﻿ Section 1: Business Fluctuations ﻿

### Random Fact

 The combined (federal, state, local) top corporate income tax rate in the United States is 39.2%. It's the highest in the world. The top rate in Japan is 38%. The top rate in Switzerland is 22%. The top rate in Brazil is 25%. The top rate in Mexico is 30%. The top rate in Canada is 34% (http://www.huffingtonpost.com/2012/03/30/us-corporate-tax-rate_n_1392310.html).

Recessions, Expansions, Peaks, and Troughs

Business fluctuations are the increases and decreases in economic activity, as measured by increases and decreases in real GDP. A recession (or contraction) is defined as a decrease in GDP of at least two quarters (6 months). An expansion is any period of time during which real GDP is increasing. One full business fluctuation consists of one recession and one expansion. The height of an expansion (points A, C, and E in the graph below) is called the peak. The lowest phase of a fluctuation is the trough (points B and D in the graph below).

A typical economy experiences continuous increases and decreases in economic activity. From point A to B, GDP is falling, and we are experiencing a recession if the decline is at least two consecutive quarters. From B to C, activity picks up, and there is an expansion. From C to D, the recession appears more severe, and we may even speak of a depression. A recession in the United States lasts on average approximately 1 year. An expansion usually lasts on average more than 5 years.

Business Fluctuations in the United States

Below is a table with nominal and real quarterly GDP changes, starting with the first quarter of 1979 (seasonally adjusted rates).
 Year and Quarter Current Dollar (Nominal GDP)Percent Change Chained 2005 (Real GDP)Percent Change 1979q1 8.1 0.8 1979q2 10.7 0.4 1979q3 12.1 2.9 1979q4 9.5 1.2 1980q1 10.1 1.3 1980q2 0.6 -7.8 1980q3 8.7 -0.7 1980q4 20.1 7.6 1981q1 20.0 8.4 1981q2 4.4 -3.1 1981q3 12.6 4.9 1981q4 2.2 -4.9 1982q1 -1.2 -6.4 1982q2 7.2 2.2 1982q3 4.2 -1.5 1982q4 4.7 0.4 1983q1 8.5 5.0 1983q2 12.5 9.3 1983q3 12.6 8.1 1983q4 11.8 8.4 1984q1 13.6 8.1 1984q2 10.8 7.1 1984q3 7.3 3.9 1984q4 6.0 3.3 1985q1 8.5 3.8 1985q2 5.8 3.5 1985q3 8.2 6.4 1985q4 5.8 3.1 1986q1 6.0 3.9 1986q2 3.7 1.6 1986q3 6.3 3.9 1986q4 4.7 2.0 1987q1 6.1 2.7 1987q2 6.8 4.5 1987q3 6.8 3.7 1987q4 10.3 7.2 1988q1 5.5 2.0 1988q2 9.2 5.2 1988q3 6.8 2.1 1988q4 8.6 5.4 1989q1 8.9 4.1 1989q2 6.6 2.6 1989q3 5.8 2.9 1989q4 3.8 1.0 1990q1 9.8 4.7 1990q2 5.8 1.0 1990q3 3.7 0.0 1990q4 -0.3 -3.5 1991q1 2.4 -1.9 1991q2 5.7 2.7 1991q3 4.9 1.7 1991q4 4.0 1.6 1992q1 6.6 4.5 1992q2 6.9 4.3 1992q3 6.1 4.2 1992q4 6.7 4.5 1993q1 3.2 0.7 1993q2 4.9 2.6 1993q3 4.0 2.1 1993q4 7.7 5.4 1994q1 6.2 4.0 1994q2 7.6 5.6 1994q3 4.9 2.3 1994q4 6.7 4.3 1995q1 3.7 1.1 1995q2 2.7 0.9
 1995q3 5.2 3.3 1995q4 5 3 1996q1 5.5 2.9 1996q2 8.2 6.7 1996q3 4.7 3.4 1996q4 7 4.8 1997q1 5.8 3.1 1997q2 7.1 6.1 1997q3 6.6 5.1 1997q4 4.6 3.1 1998q1 4.5 3.8 1998q2 4.6 3.6 1998q3 7 5.4 1998q4 8.4 7.1 1999q1 5.5 3.6 1999q2 4.6 3.2 1999q3 6.8 5.2 1999q4 8.9 7.4 2000q1 4.3 1.1 2000q2 10.2 8 2000q3 2.8 0.3 2000q4 4.6 2.4 2001q1 1.4 -1.3 2001q2 5.5 2.6 2001q3 0.2 -1.1 2001q4 2.7 1.4 2002q1 4.9 3.5 2002q2 3.7 2.2 2002q3 4 2.1 2002q4 2.5 0.1 2003q1 4.6 1.6 2003q2 4.5 3.2 2003q3 9.3 6.9 2003q4 5.8 3.6 2004q1 6.5 2.8 2004q2 6.4 2.9 2004q3 6 3 2004q4 6.7 3.5 2005q1 8 4.1 2005q2 4.5 1.7 2005q3 7.4 3.1 2005q4 5.6 2.1 2006q1 8.6 5.4 2006q2 5.1 1.4 2006q3 3.2 0.1 2006q4 4.8 3 2007q1 5.2 0.5 2007q2 6.5 3.6 2007q3 4.3 3 2007q4 3.6 1.7 2008q1 0.6 -1.8 2008q2 4 1.3 2008q3 -0.6 -3.7 2008q4 -8.4 -8.9 2009q1 -4.4 -5.3 2009q2 -1.1 -0.3 2009q3 1.9 1.4 2009q4 5.3 4 2010q1 3.9 2.3 2010q2 4.1 2.2 2010q3 4.6 2.6 2010q4 4.5 2.4 2011q1 2.2 0.1 2011q2 5.2 2.5 2011q3 4.3 1.3 2011q4 4.2 4.1 2012q1 4.2 2 2012q2 2.8 1.3 2012q3 5.9 3.1

