Market Failures And Business Cycles (Part 1)

The following is the most comprehensive ever explanation to the most mysterious phenomenon of Capitalism – the Business Cycles. In order to ensure that the article can be read by any well educated reader, I have minimized the economics jargon and have added a short and simple introduction to the structure of the economy. Each and every one of us would be interested to know as to why we cannot have a paradise on earth. Why is it that we are often besieged by such painful downslides of economic activity such as Great Depression or the nerve wracking periods such as Stagflations? Why can’t we all be always happy with hundred percent employment all the time, with each and every one of us employed? The following article provides simple and complete Business Cycle explanations to Depressions before 1930s, Recessions after 1940s, Stagflations of 70s and Continuous Booms of 80s and 90s.

The income that we earn is normally divided into two portions, Consumption and Savings. We normally consume a large portion of the income we earn for our day to day necessities as well as irregular buys. Regular necessities include food, clothing, toothpastes, soaps and other daily necessities. Irregular buys include bikes, cars, books, movies, music and so on. After we spend most of our incomes on Consumption, we save a small portion of our income and invest it in shares, bonds, fixed deposits and other long term investments.

In direct relation to our above mentioned activity, our economy is divided into two sectors – Consumption sector and Investment sector. If we exclude the government spending, Consumption sector constitutes roughly around 80% of the size of economy. It includes everything that we buy – food, clothing, cars, bikes, TVs and other durable goods, books – every thing. And around 20 percent of the size our economy is constituted by the Investment sector. Investment sector mainly includes activities such as installing new plants and capacities, and housing. A three sector model would also include government spending as well. However free markets have more to do with these sectors and less to do with Government Spending, so let us exclude governemnt spending. The figures given above are only approximate and can vary sizeably from economy to economy.

So how are profits made by the Consumption sector manufacturers? In any economy, Consumption sector always produces in excess of its requirements – it produces surplus. Consumption sector capitalists as well as households also save a certain portion of their income. Investors invest these Savings in the Investment sector. So these Savings turn into the earnings of the Investment sector capitalists and workers. The workers and capitalists of the Investment sector then spend their earnings on the consumption goods. So basically the surplus production of the Consumption sector is consumed by the workers and capitalists of the Investment sector. Therefore in a circular flow monetary economy, the income of the Investment sector becomes the profit or surplus of the Consumption sector firms. There is a small assumption that is made here on which I shall allude to at the end of the article.

So there are two things that we have to note here. First the size of the investment sector decides on the size of the profits of the Consumption sector. If there are huge Investments made, the Consumption sector capitalists make huge surpluses or profits and if the size of the Investment sector is on the lower side, the Consumption sector capitalists would make lower surpluses or profits. Also all of the Savings made should always be invested. If Savings are made but are not invested, then it would lead to a lower size of Investments and lower profits. Insufficient profits would force the producers to cut down on their production levels and this would directly lead to rising unemployment and recession! It is a long recognized economic thought that Savings made should be compulsorily invested fully so that the economy can be in equilibrium. If the Savings made are not invested fully, it can lead to disequilibrium between Supply and Demand and can lead to piling up of unsold stocks of inventories and a subsequent recession.

With the above short introduction to the structure of our economy, we are ready for a small journey into the fascinating world of Business Cycles.

Our economies are rarely ever static. They keep growing in size every year. Now in a growing economy Consumption also grows. Year on year more cars are purchased, more televisions are bought, more computers are installed and so on. It is natural that when Consumption grows by say 6%, the suppliers would expect their surplus also to grow by 6% because surplus, which is called profit in the business parlance, is obviously measured in percentage terms. However the surplus production has to be consumed by the workers of the Investment sector which obviously means that even Investment would have to grow by 6%. However this would mean that Savings, which is the fund for Investment, would also have to grow by 6%. What would happen if Consumption grows by 6% but Investment or Savings do not grow by an equivalent percentage? To the extent of the inequality, producers’ surplus would remain unsold and the economy would be in disequilibrium. So the equilibrium condition of the economy would be –

Periodic Growth percentage of Consumption = Periodic growth percentage of Investment = Periodic growth percentage of Savings.

