Section 1: Business Fluctuations

Recessions, Expansions, Peaks, and Troughs

Business fluctuations are increases and decreases in economic activity, as measured by increases and decreases in real GDP. A recession (or contraction) is defined as a decrease in real GDP of at least two consecutive quarters (6 months). An expansion is any period of time during which real GDP is increasing. One full business fluctuation consists of one recession and one expansion. The height of an expansion (points A, C, and E in the graph below) is called the peak. The lowest phase of a fluctuation is the trough (points B and D in the graph below).

A typical economy experiences continuous increases and decreases in economic activity. From point A to B, GDP is falling, and we are experiencing a recession if the decline is at least two consecutive quarters. From B to C, activity picks up, and there is an expansion. From C to D, the recession appears more severe, and we may even speak of a depression. A recession in the United States lasts on average approximately 1 year. An expansion usually lasts on average more than 5 years.

Business Fluctuations in the United States

Below is a table with nominal and real quarterly GDP changes, starting with the first quarter of 1979 (seasonally adjusted rates). For the “Chained” changes (real GDP) a base year is chosen to keep prices constant.

Source: Bureau of Economic Analysis, 2023 (https://www.bea.gov/sites/default/files/2023-12/gdp3q23_3rd.pdf).

The table above shows that the expansion that began in 1982 lasted through the second quarter of 1990. The recession of 1990 lasted through the first quarter of 1991. Unemployment rose to 7.8% during this recession. We experienced some stagnation immediately preceding and following the September 11 terrorist attack in 2001. However, the economy (real GDP) did not decline for two consecutive quarters, so according to the official definition, we did not experience a recession in 2001. Therefore, the expansion that began in 1991 lasted through the second quarter of 2008. The recession associated with the housing crisis began in the third quarter of 2008. Real GDP continued to decline in the first two quarters of 2009 and pushed unemployment levels in some parts of the country past 10%, the highest since 1982. From 2009 until 2019 real GDP increased during most quarters and this resulted in a gradually declining and historically very low unemployment rate in 2019. The pandemic lowered real GDP significantly through the second quarter of 2020 and increased United States unemployment to more than 11% that summer. As the economy recovered starting in the third quarter of 2020, the unemployment rate eventually came down to below 4% and it has remained there through this year.

Models about the Causes of Fluctuations

John Maynard Keynes, whose theories are discussed in more detail in Unit 5, argued that recessions are caused by a decrease in demand for goods and services. When demand drops, businesses inventories rise. Businesses then decrease production, and lay off workers. As unemployment increases and incomes decrease, consumption spending decreases even more. Businesses then further decrease production, and the cycle continues. Keynes expressed fears that without government intervention, a recession could easily turn into a depression.

Classical economists disagree with Keynes’s explanation of what causes business fluctuations. They believe that production, not demand, is key and that in the long run, increases in production automatically lead to full employment and increases in real earnings for workers and entrepreneurs. In other words, more supply leads to more real demand in the long run. If there is a surplus or shortage of products or jobs in the short run, the market corrects this by allowing wages, prices, and interest rates to fluctuate. Lower wages decreases firms’ cost of production, thus helping them to become more profitable in the long run. Lower prices give buyers the incentive to increase their quantity demanded. Lower interest rates lower firms’ cost of borrowing funds. As the rate decreases, businesses will regain the incentive to borrow and invest in new technology and capital. Classical economists believe that fluctuations are normal dynamic phenomena and that the market helps to turn recessions into expansions by itself in the long run.

Keynes believed that government intervention is necessary during inflationary and recessionary times. Classical economists believe that government intervention may be beneficial in the short run, but is harmful to the economy in the long run. For example, since the government took control of the banking system in 1913 (establishment of the Federal Reserve System), it has had a history of increasing the country’s money supply consistently almost every year. An increase in the money supply, as we will see in a later unit, equates to inflation, and is harmful to the economy in the long run. High inflation raises interest rates, which lowers borrowing and investments. This eventually decreases wages, purchasing power, and the demand for goods and services. During inflationary times, businesses are faced with lower real rates of return on investments and economic uncertainty regarding real prices, wages, profits and investments.

According to classical economists, regulations and rules are important components of a well-functioning free market economy. However, excessive government regulations, such as complex and stifling consumer laws, labor laws that discourage productivity, costly and non-essential safety requirements, product restrictions, costly pollution control measures, and protectionist policies (trade restrictions, such as tariffs and quotas) contribute to economic slowdowns. Minimum wage and other labor laws are meant to protect workers. However, if a business’s costs increase without a productivity increase, then the business may lose money and it may be forced to downsize, go bankrupt, or move abroad. Anti-trust laws may also harm businesses if they punish innovation and add costs to business operations (this is discussed in Microeconomics). According to classical economists, government policies that contribute to increased business expenses and economic inefficiencies may eventually lead to recessions and increases in unemployment.