Source: Bureau of Economic Analysis, 2012.

The table above shows that the expansion that began in 1982 lasted through the second quarter of 1990. The recession of 1990 lasted through the first quarter of 1991. Unemployment rose to 7.8% during this recession. We experienced some stagnation immediately preceding and following the September 11 terrorist attack in 2001. However, the decline was not for two consecutive quarters, so according to the official definition, we did not experience a recession in 2001. The next expansion began in 1991, and lasted through the second quarter of 2008. The most recent recession began in the third quarter of 2008. Real GDP continued to decline in 2009 and pushed unemployment levels in some parts of the country past 10%, the highest since 1982. During the most recent years GDP has increased but not enough to put a dent in the relatively high unemployment rate.

Models about the Causes of Fluctuations

What causes recessions? Are they a natural phenomenon, or can they be prevented? Many explanations have been given as to why business fluctuations occur.

John Maynard Keynes, whose theories are discussed in more detail in Unit 5, argued that production does not always equal consumer demand. When demand is not high enough, businesses face increasing inventories. Businesses then decrease production, and lay off workers. As unemployment increases and incomes decrease, consumption spending decreases even more. Businesses then further decrease production, and the cycle continues. Keynes expressed fears that without government intervention, a recession could easily turn into a depression. This indeed occurred in the 1930s. Interestingly, this is the period of time during which Keynes wrote his most influential works.

Classical economists disagree with Keynes's explanation of what causes business fluctuations. They don't believe that recessions are caused by overproduction and a lack of consumer demand. They believe that production in the long run automatically leads to employment and sufficient real earnings for workers and entrepreneurs. In other words, sufficient supply leads to sufficient demand in the long run. If there is a surplus or shortage of products or jobs in the short run, the market corrects this by allowing wages, prices, and interest rates to fluctuate. Lower wages decreases firms' cost of production, thus helping them to become more profitable in the long run. Lower prices give buyers the incentive to increase their quantity demanded. Lower interest rates lower firms' cost of borrowing funds. As the rate decreases, businesses will regain the incentive to borrow and invest in new technology and capital. Classical economists believe that fluctuations are normal dynamic phenomena and that the market helps turn recessions into expansions in the long run.

