The idea of the business cycle goes back at least to Marx' description of capitalisms booms and busts in Das Kapital, and has been described in more detail by modern writers starting in the 1940s. Business cycles -- which do not occur at any sort of regular interval -- are generally understood in terms of when the direction of the economy changes (Romer, 2008). As Brad DeLong (2010) describes, Marx noted that business cycles occur when there is an overaccumulation of capital and overproduction of goods. In order to restore balance to the overheated economy, a crisis must follow. This crisis will create the depreciation of the value of assets. Marx further described what would happen to employment (it would go down). Real capital is destroyed, which means the equipment and factories must cease production, workers must be made unemployed and capital will inevitably sit on the sidelines -- in other words a recession must occur.
A business cycle today looks much like this. In the past few years, the U.S. economy saw a boom, lead by real estate. Arguably, there was overconstruction in residential housing and this fueled a general economic boom. When a demand shock occurred -- in this case a rapid increase in interest rates but the exact cause is not important -- demand fell and the excess production became idle. The result was a down cycle. Business cycles are measured a number of ways, including the peak to trough time cycle. The last down cycle lasted 18 months from December 2007 to June 2009. The cycle of course includes the up portion of the cycle. The NBER (2011) defines a cycle as an up portion followed by a down portion. When the economy begins to improve from its nadir, a new business cycle is begun. Thus a business cycle is a complete loop, from trough to peak and back to trough.
The data for 2011 does not show a business cycle. It shows a small section of the cycle, so it is not particularly useful for illustrative purposes. This year is part of a business cycle that began in July 2009 when the economy began to recover from the depths of the recession. The last three upward movements in business cycles, according to NBER, were 73, 120 and 92 months in duration. This indicates that the latter half of 2011 is still going to be in the early part of the business cycle -- although there have been a couple of short economic gain cycles on record, such as from mid-1980 to mid-1981. Knowing that it is possible that the business cycle is somewhere other than at the beginning of an up cycle, we can use the recent data to test the hypothesis that we are in the early stages of an economic growth cycle.
Of particular note in terms of defining the business cycle is GDP. The GDP is currently growing, albeit slowly. The Q2 growth rate for 2011 was 1.3% and for Q3 was 2.0%. This indicates slow growth, but any growth supports the null hypothesis. The next step is to consider other indicators, because we know from economic orthodoxy how these indicators should perform if we are on the downside of a business cycle.
In general -- and there is near universal agreement among economic schools of thought -- the following are characteristics of the downside part of the business cycle. Following an overaccumulation of capital -- or a "bubble" if one prefers -- the economy will experience a decline. Production is going to fall, unemployment is going to rise. With the latter, consumer spending is also going to decline. With a decline in demand, it is expected that prices will fall and production will fall further. If these movements are intense, the result will be a negative feedback loop.
What we see in the recent economic data from the BEA is that the unemployment rate is essentially stable, rangebound between 9.0% and 9.2%. That these figures are historically high means that we are close to the bottom of a business cycle, and the flat trend indicates that whatever direction we are moving in, we are not moving with significant intensity. It is worth taking the unemployment figures in context with the number of jobs in the economy -- remember that unemployment can be affected by either its numerator or denominator. The numerator -- jobs -- has been growing. While changes in payroll employment are relatively low, they are positive across the past five months. If the unemployment rate is stagnant it is not because the economy is failing to create jobs but rather because there are just as many people entering the workforce as there are new jobs created.
Some other changes that one would expect during an economic down cycle are a reduction in average hourly earnings, as there is a higher supply of workers, lowering worker bargaining power. The average hourly wage has increased slightly over the past five months. This indicates that there is not a higher supply of workers in the economy, that if anything workers are being awarded a cost of living increase.
It is also expected that the rate of inflation will drop towards the bottom of the business cycle -- lower demand leads to lower prices. The CPI is not moving much, with annualized rates topping out at 0.5%, which is well below the Fed's target inflation rate. Two of the past six months have seen deflation, which indicates a very poor economy. The trend is that CPI has declined the past four months, indicating that we may be moving towards the bottom of the business cycle. Support for this can be found with the producer price index and the U.S. import price index, both of which are tracking the CPI trend.
The evidence is actually inconclusive at this point. The GDP indicates that we are emerging from the bottom of a business cycle, the unemployment information suggests that we are still at the bottom, and the CPI information could make the case that the current trend is downward to the bottom of what would be a short-lived business cycle like the one in the early 80s.
The reverse of the current situation is an economy that is at or near the peak of the business cycle. In such a circumstance, the GDP is rising and unemployment is low. Consumers in this situation have more disposable income and more confidence, and this fuels not only higher levels of demand but higher prices too, partly because supply struggles to keep up but partly because consumers lose their price sensitivity when they feel flush.
In a growing economy, the rise in prices spurs producers to invest more, further boosting the GDP. The economy becomes a positive feedback loop. Businesses are hiring more, and this lowers the unemployment rate, thereby increasing consumer spending, until the cycle is broken. Inflation grows, however, in this situation because prices are rising. With higher inflation, interest rates are raised, because the Fed has an inflation fighting mandate and raises rates as in order to achieve this objective. This causes a rise in CPI, but eventually it also causes businesses to begin to reduce investment. This is because the cost of capital is dependent on the interest rates, so the higher the interest rates, the higher the cost of capital. This means that businesses need a higher rate of return on an investment to accept it, and therefore they accept fewer projects.
The current economy is caught in the middle. At the bottom end of the cycle, with only a vague upward trend, the economy at this point is caught in a place where business is just good enough (in terms of consumer demand) to keep the economy from falling back…