ‘stimulus package’ is coming. “Tens of millions Americans will have a check in the mail. island3It is there to strengthen the middle class, to create jobs and to turn this economy around.” The plan would send checks of $600 to individuals and $1,200 to couples who paid income tax and who filed jointly. People who did not pay federal income taxes but who had earned income of more than $3,000 would get checks of $300 per individual or $600 per couple” she said. The stimulus package is aimed at re-energising the economy back to its feet. But economists may not necessarily agree that the ‘package’ as it is, alone would be sufficient. To understand this, one needs to understand the key to short term macroeconomic baheviour, simply called as Business Cycles.

Short term fluctuations in macroeconomic output, employment and prices are called business cycles (BCs) resulting the recurring expansion and contraction (leading to recession) of the national economy. Expansion is the normal state of the economy; recessions are rare and brief but are the defining characteristic in a business cycle. The dominant macroeconomic model where BCs are closely watched is the free-market enterprise system.

“Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises[1].


US GDP

The BCs influence actual GDP (production) rather than the potential GDP. Actual GDP often changes sharply from year to year.

The “quarter to quarter growth in Real GDP” as shown by the US Bureau of Economic Analysis clearly indicates the graphical trend in decline in GDP and starting of the recession in the Q4/2007, where a negative GDP growth is reported. A stagnant trend existed throughout the Q1 of 2008.

The “US Monthly GDP-Latest Estimates[2]shows even more clear (zoomed in) view of the monthly GDP scenario clearly showing the negative GDP trends (circled), namely Oct -2007 and Nov-2007.

US UNEMPLOYMENT

As stated, the broadest indicator of the three indicators is unemployment. Unemployment, stands for the percentage of labour force that is unemployed in the economy. BCs affect on unemployment rates as well. The table and graph (next page) clearly show the rising trend in the unemployment levels. The pattern is clearly discernible; From Jan-2007 to Nov 2007 it was growing at a slow rate; the second phase begins from Dec 2007 onwards where a steady climb in the rate is clearly evident; this is the recessionary period. It is important to note that the importance of unemployment rate is not limited to being an ‘recession indicator.’ Some strongly believe that the key to recovery is here – rather than the proposed stimulus package (discussed below) by the Bush Administration.

Skepticism is high on refinancing and liquidity plans.

Merrill Lynch investment strategist Rich Bernstein: “Investors have been reluctant to admit that this cycle, unlike 1998’s credit crisis, is imbedded in the real economy. The US government can come up with any number of refinancing and liquidity plans, but households are likely to increasingly default on mortgages and other debts if cash flow is not stabilized via employment[3].”

WILL THIS CAUSE THE MULTIPLIER EFFECT?

The multiplier theory was suggested by John Maynard Keynes as a tool to help governments to achieve full employment. It measured the amount of government spending for a level of national income that would prevent unemployment.

The more the need for consumption, the greater is the multiplier effect and Keynes expected the government can influence the size of the multiplier through changes in direct taxes such as a cut in the basic rate of income tax will increase the amount of extra income that will be spent on further goods and services.

In the 2008 Recession, instead of Keynes “Tax Cuts” approach (1), the US government appears to directly handout lump sums to US households in the form of a “Stimulus Package” at a cost of $ 146 billion.

US House Speaker Nancy Pelosi, D-California, at a Capitol Hill news conference:

“Tens of millions Americans will have a check in the mail. It is there to strengthen the middle class, to create jobs and to turn this economy around.” The plan would send checks of $600 to individuals and $1,200 to couples who paid income tax and who filed jointly. People who did not pay federal income taxes but who had earned income of more than $3,000 would get checks of $300 per individual or $600 per couple[4].”

However, opinion surveys in 2008 March found that upto 87% of the public plans to either invest their tax rebates or use it to pay down debt[5]. With the steady rise of inflation post March, this percentage can only grow upwards. In fact, if more than 80% of the US public are unwilling to spend their tax savings, will they even spend what they receive on a check? Thus, the “checks in the mail” are less likely to be used for spending and thereby, to the economy is less likely to be stimulated. Therefore, any calls for the multiplier effect should be viewed with high skepticism.

US INFLATION

Inflation, in which the price levels of economy increase, affects the purchasing power, eroding power of money. Historical evidence shows that rapid price changes disturb the economic decisions of companies and individuals, people lose their confidence in currency, slows down the economic activity and increases unemployment. The United States has lost 760,000 jobs in the past nine months, according the US Bureau of Labour Statistics estimates.

The graphs below illustrate how the inflation rates soared from end of Q4 / 2007 onwards as the US economy entered recessionary cycle.

What Caused the Crisis?

It is incorrect to say that one can correctly judge the trigger-exact reason for a recession –especially for one that is as complex as the 2008 Recession, where a host of multifarious and interwoven factors have been at play. It is strongly believed that the increase in consumer debt to about $ 943 billion, is the strongest contributory factor (per capita debt: $3,112.19). This consumer debt growth, in turn, has its roots in the last US recession in 1992. In its aftermath, the Federal Reserve artificially expanded credit and investment, but was not backed by increase in voluntary household saving. The instrument from this expansion has been transferred to the market by the banking system as newly created loans at extremely low interest rates. This fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real-estate assets, and the stock market, where indices soared. However, this bubble is not based on voluntary savings (healthy for economy) but artificial expansion (unhealthy for the economy). Entrepreneurs use these artificial funds for investment but with the pretentious confidence that their funds are from savings.

Nevertheless, Nouriel Roubini, president of Roubini Global Economics had foreseen the US Recession back in August 2006. His diagnosis: “The decline in investment in the housing sector and inventories that are not moving[6].” He highlighted US National Association of Realtors data that stated “sales of existing homes fell 4.1% in July, while inventories soared to a 13-year high and prices flattened out on a year-over-year basis”.

“By itself this slump is enough to trigger a U.S. recession: its effects on real residential investment, wealth and consumption, and employment will be more severe than the tech bust (dot com bust) that triggered the 2001 recession. Housing has accounted, directly and indirectly, for about 30% of employment growth during this expansion, including employment in retail and in manufacturing producing consumer goods..[7]

In order to protect the banking and finance sector, the state, through the Federal Reserve has intervened with a ‘bailout package’ of $700+ billion and to cushion the negative recessionary effects on households and stimulate the economy, the Bush Administration has unleashed a “stimulus package” though it is yet to be seen whether the “bailout” and the “Stimulus package” are a treatment for symptoms rather than the disease itself. The only clear lesson from the chaotic US economy so far is the financial bailout affirming the popular economics saying that “In good times, financial markets embrace capitalism. In bad times, financial markets re-discover socialism.”

(The Writer is a Research Officer with the Social Indicator-Centre for Policy Alternatives, Colombo 3. His email is josephonline@gmail.com )


[1] Burns and Mitchell, 1946, p. 3

[3] FORTUNE MAGAZINE – OCT 15, 2008

[5] Kathleen Pender in San Francisco Chronicle, February 5, 2008– “Consumers not likely to spend tax rebates “

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