Keynes believed that government intervention is necessary during inflationary or recessionary times. Classical economists (and related schools) believe that government intervention is harmful to the economy in the long run. These economists point out that since the government took control of the banking system in 1913 (establishment of the Federal Reserve System), it has had a history of increasing the country's money supply considerably almost every year. An increase in the money supply, as we will see in a later unit, equates to inflation, and is generally harmful to the economy in the long run. High inflation raises interest rates, which lowers borrowing and investments. This eventually decreases wages, purchasing power, and the demand for goods and services. During inflationary times, businesses are faced with lower real rates of return on investments and economic uncertainty regarding real prices, wages, profits and investments.

According to classical economists, regulations and economic rules are important components of a well-functioning free market economy. However, excessive government regulations, such as complicated consumer laws, labor laws that discourage productivity, costly safety requirements, product restrictions, costly pollution control measures, and protectionist policies (trade restrictions, such as tariffs and quotas) can contribute to economic slowdowns. Minimum wage and other labor laws are meant to protect workers and usually serve a sound social purpose. However, if a business's costs increase without a productivity increase, then the business may lose money and go bankrupt or move abroad. Anti-trust laws may also harm businesses if they punish innovation and add costs to business operations (this is discussed in Microeconomics). According to classical economists, government policies that contribute to increased business expenses and economic inefficiencies may eventually lead to recessions and increases in unemployment.

The Most Recent Recession

There has been extensive debate about what caused the most recent recession. Some economists argue that deregulation in the financial services industry encouraged corporations to take excessive risks which led to numerous bankruptcies when the housing market declined. Others claim that the regulations in place were adequate, but that there was insufficient enforcement and supervision by regulatory agencies such as the Federal Deposit Insurance Corporation, the Federal Reserve, the Security and Exchange Commission and the Commodity Futures Trading Commission.

It has always been an American dream to own your house. It has become one of the core values in American culture. During the long economic expansion that began in the early 1990s and lasted through early 2008, economic activity was robust, real GDP increased considerably, incomes rose and unemployment declined to historic lows. People that owned a home saw their home values rise sharply. Many real estate speculators (investors) found a quick way to large fortunes and bought houses aggressively. Families that didn't own a home yet wanted to get in on the act, too. With the help of government laws, many households found a way to finance a home, even if they couldn't afford one. Government-supported mortgage companies such as Freddie Mac and Fannie Mae were given mandates by government officials to encourage households to fulfill their American dream. Laws were passed that encouraged low-income families to buy a house. Even people without a job qualified for a mortgage. Many mortgages had favorable conditions (low interest rates), but usually only during the first few years of the loan. Banks and other financial institutions saw a way to make considerable profits by issuing large numbers of mortgages to home buyers. Each loan, after all, brought in revenue from fees, commissions and interest income. Many banks didn't hold on to the loans they had issued. Banks bundled the thousands of mortgages into mortgage securities and sold them as investment pieces (similar to mutual funds) to investors who were told that these mortgages were low risk (highly rated). The Federal Reserve fed this economic expansion of rising mortgage debt by allowing the money supply to increase.

When in 2007 housing prices began to decline and mortgage holders were in their third or fourth payment year and no longer able to take advantage of artificially low rates and incentives, the bubble burst.

