Has the Business Cycle Changed Since 1945?
The sustained growth of the United States and most other industrialised economies in the 1950s and 1960s raised the question: is the business cycle obsolete?' A Social Science Research Council (SSRC) conference addressed this question in 1967 and the resulting papers are published in Bronfenbrenner (1969). Further light on the problem was shed by the NBER colloquium conference in 1970, the papers from which are published in Zarnowitz (ed.) (1972). Following the experiences of the 1970s, with its two oil price shocks, and the deep recession of the 1980s, a new perspective emerged from an NBER conference on the US business cycle in 1984, the papers from which were published in Gordon (ed.) (1986).
The 1967 conference was designed to be a successor to the 1952 conference on the business cycle in the post-war world (papers published in Lundberg (ed.) (1955)). It considered a number of papers outlining the post-Korean War economic experience of a number of countries, including the United States, United Kingdom and various European countries. The general conclusion was that the business cycle still existed, albeit without strict periodicity, but that its character had changed. The period and amplitude seemed to be decreasing, although neither was clearly smaller than in the fifteen to twenty year period prior to the 1914-18. The cycle seemed to be taking the form of a growth cycle, with alternating rates of growth rather than the expansions and contractions, involving negative growth, of the classical cycle. In addition some interest was shown in the possibility of a political business cycle (Mullineux 1984, Ch. 3) because of the observed alternation between government policies designed to reduce inflation and unemployment. R.C.O. Matthews expressed concern about the lags in policy and the possibility that the government might act out of phase with the cycle it was trying to cure, thus exacerbating it, and also about the severity of policy reactions in the United Kingdom to economic events.
An interesting by-product of the conference was the comparison of cycles in socialist and capitalist economies. The conference agreed that socialist planning in the USSR had reduced economic fluctuations to those due to random shocks emanating largely from political circumstances (e.g. Stalin's death) and natural phenomena, such as bad weather. Some doubts about the reliability of the Russian data were expressed and the conference conclusion was not unanimously supported. It was, however, felt that maintenance of a high degree of stability was compatible with capitalist organisation and that the catastrophe of 1929-33 was very unlikely to be repeated.
The comparison of socialist and capitalist economic experience could prove a fruitful avenue for further cycle research. If it could be shown that cycles in the Soviet economy result largely from exogenous shocks, then some measure of the size of the cycle expected from exogenous shocks could be imputed to other economies - the differences between these cycles attributable to shocks, and the observed cycles attributed to factors endogenous to the capitalist system. More generally, one could analyse the major differences between socialist and capitalist economies in the hope of isolating probable areas of cycle generation.
The 1970 NBER colloquium concluded that the business cycle, while not obsolete, had undergone important changes and that the evaluation of the economic system and its institutions required new tools of analysis. The papers by Mintz, Fabricant and Moore (all in Zarnowitz (ed.) 1972) considered various methods of analysing 'growth cycles. It was argued that cumulative changes in the organisation of the economy can affect the nature of economic motion over time and that government attempts to reduce instability might alter the structure of the economy and change the character of economic fluctuations as a consequence. Although cycles were believed to have attenuated since the War, it was felt that they were still potentially dangerous and, as a further motivation for the continued study of the business cycle, Zarnowitz noted that good forecasting requires knowledge of business cycles.
In support of the hypothesis that cycles had become milder and shorter, Zarnowitz drew on results from NBER studies. The four recessions in the United States between 1948 and 1961 had an average duration often months, whereas the twenty-two recessions between 1854 and 1948 averaged twenty-two months and were more than ten months in all but three cases. Expansions had also become longer. Between 1949 and 1961 the average duration was thirty-six months and between 1961 and 1969 it was forty-nine months, whereas for the period 1854-1945 the twenty-two expansions had an average duration of twenty-nine months. This shortening of contractions and lengthening of expansions is clearly consistent with the growth cycle hypothesis. Romer (1986), however, finds that the methods used to construct the conventional US industrial production figures have exaggerated the fluctuations in the series, especially pre-First World War. This was consistent with Romer's previous findings that historical US unemployment and GNP series are excessively volatile, and suggests that the apparent stabilisation of the post-war economy might be a statistical artificat not warranting the status of a "stylised fact'.
Zarnowitz postulates that the observed changes could originate from a number of sources. Firstly, the intensity of external shocks could have been reduced since the strongest shocks are probably caused by major wars. Zarnowitz looks at years excluding wars and still finds that the more recent cycles had more moderate contractions and longer expansions, though the expansions are perhaps a little less vigorous. As if to verify this view the 1970s brought larger shocks, particularly the oil price shocks of 1973 and 1979; these seem to have caused another structural change in the cycle, growth trends becoming less pronounced and zero and negative growth again being recorded in recessions. In addition, in the 1950s and 1960s the economies could still have been feeling the benefits of the major shock provided by the Second World War. In this connection the long swing hypothesis would suggest that the 1950s and 1960s represented an upswing of the long wave, with typically strong growth trends, and the 1970s brought a downswing of the wave, with weaker, and possibly zero or negative, growth trends. Advocates of this view include Mandel (1978a, 1978b, 1980) and Van Duijn (1983).
