‘Qui capite ipse suo instituit vestigial retro’ (‘Who in his folly seeks to advance backwards’).
Economic growth has never been stable – it has moved in fits and starts, with booms followed by contractions, followed by booms and so on. Up to the start of the twentieth century, economic growth fluctuation was relatively localized, at worst affecting regions and sometimes a whole continent. The causes for economic downturns were also considered to be represented by a single factor – a drought, a flood, other natural disasters, wars or pestilence. For example, the Black Death killed between seventeen and twenty-eight million people in the period 1347-1353. Although there is debate about its overall economic impact, it is believed to have had a significant effect on the agrarian economy, which represented about 90 percent of European economic activity. The dwindling supply of food led to inflation resulting in policy-responses designed to put a lid on the rising prices and rising fortunes of the feudal agrarian sector. Arguably it was this cycle of events, which led to the Peasants’ Revolts of the latter part of the fourteenth century.
War has always been thought to be a result of and trigger for both economic expansion and contraction. For example, the international debt structure that emerged in the after math of World War I played a significant role in the confluence of events that led to the Great Depression of the 1930s. In turn, the hardship and inflation that ensued created the economic conditions that led to the rise of Nazi Germany and World War II. And in its wake came one of the largest economic booms of the twentieth century.
However, by the early-nineteenth century, economists knew there was something more to it than external triggers. Indeed, the Panic of 1825 is widely believed to be the first economic crisis not attributable to an external event such as war. It also had a significant international dimension. The Panic of 1825 was a result of a stock market crash in the UK arising in part out of speculative investments in Latin America. While it had the greatest impact in England, the pain was felt in Europe, Latin America and the United States. In the end, the Bank of England was bailed out the Banque de France (the French central bank). In effect, this launched the period of so-called modern economic cycles.
A number of theories have been promulgated to explain the phenomenon of cycles, but they still leave something to be desired when answering the question posed by Irving Fisher: ‘In times of depression, is the soil less fertile? Not at all. Does it lack rain? Not at all. Are the mines exhausted? No, they can perhaps pour out even more than the old volume of ore, if anyone will buy. Are the factories, then, lamed in some way—down at the heel? No; machinery and invention may be at the very peak.’[1a]
Economic cycles are characterized by phases in economic growth fluctuating between recession and recovery. A recession is broadly defined as a period of decline in aggregate economic activity lasting at least one year with wide-reaching effects throughout an economy. One of the most significant occurrences is called ‘stagflation’ where growth is slow or non-existent and prices remain high. In contrast, the recovery phase is the rebound period in aggregate economic activity characterized by relatively stable prices combined with output and productivity gains. During this phase, growth can lead to capacity constraints, which in turn fuels rising prices and declining productivity, also referred to as ‘demand-pull inflation’.
In the mid-twentieth century business cycles were primarily classified by their length and to some degree their sector impact. The best known sector cycle is the ‘agriculture commodity cycle’ which is based on a cobweb model. In essence, a cobweb model explains price fluctuations in certain sectors, such as the agriculture sector, where the amount produced must be chosen before the prices are observed such as the time lag between planting and harvesting.
The shortest cycle is the Kitchin inventory cycle of 3-5 years. The Kitchin cycle is characterized by the time lags in business information. For example, businesses increase output and employment during an upturn and over time the market becomes saturated with the product which eventually results in declining demand and prices and excess inventory. However, there is a lag between when the business knows of this market saturation and when the business can adjust production and employment levels to account for the subsequent excess inventory.