Many homeowners foreclosed on their mortgages. Banks and mortgage companies suffered significant losses because loans were not paid back. Financial institutions and other investors who had purchased mortgage securities saw the value of these assets decline drastically. Mortgage security investments worth billions became almost worthless within weeks. Insurance companies such as AIG had insured many mortgage security instruments (called credit default swaps). In the case of a security default, AIG would pay the owner of the financial instrument. With foreclosures and defaults rampant in 2008 and 2009, AIG suffered hundreds of billions of dollars in losses. The government decided that AIG, along with other large financial institutions, was too big too fail and provided bailout funds funded by taxpayer dollars or borrowed money. Many corporations were criticized for paying their managers and CEOs extravagant bonuses and compensation while the company was losing money and regular employees were laid off. To make things worse, fraudulant investment operations, such as Bernard Madoff's Ponzi scheme, came to light and forced investors to lose billions of dollars.

As a result of the financial crisis and the housing market collapse, the financial markets (stocks) crashed, confidence in the economy deteriorated, and spending (especially on larger purchases such as cars and luxury items) declined drastically. Real GDP decreased and unemployment increased.

So What Went Wrong?

The crisis resulted from a combination of factors. Many parties in the private sector (households and businesses) acted irresponsibly by taking on too many risks. Households should not borrow when they cannot afford to pay back a loan, and businesses should not lend when the borrower has insufficient funds to pay back the loan. When bundled mortgage securities were traded to investors, rating agencies should have more carefully assessed the risk of these financial instruments. Government agencies should have more carefully supervised financial institutions and prevented them from making overly risky loans. The Federal Reserve should have limited the growth of the money supply that fueled the artificial boom. Congress should not have encouraged mortgage companies and banks to make loans to households that could not afford these sizeable loans. It sounds like a noble gesture to allow everyone to enjoy a big house and live the American dream; however, these government actions actually artificially drove up housing demand, exacerbated speculation in the real estate market, and made housing prices eventually and ironically unaffordable for many. Many families are currently homeless and live in so-called tent cities. The opposite (homelessness and foreclosures) of what the government intended (homeownership and the American dream) happened.

What Can We Learn?

Businesses are learning that short-term profit motives don't usually pay off. Businesses need to make decisions that will help them survive in the long run. This means making solid and sound investments that carry a reasonable risk. And it may mean forgoing short-run profits in order to avoid overly high risks so as to survive in the long run. Households are learning that borrowing is okay as long as they can pay off the loan; borrowing is not okay when there is insufficient income. Many households are also learning about the virtues of saving. Recently, the savings rate in the United States increased from .2% to nearly 5%. This may slow economic spending and business activity somewhat in the short run, but will pay great dividends for our economy in the long run. Many homeless families currently regret that they didn't save more during the time that they had a job and a home. If they had saved significantly instead of going into deeper and deeper debt (from purchases of expensive electronics, vacations, cars, overly expensive houses, etc.), they would have weathered the economic crisis much better and probably prevented their foreclosure.

The government is learning that they need to more effectively oversee the financial services industry. There are rules in traffic and there are rules in the business world and they are necessary to ensure a smooth flow. But the rules need to be strictly and effectively enforced by the government agencies in charge (Federal Reserve, SEC, FDIC, CFTC, Office of the Comptroller of the Currency and the Office of Thrift Supervision). Because of the non-profit nature of government, many government workers have little motivation to work efficiently and effectively. We must insist that government workers work with as much motivation and productivity as our small business owners in this country.

The federal government recently spent trillions of dollars bailing out companies and stimulating the economy. Congressional spending has given us federal deficits now that are much higher than they already were. This is worrisome because it will lead to higher future taxes and a slowdown in future economic activity. The Federal Reserve has injected hundreds of billions of dollars in the financial markets in order to provide liquidity. These injections equate to large increases in the money supply, especially when the economy begins to expand again. We will see in Units 7 and 9 that this will equate to high rates of inflation. Excessive borrowing and lending by the private sector helped cause the current economic crisis. It now appears that excessive borrowing and excessive monetary expansion by our and many other governments around the world may cause the next one.

Last Updated on Wednesday, 26 December 2012 09:47