Marginalia Vol.5 Relearning the Business Cycle

Marginalia are brief notes written in the margin of a book or article. John Vandenbrink, Deputy Dean of GLOBIS University, will share his notes on topics that have caught his attention in his readings on finance, business, and economics.

During the two decades before the financial crisis of 2008, the severity of business cycles in developed economies dampened and interest rates declined over time, stimulating these economies to ever-higher levels of activity. For business managers, planning for business cycles became less and less important.

However, this unique period has ended. Following the recovery from the current global recession, business cycles will return, probably at their historical intensities.

Business managers need to relearn the concept of business cycles and prepare their enterprises to meet them. Business schools, for their part, need to train for prudent financial management through cycles.

In 2007 I needed to choose cases for two MBA finance courses. I skimmed the Internet to get ideas from the business school syllabuses posted there. I remember noticing that many more materials were available for teaching how to grow businesses than how to manage them through business cycles. Although I have no empirical evidence, I doubt it would be hard to prove that business schools pay scant attention to business cycles. This must change, because the conditions that have prevailed in recent decades cannot continue.

The Great Moderation

Since the early 1980s, the volatilities of GDP, inventories, employment, and related macroeconomic indicators have declined markedly in developed economies. Economists have named this phenomenon the "Great Moderation."

In the United States, for example, during the period 1984–2007 there were only two recessions, and they were mild. This contrasts with the more frequent and deeper recessions in previous years. Note the frequency and duration of the shaded areas in Figure 1, which I have copied from a paper produced at the Federal Reserve Bank of New York in 2008 by economists Steven J. Davis and James A. Kahn.*1

Economists have documented similar experiences in Australia, France, Italy, the United Kingdom, Canada, Germany, and Japan, among others. *2 There are many variations—with Japan the most divergent, starting a decade earlier and subject to later shocks*3 —but overall the pattern of reduced volatility of macroeconomic activity is consistent across major nations.

The Great Moderation, which led business mangers to plan less and less for business cycles, was due to a complex set of causes. What were these causes?

Ambiguous Causation

Economists have suggested various causes for the Great Moderation. They fall into three categories:
・Improved macroeconomic policies
・Structural changes in advanced economies

The first category includes developments among central banks, notably the spread of rules-based policies linked to money supply and inflation and also the increased independence of the central banks themselves.

Probably the best-known discussion of improvements in macroeconomic policies in the United States is the 2004 speech by Ben Bernanke, then a member of the Board of Governors of the Federal Reserve Bank, and now its Chairman. The title of Bernanke's speech was "The Great Moderation." He surveyed the economic literature and argued that in the United States, at least, improved monetary policy had probably made important contributions to the reduction of volatility of inflation as well as volatility of output. This reduced macroeconomic volatility had many benefits, he said, and was associated with the fact that "recessions had become less frequent and less severe." By no means did he contend that improvements in monetary policy were the sole cause of the Great Moderation, but he did clearly point to them as a major factor.

Empirical research tends to support this view, although the estimated degrees of impact are quite modest. For example, in a large study on the U.S. experience completed in 2002 economists James H. Stock and Mark W. Watson attributed 10% to 25% of the decline in output volatility since the mid-1980s to the Fed's more aggressive response to inflation. *4 Other researchers, including both those looking at U.S. data and those looking at data in other advanced economies, have found similar levels of impact. However, yet others have found no evidence of impact. *5

The category of structural changes in advanced economies is headed by supposed improvements in inventory management due to networking of supply chains through new information technologies. This cause has widespread support among economists. However, Stock and Watson found that while short-term (month-to-month, quarter-to-quarter) volatility of inventories declined, improved inventory management appeared not to reduce volatility over longer horizons, and so could not have moderated business cycles. *6

Also in this category of structural economic changes is the shift from manufacturing to services. However, the case for this proposal suffers from timing problems: the shifts in composition do not coincide with the reductions of volatilities of macroeconomic measures.

Other structural causes that have been suggested are deregulation and greater depth and sophistication of financial markets. Neither seems to have had large advocacies before 2008, and in view of their impacts during the crisis presumably neither will be put forward again.*7

The third category is luck: the view that the Great Moderation emerged because adverse shocks hitting economies were smaller and less frequent than usual.

This view has a reasonably large following. Stock and Watson analyzed monetary shocks, fiscal shocks, productivity shocks, oil price shocks, and other commodity price shocks in the United States and concluded that having smaller, fewer shocks accounted for 20% to 30% of the reduction in volatility of annual GDP growth. *8 However, a comparative study of G-7 countries and Australia by the economist Peter M. Summers found no causal link. *9

Unfortunately, while it is certain that volatilities of major macroeconomic indexes fell significantly across major developed countries during the Great Moderation, there is no consensus among the scholars about the causes. Clearly, a highly complex set of factors was at work. Probably, improved macroeconomic policies, structural changes, and luck each played modest roles, but their interactions and net impacts are ambiguous. There is in fact little evidence to give confidence that the world indeed changed in the mid-1980s.

