Where Do Business Cycles Come From?

Karl Marx gave the world the myth that economic crises are inherent to capitalism. Yet overwhelming evidence says they result from war and political unrest, or come from natural events and acts of God, and are not due to the inner workings of capitalism. War, revolution, civil war, and ethnic and religious conflicts have been the main causes of economic collapse, long-lasting stagnation, and failed recoveries. Besides these causes, it has been politics that has ruined the economic well-being of people throughout history.

The 20th Century

One can trace back the evils of the 20th century to the illusion that with good intentions would come intended results. The monstrous ideologies of the past century suffered from the error that one could create a paradise on earth through political force. The horrors began with World War I. None of the belligerents reached their goals, and the end of the war brought not peace but the groundwork for new conflicts. The world was not made safe for democracy. Communism and fascism were on the rise. The gold standard fell out of place. Free trade was pushed aside in favor of protectionism. The Great Depression, which dates from 1929 to 1939 for the United States but which began in Great Britain in the early 1920s, was the consequence of the costs of the war and the world conflicts after the duplicitous Treaty of Versailles.

It took until after the end of World War II for the Western nations to find their way back to cooperation again (for the details of this and the other episodes and a timeline of the major economic events since 1913, see Capitalism Beyond the State and Politics).

Yet in Eastern Europe, the stagnation continued even longer. The Soviet Union imposed its socialist system on the countries in Eastern Europe. The Soviet leader Joseph Stalin gained these territories with the explicit consent of the British Prime Minister Winston Churchill and President Franklin Delano Roosevelt at the Yalta Conference in February 1945. Poland fell into the hands of the Communists although guaranteeing Polish independence had been the declared reason for the United Kingdom to enter World War II.

Western Europe benefited from the American Marshall Plan from 1948 to 1952, intended to alleviate the postwar misery and launch the region’s recovery. While the immediate relief came from the financial aid, the long-term benefits of the Marshall Plan were due to the program’s linking of aid to economic liberalization. In the United States and in many other countries that had adopted free market policies, the 1950s proved prosperous beyond imagination.

Welfare-Warfare State

The major economic fluctuations during the 18th and 19th centuries resulted from war and domestic conflicts such as the Napoleonic Wars, the American Civil War, and the wars of independence.

But the Great Depression was long and deep because of the faulty monetary policy of the Federal Reserve System and the many economic policy errors of the Roosevelt administration (March 1933 to April 1945). The boom of the 1950s came after Roosevelt’s demise, when a pro-market orientation of the American economic policy took hold. Yet policies changed again toward interventionism in the 1960s and in the 1970s.

In the United States, the welfare state, whose foundations came into existence during the New Deal of the 1930s, expanded in the 1960s. After the 1962 Cuban crisis and President John F. Kennedy’s assassination in 1963, the Vietnam War began. In tandem with the war, the welfare state grew at a fast pace in this period. The American central bank, together with the other major central banks, gave full support to this expansion of government expenditure with a loose monetary policy under the spell of the cheap-money cult.

Stagflation

When, during the war in the Middle East in October 1973 (the Yom Kippur War, October 6–25, 1973), the group of oil-exporting countries (OPEC) ceased selling crude oil, the simultaneous occurrence of recession and inflation brought the stagflation of the 1970s. The desperate attempts to stimulate the economy through public expenditure programs combined with easy money failed miserably. The economies of the industrialized countries did not recover despite massive government spending combined with strong monetary stimuli. What increased was unemployment, the inflation rate, and government debt.

The economic policy at that time followed a Keynesian orientation. This economic doctrine as laid down by the English economist John Maynard Keynes (1883–1946) states that one must overcome an economic crisis with more government spending and more easy money.

The term “stagflation” signifies that economic stagnation and price inflation appear together. In the 1970s, the major industrialized countries suffered from low growth, high rates of price inflation, persistent underemployment, and widening budget deficits. In the United States, both the price-inflation rate and the unemployment rate reached double digits. In August 1971, President Richard Nixon imposed price and wage controls on the American economy.