Suppose during a particular period, there was a perfect equilibrium in which Consumption was C, Investment was I and Savings was S. Suppose during the next financial period C grows by a certain X percentage points. Then S and I would also have to grow by the same X percentage points. Suppose either I or S does not grow by X percentage points, the economy would be in disequilibrium even if Investment is equal to Savings!

A normal characteristic of any recession is the presence of huge un-invested Savings. Investors hoard money without investing it because of lack of investor confidence. At the trough or the lowest point in a business cycle, Consumption is relatively low and Savings are relatively high, especially un-invested Savings. Then as economic activity picks up, all of the Savings are invested and the producers of the Consumption sector would be able to realize their expected surpluses. The size of Investment sector is equal to the surplus of the Consumption sector. Since Savings are high and are fully invested, the producers of the Consumption sector would be able to realize huge surpluses. Economic activity picks up a roaring speed.

As economic activity picks up, there starts a battle amongst the producers for market shares. For example, each car manufacturer wants to sell as many cars as possible. He would not think – let me produce less cars now, let me save and invest more for later. So as the battle for market share picks up, Consumption accelerates at the expense of Savings i.e. Consumption grows at a faster rate than Savings. Our above mentioned condition tells us that for equilibrium to exist, Consumption and Savings have to grow at an equal pace. So if Consumption grows at a faster pace than Savings, would this lead to disequilibrium immediately? This may not immediately lead to disequilibrium because producers would obviously not keep expecting to earn abnormally high profits the way they earned in the initial stages of the boom. Their expectations are also geared towards comparatively lower profits or what is called as normal profits as the boom progresses and therefore lower growth rate in Savings vis-à-vis Consumption would not immediately damage their expectations of surplus. This way the boom progresses from the trough to the peak for a few years.

After a few years of growth of Consumption at a faster rate than Savings, the percentage of Savings in the income would drop so low that Savings are not sufficient to meet the expectations of surplus of the producers of the Consumption sector. Even if Savings are fully invested, this does not generate the surplus as expected by the Consumption sector because of the lower size of investment and would lead to disequilibrium. Producers see their unsold inventory stock piles rise and their profits dwindle. The situation needs correction. Consumption needs to be cut and Savings need to be raised. As they are not able to sell their goods, the producers of Consumption sector would be more than willing to do so. They cut their production and increase their Savings.

However the required correction might not materialize! The very objective of capitalist economies is Consumption. If Consumption is on the decline, we cannot expect Investment to increase. We cannot have fewer bikes sold as compared to previous year and at the same time have much higher Investment in the bike sector as compared to the previous year. A cut in Consumption might increase Savings but would not raise Investment. Investment follows the path of Consumption and it itself starts in the downward trend. As a result the increased Savings are not invested and the disequilibrium takes on a relatively permanent position and we have a recession! There are no automatic forces to ensure immediate correction. What started with a cut in Consumption to increase Savings leads to a fall in Investment. This drop in Investment leads to a further depletion of aggregate demand which then prompts the producers to cut their production levels even further. Consumption declines even further and the spiral continues until the economy settles at a low output with a lot of unemployment. This sort of downward spirals were recognized by the eminent British economist John Maynard Keynes. Eventually, after a few years of low output, some invention or some enthusiastic entrepreneurs who are attracted by prevalent low interest rates might trigger Investment to reverse its downward path and start the process of expansion all over again. I believe that most recessions in US and Europe after 1940s occurred in this way. I would call these cycles – the Consumption led Business Cycles.