Secondly, the system could perhaps have become less vulnerable to shocks in the 1950s and 1960s as a result of the stabilising influences of structural, institutional and policy changes. The wider application of built-in stabilisers through the tax system and in transfer payments probably had such an effect. The role of government policy intervention also needed to be examined. In 1970 the belief seemed to be that although government policy reactions could sometimes get out of phase with the cycle - and had sometimes entailed overreaction and, therefore, had destabilising effects - government policy intervention, in the form of demand management, had contributed to the reduction in the amplitude of the cycle and to its conversion to a growth cycle in the post-war period. Alternative views of the role of the government in the business cycle are examined in Mullineux (1984, Ch. 3). In the 1970s, scepticism about the potential for the government to stabilise the economy using demand management grew. The disenchantment with demand management policies and the preoccupation with supply side policies in the late 1970s and early 1980s was prompted, in part, by the seemingly markedly different experience of the 1970s, in which inflation and unemployment were significantly higher and growth was lower than in the 1960s.
The general findings of the colloquium as outlined by Zarnowitz (1972), were as follows. First, economic fluctuations had become milder in the post-Second World War period in the United States and other developed countries, slowdowns in growth largely replacing declines in economic activity. Many features of these growth cycles are similar, though perhaps in modified form, to the classical business cycle. The Mintz paper shows that leading indicators are still useful for predicting declines and accelerations in growth. The Moore paper shows that rates of change of prices have a close correspondence with the US cycle. Fabricant finds that the 1969-80 diffusion indices resemble the patterns of past recessions. Second, structural changes were given much of the credit for the greater stability. The whole question of interactions between endogenous and exogenous forces, however, was judged to require further study, especially with reference to major historical changes. Research needed to be extended in three directions:
1. To examine the effects of fluctuations in and disturbances to exogenous variables.
2. To learn about the specification errors of existing models, in order to decide how much of the serial correlation is due to misspecification.
3. To include a greater variety of model, since most of the models analysed were Keynesian-dominated.
Further, whatever their causes, the moderation and modification of the business cycle in the 1950s and 1960s required a more complete reference chronology, ideally integrating classical and growth cycles. Finally, the 1969-70 US recession disclosed both important differences and similarities when compared with earlier recessions - the major difference being the persistence of inflation in the face of declining production and rising unemployment.
As noted above, this last point posed major problems for Keynesians, and the continuing experience of stagflation in the 1970s provoked speculation that there had been a further alteration in the structure of the business cycle. One of the major questions raised was the extent to which the essentially Keynesian, large-scale econometric models were misspecified, especially with regard to the monetary sector and inflation forecasting.
The purpose of the 1984 conference was to consider whether the US business cycle had changed since the War. Gordon (ed.) (1986) drew attention to the revival of interest in the business cycle, following the severe recessions of 1974-5 and 1981-2 and the intellectual ferment caused by the Lucas (1975) and subsequent equilibrium business cycle contributions.38 He suggested that the stage had been reached where the terms macroeconomic theory and business cycle theory were virtually interchangeable and that another peak in the cycle of interest in business cycles had been reached following the trough in the 1960s. Seven of the twelve papers published in Gordon (ed.) (1986) consider specific components of economic activity, while the remaining five focus on aggregate economic activity. Of the latter, the papers by Eckstein and Sinai (1986) and Blanchard and Watson (1986) attempt to identify the shocks or impulses that generate business cycles, and the papers by De Long and Summers (1986) and Zarnowitz and Moore (1986) concentrate on changes in cyclical behaviour.
Gordon notes that, following the debates between Keynesians and the Friedmanite monetarists in the late 1960s and early 1970s, the oil shocks of 1973-4 and 1979-80 restimulated interest in the Frischian view that external impulses or real shocks, rather than the money supply or its rate of change, were a major source of business cycle fluctuation (Friedman and Schwartz 1963a, b). Because the oil price shocks were of a supply side nature, it has now become common to distinguish between three types of shock: monetary, real demand and real supply shocks. The recognition of the importance of supply side shocks, Gordon notes, meant the government could not be regarded as the sole source of mainly monetary shocks.