On the contrary, the depth of the current global recession tells us that business cycles refuse to be things of the past. Perhaps business cycles were not moderated, but deferred. Perhaps ever declining interest rates—which now can fall no lower—played a role. Perhaps the central banks' tendencies to cushion each recession with successively lower interest rates constrained what Joseph Schumpeter famously called creative destruction: the incessant process of change that destroys old forms of production from within, with established businesses giving way in competition to businesses with improved technologies and more efficient forms of organizing production. In hindsight, declining interest rates seem as plausible a cause for the Great Moderation as the candidates mentioned above.

Why Business Cycles Will Reassert Themselves

Thus, the causes of the Great Moderation were complex and ambiguous. Moreover, they cannot be counted on to persist into the future.

This is true, in particular, for the supposedly improved macroeconomic policies of the Great Moderation. If indeed they were material in the first place, they will nevertheless be powerless for decades to come.

Recall what the world witnessed through the decades of the Great Moderation. Central banks in developed countries cut interest rates to the point that they destroyed any semblance of balance between savers, on one hand, and investors in real, productive assets, on the other. By 2007, bank depositors earned historically very low nominal interest. Professional fund managers, pressed for yield, pushed down credit spreads on junk bonds to finance risky corporate mergers, and they unwittingly moved their clients' cash into highly rated, supposedly safe mortgage bonds and related instruments, inadvertently facilitating an enormous asset bubble in U.S. real estate. Foundations, dependent on returns to fund their activities, invested endowments in risky bonds linked through derivatives to high-interest-rate currencies.

Savers were starved for returns. Investors in real assets were awash in cheap borrowed cash. Central banks will not repeat the low interest rate policies that over stimulated economies, propped up weak businesses, and led ultimately to the crisis in 2008.

By the time of the outbreak of the current global crisis, central banks had used up their traditional ammunition—their powers to reduce interest rates and expand the supply of money. Immediately, they faced the zero lower bound: the inability in practice to push interest rates below zero percent in nominal terms.

Lacking traditional powers, they were forced to adopt new, untested policies on a massive scale. Central bankers will not want to repeat this scenario. It will remain fixed in their minds for decades to come. They will be much less ready to help troubled businesses through the downturns. They will not quickly reduce the cost of funds, flood economies with cash, and press banks to lend, as they once did.

When prosperous times finally return, central bankers will raise interest rates more quickly and higher than they did during the Great Moderation. They will still attempt to temper business cycles, but the economic climate will no longer be as business-friendly as during the Great Moderation.

Looking Back to Schumpeter

Thus, businessmen accustomed to managing growth will need to come to grips with cyclicality, and business schools will need to help train them. How to begin?

They could do no better than to start by reading Joseph Schumpeter's seminal work on business cycles in "The Theory of Economic Development," which he first published in 1911. Schumpeter's contribution was to present business cycles not as monetary phenomena or things rooted in bank credit, but as an essential aspect of economic development wherein private entrepreneurs engaged in competition are the primary actors. Business cycles, he says, are not the only manifestation of creative destruction; they merely speed up a process that is ongoing in the economy and society. His discussion remains insightful today, particularly for businessmen, because it is they who are at the center of his analysis.

It may be hard to envision today, but in a few years the "Great Recession" in the United States, the deep-seated economic malaise in Japan, and the threatening structural faults in Europe will give way to renewed confidence and activity. These new forces will then precipitate the return of a once unquestioned but in recent decades much tamed phenomenon, the business cycle.

In their future appearances, business cycles will be much stronger than during the Great Moderation, when, deceptively, the actions of central banks appeared to tame them. Business managers will need to guide their firms more prudently. Business schools will need to teach them how. The one saving grace is that time to prepare will be ample, because working through the depths of the current, long-delayed downturn in the business cycle may take years.

*1 Davis, Steven J., and Kahn, James A., "Interpreting the Great Moderation: Changes in the Volatility of Economic Activity at the Macro and Micro Levels," Federal Reserve Bank of New York Staff Report No. 334, July 2008.
*2 This particular list of countries is from a paper by Peter M. Summers, "What Caused The Great Moderation? Some Cross-Country Evidence," Federal Reserve Board of Kansas City, Economic Review, Third Quarter 2005.
*3 Ko, Jun-Hyung, and Murase, Koichi, "The Great Moderation in the Japanese Economy," Research Center for Price Dynamics, Institute of Economic Research, Hitotsubashi University, Working Paper Series No. 60, July 5, 2010.
*4 Stock, James H., and Watson, Mark W., "Has the Business Cycle Changed and {{{Why}}}?" National Bureau of Economic Research, NBER Macroeconomics Annual 2002, Volume 17, January 2003, p. 199, URL:
*5 Benati, Luca, "The 'Great Moderation' in the United Kingdom," Working Paper Series, No. 769, European Central Bank, June 2007.
*6 Stock and Watson, pp. 185–186.
*7 Den Haan, Wouter, and Sterk, Vincent, "The myth of financial innovation and the Great Moderation," Vox, Nov. 8, 2011, The authors write, "[We] find very little evidence for the idea that financial innovation contributed to greater macroeconomic stability."
*8 Stock and Watson, p. 162.
*9 Summers, pp. 17–20.