Something reverse can happen which would be even more damaging than the just discussed case. Instead of Consumption growing at a faster rate than Savings, it might so happen that Savings and Investment grow at a much faster rate than Consumption. For example, prior to Great Depression, the importance of aggregate demand as explained by Keynes was not understood. As a result government policies normally favored huge Investments and were not geared towards propelling aggregate demand. It is well documented that one of the reasons for the Great Depression was US government policies which led to uneven distribution of income heavily in favor of the rich and the consequent depletion of the buying power of the households. So Great depression could have easily resulted from Investment/Savings growing at a much faster rate than Consumption. Huge Investment/Savings would mean that huge surpluses are realized by the producers of the Consumption sector. This would prompt them to invest in an even bigger way in plant and machinery and this huge Investment/surplus pattern continues for a few years. After a few years, we have huge capacities with insufficient Consumption or buying power!

The capacities of production rise to an extent where the producers would not really be interested in investing their surpluses as they already have huge unutilized capacities much in excess of the buying power of the households. As a result Savings are not invested i.e. Investment lags behind Savings. Money is hoarded, the circular flow of income in the economy stops and the economy gets paralyzed. Demand gets constricted which in turn constricts Supply. These constrictions worsen the situation even more because, on account of drop in production, the percentage of unutilized capacities increases even more than before which makes Investment in new capacities even more unattractive further increasing the hoarded money. The economy gets involved in a vicious downward spiral that can dramatically reduce incomes and severely aggravate unemployment. Ultimately after a few years, some huge Investment opportunity prompts entrepreneurs to start investing all of the Savings and the economy restarts on the expansionary path. Or it can so happen that the huge excess capacities get destroyed on account of lack of demand – for example, some new technology makes plants with older technology unsuitable to the new needs and such plants and factories become useless. This way excess capacity is weeded out making the economy conducive for Investment and growth. I believe that most business cycles in US and Europe prior to 1930s occurred in this way, they were all mostly Investment propelled. I would call those cycles – the Investment led Business cycles.

How can stagflations occur? During the Consumption led cycles, after several years of growth, Consumption eats away into Savings and surpluses realized would fall short of expectations for the producers of Consumption sector. Savings are low and a correction is required by cutting Consumption and increasing the Savings. The extent of correction defines the strength of the next boom. If the correction is big and Savings are piled up in a large manner during the downturn, then, at the beginning of the next boom, it gives the chance for Consumption to nibble away at Savings slowly and steadily for a large number of years – booms can last very long. If the correction is very small, if Savings are not too large at the beginning of the boom, the boom is then nipped in the bud itself. As there are no large Savings made, as soon as Consumption tries to nibble away Savings, Savings would immediately fall below the danger mark and the surpluses expected by the Consumption sector are not realized and a recession would start as immediately as the boom starts. In such cases, the booms might not last for more than one or two years. Such cases of insufficient corrections can occur on account of government intervention. Government tries to arrest the downward slide by trying to propel the aggregate demand using expansionary policies such as cutting down interest rates or indulging in deficit spending. Government’s intention in doing so would be to arrest the downward slide and decrease unemployment. However the effect of the government intervention would be that, economy starts expanding even before the Consumption is cut and Savings are increased to the required extent. As the economy starts expanding, Consumption tries to eat away at Savings and this immediately brings the Savings below the danger level and an immediate onset of recession. More workers are fired and a downward slide starts once again. Once again the government intervenes and tries to arrest the slide and once again the same thing would repeat itself and more workers are fired. Unemployment keeps soaring. Ultimately the producers realize that low surpluses are here to stay along with expansion.

Apart from low surpluses there is the problem of rising interest rates. As the economy tries to expand, there would be good amount of Investment demand. However as Savings are low and Investment demand is high, there is a huge demand for the limited funds available causing the interest rates to rise vertically. Government borrowing and deficit spending in order to boost the economy eats into the already low Savings and aggravates the situation even further. The situation mimics that of a boom time when both short term and long term interest rates are very high. Abnormally high interest rates lead to cost-led inflation. Very high interest rates coupled with low surpluses make Investment as well as production expansion unattractive to the producers of the Consumption sector. They start pocketing their profits without either investing or expanding production and the economy starts stagnating without growth. Under normal circumstances, pocketing of profits would lead to hoarding of money and paralyze the economy on account of stoppage in the circulation of money. However in this case, on account of government’s expansionary policies as well as cost-led inflation, capitalists do not hoard the money as money would lose its value on account of inflation. They start spending the pocketed profits and the circulation of money is not disrupted.