The dominant macroeconomic model from the mid-1960s until the end of the 1970s was Keynesianism, according to which an economy is in the state either of a deflationary or an inflationary gap. According to this model, a lack of demand results in a deflationary gap and in turn a falling price level and rising unemployment. Such a situation requires that a central bank and a government apply expansive monetary and fiscal policies to stimulate the economy. In an inflationary gap, the Keynesian model demands a fiscal and monetary contraction.

Confronted with stagflation, the Keynesian policy makers had no answer. While doing away with the unemployment would require expansive policies of more government spending and lower interest rates, curbing the price inflation would need a restrictive policy of less public spending and higher interest rates. In the face of stagflation, the Keynesian policy became impotent. High unemployment and stagnant growth meant widening budget deficits and a mounting public debt.

Monetarism

After the disaster of Keynesianism became obvious, monetarism followed as the leading policy paradigm. The focus of this concept is the money supply as the determinant of the price level. From now on, the claim went, monetary policy would take over the helm from fiscal policy and tame the business cycle by maintaining a steady increase of the money supply. What appeared simple at first sight proved tricky to realize in practice. Monetarism’s unresolved problems included identifying which criteria to use to define the money supply in order to calibrate monetary policy, how the so-called monetary transmission mechanism works in detail, and how the money supply and the price level impact real gross domestic product and employment.

In the late 1980s, the high time of central banking began under Alan Greenspan as the chairman of the Federal Reserve System. He excelled as the maestro of bailouts. Whenever there was a crisis, he stood ready to boost liquidity. His policy laid the groundwork for the crisis of 2008.

In Japan, the central bank stimulated the excessive boom of the 1980s because the price level was apparently stable. When the crisis came in 1990, neither expansive fiscal nor expansive monetary policy helped to get the Japanese economy out of its slump, despite the size and duration of the measures.

The Path to 2008

At the turn of the century, Keynesianism made a comeback in form of New Keynesianism. The representatives of this school believed that the Great Moderation since the beginning of the 1980s was real and ignored the warnings of representatives of other schools of economic thinking, such as Austrian economists.

The financial crisis took the New Keynesians by surprise. They quickly abandoned their confidence in their models. Without reservation, the New Keynesians now called for support from fiscal policy. The result was a new breed of economic policy best called vulgar Keynesianism. Public debt exploded because of unrestrained government spending along with an explosive increase of central bank money.

The recovery after 2008 has been weak. The massive fiscal and monetary stimuli to fight the downturn of 2008 have not produced a swift recovery but have laid the groundwork for an even worse crisis. The economy has settled on a flatter trajectory. While the economy has not yet fully recovered from the crisis of 2008, the next bust is already waiting.

Conclusion

While the impact of natural disasters on economic fluctuations has receded as the relative size of the agricultural sector has decreased, the role of politics as the catalyst of economic crises has taken the front seat. Nowadays, there is little tolerance for fluctuations in the economy. Even small swings of economic activity lead to exaggerated policy reactions. The fear is that even a small increase in unemployment would cost politicians their positions. Yet by not allowing the small fluctuations to play out, economic policy fails. 

The depth and length of the economic crises over the past 100 years are the result of politics, either systemic because of war and welfare policies or because of fiscal and monetary policy decisions. The way out is not more politics or better politicians, but less politics and more capitalism. Unlike what was possible before the industrial revolution — when the forces of nature governed the economy — we can get rid of of the extreme swings of business activity when the dominance of politics over the economy ceases.

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Antony Mueller

Antony P. Mueller is a professor of economics at the Federal University UFS in Brazil where he is also a researcher at the Center of Applied Economics, and Senior Fellow of the American Institute for Economic Research. Antony Mueller earned his doctorate in economics summa cum laude from the University of Erlangen-Nuremberg, Germany. He was a Fulbright Scholar in the United States and a visiting professor at the Universidad Francisco Marroquin (UFM) in Guatemala as well as a member of the German academic exchange program DAAD. Antony Mueller has recently published the book “Beyond the State and Politics. Capitalism for the New Millennium”.