The overall picture to be gleaned from the 1984 conference is that the propagation model may change over time due to structural and institutional changes and changes in government policy perspectives. Such changes are likely to be slow and may take years to detect; nevertheless, it may not be appropriate to treat the post-war period as a whole any more. The 1970s and 1980s appear to be different from the 1950s and 1960s. In the 1970s it became evident that supply shocks could have a major impact, along with aggregate demand shocks. Thus the combinations of shocks hitting an economy may change over time. Although cycles may be all alike in the sense of being generated by the same, but possibly slowly changing, propagation model, they will still lend themselves to historical analysis since each cycle is caused by a unique combination of shocks, given the Frisch-inspired view of cycle generation. Historical analysis is also necessary to assess the impact of structural, institutional and policy changes. Further, the institutional and related differences between countries can be used to explain differences in cyclical behaviour between them. In the conference it was, however, noted that the business cycle might be in the process of becoming a fluctuation in world economic output due to the increased synchronisation of cycles in the OECD countries and growing international interdependence. But the evolution of the Third World debt problem39 has demonstrated that the interdependence is increasingly North-South as well as intra-OECD. It may therefore make little sense to confine analysis to business cycles in one country, even as large and important as the United States, in future. The conference included remarkably little discussion, beyond the oil shocks, of open economy influences on the US business cycle and its post-war changes in behaviour. With hindsight, this was the beginning of the period now referred to as globalization.
Following the declaration that the cycle was alive and well in the early 1980s, one of the longest sustained recoveries in the post-war period has been witnessed, particularly in the United States and the United Kingdom, since the recession of the early 1980s, which hit economies on both sides of the Atlantic very badly. Although sustained, the average rate of growth has been considerably below that of the 1960s. In the summer of 1988, signs of a buildup of inflationary pressure were beginning to emerge. These are commonly associated with boom conditions and in the past all booms have eventually bust. Nevertheless, this experience of sustained growth, in countries that have experienced 'Reaganomics' and 'Thatcherism' respectively, has again raised the question of the cycle's obsolescence. Others point to the possibility that the changes wrought by the Reagan and Thatcher governments have increased the risk of a future depression, probably on a worldwide scale, and financial crises - the 1982 Mexican debt crisis and the October 1987 worldwide stock market price collapse merely being a presage of worse to come. These changes, which included the weakening of automatic stabilisers and deregulation, run counter to the positive influences on increased post-war stability identified in the 1984 conference.
US, UK and other OECD governments are adapting their tax systems to achieve 'fiscal neutrality' and increasing the proportion of expenditure-related tax revenue relative to income-related tax revenue. These changes are reducing the degree of progressiveness in the tax structure. At the same time, particularly in the United Kingdom, unemployment benefit is declining in relation to average wages and being made harder to qualify for. The automatic stabilisers are, therefore, likely to be less effective. Further, a number of OECD governments have succeeded in reducing the rate of growth of their expenditure. In the United Kingdom, the government's share of total GNP has been declining and the government was able to announce a fiscal surplus in 1988. Working in the opposite direction, the financial liberalisation and innovation since the mid-1970s in the United States and in the 1980s worldwide have increased the access of consumers to credit and therefore their ability to smooth consumption flows in the face of income fluctuations. (See Mullineux 1987b, c for further discussion.) The result may, however, be that financial crises will have a greater impact in the future unless central banks can avert them. Central banks were apparently successful in curtailing the economic impact of the October 1987 stock market crashes by adding liquidity to the financial, and especially the banking, system and/or reducing interest rates. In hindsight, they may even have overdone it since by the summer of 1988,world growth projections were being increased and talk of recession had been replaced by that of inflation. A co-ordinated interest rate increase was engineered by the central banks of the major OECD countries in August 1988 to dampen inflationary expectations. From a post 2007-9 Global Financial Crisis perspective, it is clear that continued financial innovation and liberalization supported by crisis averting loose monetary policy was storing up problems for the future, Rajan (2010).
The financial liberalisation has also included the removal of capital controls.40 This has allowed international capital flows to react to interest rate differentials and other factors very rapidly and has further increased international economic interdependence and accelerated globalisation. The implications of this are discussed further by Eichengreen and Portes (1987), who note various parallels between the 1970s and 1980s and the 1920s, when financial liberalisation was also a prominent feature (see Chapter 3 for further discussion). The other major change in the 1980s was the decline in the inflation rate, following the post-war peaks of the 1970s, and the rise in the real interest rate to post-war high positive levels. This has been attributed, inter alia, to the high, by historical standards, US budget deficit at a time when the savings ratio was low in the United States, perhaps due to falling inflation. Whatever their cause, the high positive real interest rates may account for the lower investment and slower average growth in many of the OECD countries in the 1980s compared with the 1960s. But their effect on the nature and shape of the business cycle warrants further investigation if, rather than the real wage, they are indeed the most important price in the whole economy, as De Long and Summers (1986) assert. In the event, growing capital inflows into the US in the 1990s and 2000s lowered real long term interest sites significantly, Rajan (2010).