However the demand does not increase despite the lack of hoarding – why? What should have been saved and invested is now being spent directly by the capitalists. The income that would have reached the hands of a hundred Investment workers is now in the hands of a single capitalist. As a result, where hundred toothpastes would have been purchased by hundred Investment workers, only one toothpaste is purchased by the solitary capitalist! As a result the demand for goods suffers despite the fact that money is not being hoarded. Capitalists are high earners; they consume a small portion of their income and start spending the rest of their income on speculation in real estate and shares. Shares and lands are bought and re-bought at higher and higher rates leading to a speculative bubble and soaring inflation. Housing becomes very costly and the workers find their buying power reduced as a large portion of their incomes goes in providing housing for themselves. Workers then start demanding for higher wages and periodic wage hike agreements become part of the wage agreements making inflation a relatively permanent phenomenon. Unlike what some economists say about the unreasonability of wage hike demands by labor unions, the wage hike demands of workers were actually beneficial to the stagflationary economies of the 70s. The hike demands of workers actually act as some sort of a small check on the speculation of capitalists – instead of wild speculation, some money in the hands of the capitalists gets diverted towards wage hikes. Overall, stagnation and inflation co-exist together. This is how you get stagflation.

There was a continuous boom for two decades in US and other nations during the 80s and 90s. How could the booms last so long during this period? The booms during this period were Investment led. Huge amounts of Investments in IT infrastructure propelled these booms. However these huge Investments in IT are completely different from those that propelled the Investment led booms prior to 1930s. The huge Investments prior to 1930s led to piling up of new capacities in a big way. This gave in to the chance of there being over-Investment on account of huge unutilized capacities which ultimately led to further Investment being unattractive thereby resulting in Investment lagging behind Savings. However the Investment of the 80s and 90s was not that way. Investment in IT technology did not increase the plant capacities. For example, more cars cannot be produced just because car companies invest huge sums in IT. Therefore depressions of the type that occurred prior to 1930s are ruled out and the boom lasts as long as the IT spending lasts. Why couldn’t Consumption eat into Savings during this period? On account of the fear of being replaced by computers, the bargaining power of the workers reduced dramatically upon which wage led and the subsequent cost led inflations were completely absent. Therefore producers could save their surpluses and invest them without having to spend them on increasing costs. Also the prime reason for Investment in IT being cost cutting, cost cutting ensured that Consumption would never eat into Savings. This way neither Consumption would eat into Savings nor would Savings/Investment lead to excess capacities. Both types of downturns are ruled out. Booms would last as long as the IT spending would last. This is how booms lasted so long during the 80s and the 90s leading to a virtual absence of business cycles.

A small note before closing out. From the capitalists’ point of view, it would be great if the households immediately spend all that they earn on Consumption – sales would get boosted. So household savings make a dent or a hole in Consumption. This hole is then filled by the immediate Investment of those household Savings. So the phenomenon of investing the household Savings is like digging a hole and filling it up. Therefore household Savings do not affect the financial position of an economy as much as the Capitalist Savings. A shrinkage in household Savings would not directly affect the margins of the firms. So just make a mental note that the above discussion on Savings had more to do with Capitalist Savings and less to do with Household Savings.

About the Author: Thotakura R is the originator a new revolutionary economic model called "Threeway Economics" that demystifies the longstanding mysteries of capitalism to a great level of detail including Business Cycles,Inverted Yield Curves,Inflations,Price/Wage rigidities. To learn more, Visit his site at: http://www.threewayeconomics.com

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