The Nails Aren't In The Coffin Of The Business Cycle Yet

With the current economic expansion soon to celebrate its sixth birthday, and growth having settled into a narrow, steady range of 2% to 2 1/2%, economists and business strategists are wondering whether the dreaded business cycle has been at last slain. Why can't the recovery last indefinitely?

Business cycles--the market economy's tendency to boom and bust--are generally caused by the penchant of markets to overshoot. Neither the company nor the consumer has perfect foresight. Euphoria on the upside and panic on the downside prevent real-world markets from being as perfectly self-correcting as they are in textbooks. Businesses overinvest, expecting that booms will last forever. When overbuilding and excess capacity lead to disappointing returns and even bankruptcies, businesses pull back sharply. This cycle of misperception and excess intensifies the minute swings of normal economic equilibrium.

In this century, governments have sought to temper booms and busts through fiscal and monetary policy. But results have been mixed. For business cycles to have been tamed, as some suggest, one of two things must have happened. Either the private economy is more resilient and prescient, or the managers of fiscal and monetary policy are smarter.

PARADOX. In some respects, the new economy truly is more flexible than the old. Mass production at huge and rigid plants has given way to more customized manufacturing. Inventories are leaner. And the manufacturing economy itself is being overtaken by a service economy. Moreover, wage rigidities are a thing of the past. Deregulation lets markets make quicker adjustments, write off excess capacity, and exit unprofitable product lines. Greater competition disciplines prices.

But there is a paradox. If business cycles reflect the market's tendency to overshoot, a freer economy is, if anything, more inclined to bouts of excess. Today's markets are better at adjusting, but that hasn't prevented cycles of real estate overbuilding, periodic excess capacity in everything from computer chips to phone lines, ill-considered mergers and acquisitions, costly bank lending fads and wild speculative swings in securities. The new economy may be more flexible than the old, but outbreaks of euphoria and the herd instinct are still hallmarks of capitalism.

By the same token, it's not clear that today's managers of fiscal and monetary policies are any more clever than their predecessors. In the '60s, the fine-tuners were fiscalists, hoping to manage growth by adjusting budgetary deficits or surpluses. But today, fiscal policy is off the table. The deficits of the '80s, and the current bipartisan commitment to reduce them, leave government with limited capacity to use public spending counter-cyclically. If the balanced-budget amendment to the constitution is enacted, federal fiscal policy will become permanently pro-cyclical. In recessions, as tax receipts fall, public spending would fall with them, deepening slumps.

LEAKPROOF. That leaves monetary policy. In this recovery, the Federal Reserve appears to have conducted monetary policy just about perfectly, keeping its foot off the brake while remaining ever-vigilant. But Fed Chairman Alan Greenspan has also been uncommonly lucky, since there are currently few inflationary pressures spurring the Fed to tighten. Greenspan's seemingly flawless stewardship of monetary policy is a bit like maintaining a leakproof roof when the sun is shining.

The inflation of the '70s, let's recall, was only partly the result of a macroeconomy overheated by Vietnam War spending. The proximate causes were sectoral and the products of happenstance--the OPEC oil price hike, a series of bad harvests that raised food prices, structural inflation in the medical sector, and speculation against the dollar. In response to these, the Fed of Paul A. Volcker sent interest rates skyward and the economy into a deep freeze.

Critics of the Fed often claim, with some justification, that few recoveries die of old age. More often, they are done in by the Fed's itchy trigger finger. As an agency accountable mainly to a community of creditors, the Fed is structurally biased to be more wary of inflation than of recession. The Fed, just like the private economy, sometimes overreacts and overshoots. As soon as some extraneous source of inflation strikes, the Fed will likely overreact again.

In short, the economy may indeed be more resilient than it once was. And it is doubtless capable of growing at better than 2 1/2% a year for a long time. But as long as businesspeople aren't angels and central bankers aren't philosopher kings, the report of the business cycle's death is greatly exaggerated.

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