The Recession of 2008/2009

Video Explanations
For a video explanation of the causes of the 2008/2009 recession, please watch the following:

There has been extensive debate about what caused the most recent recession. Some economists argue that deregulation in the financial services industry encouraged corporations to take excessive risks which led to numerous bankruptcies when the housing market declined. Others claim that the regulations in place were adequate, but that there was insufficient enforcement and supervision by regulatory agencies such as the Federal Deposit Insurance Corporation, the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission.

It has always been an American dream to own your house. It has become one of the core values in American culture. During the long economic expansion that began in the early 1990s and lasted through early 2008, economic activity was robust, real GDP increased considerably, incomes rose and unemployment declined to historic lows. People that owned a home saw their home values rise sharply. Many real estate speculators (investors) found a quick way to large fortunes and bought houses aggressively. Families that didn’t own a home yet wanted to get in on the act, too. With the help of government laws, many households found a way to finance a home, even if they couldn’t afford one. Government-supported mortgage companies such as Freddie Mac and Fannie Mae were given mandates by government officials to encourage households to fulfill their American dream. Laws were passed that encouraged low-income families to buy a house. Even people without a job qualified for a mortgage. Many mortgages had favorable conditions (low interest rates), but usually only during the first few years of the loan. Banks and other financial institutions saw a way to make considerable profits by issuing large numbers of mortgages to home buyers. Each loan, after all, brought in revenue from fees, commissions and interest income. Many banks didn’t hold on to the loans they had issued. Banks bundled the thousands of mortgages into mortgage securities and sold them as investment pieces (similar to mutual funds) to investors who were told that these mortgages were low risk (highly rated). The Federal Reserve fed this economic expansion of rising mortgage debt by increasing the money supply considerably.

When in 2007 more and more households defaulted on their mortgages (many households didn’t have enough income to afford their mortgages, and some had mortgages that had low monthly payments during the first several years, but much higher payments later), housing prices began to decline and the housing bubble burst.

Millions of homeowners defaulted on their mortgages, forcing mortgage lenders to foreclose on the homeowners and take back possession of their properties. Financial institutions and other investors who had purchased mortgage securities saw the value of these assets decline drastically. Mortgage security investments worth billions became almost worthless within weeks. Insurance companies such as AIG had insured many mortgage security instruments (called credit default swaps). In the case of a security default, AIG would pay the owner of the financial instrument if it defaulted. With foreclosures and defaults rampant in 2008 and 2009, AIG suffered hundreds of billions of dollars in losses. The government decided that AIG, along with other large financial institutions, was too big too fail and provided bailout funds funded by taxpayer dollars or borrowed money. Many corporations were criticized for paying their managers and CEOs extravagant bonuses and compensation while the company was losing money and regular employees were laid off. To make things worse, fraudulent investment operations, such as Bernard Madoff’s Ponzi scheme, came to light and forced investors to lose billions of dollars.

As a result of the financial crisis and the housing market collapse, the financial markets (stocks) crashed, confidence in the economy deteriorated, and spending (especially on larger purchases such as cars and luxury items) declined drastically. Real GDP decreased and unemployment increased.

So What Went Wrong?

The crisis resulted from a combination of factors. Many parties in the private sector (households and businesses) acted irresponsibly by taking on too many risks. Households should not borrow when they cannot afford to pay back a loan, and businesses should not lend when the borrower has insufficient funds to pay back the loan. When bundled mortgage securities were traded to investors, rating agencies should have more carefully assessed the risk of these financial instruments. Government agencies should have more carefully supervised financial institutions and prevented them from making overly risky loans. The Federal Reserve should have limited the growth of the money supply that fueled the artificial boom. Congress should not have encouraged mortgage companies and banks to make loans to households that could not afford these sizable loans. It sounds like a noble gesture to allow everyone to enjoy a big house and live the American dream; however, these government actions actually artificially drove up housing demand, exacerbated speculation in the real estate market, and made housing prices eventually and ironically non-affordable for many. Many families became homeless and lived in so-called tent cities. The opposite (homelessness and foreclosures) of what the government intended (home ownership and the American dream) happened. As we will see throughout our text, well meaning and seemingly noble government actions frequently lead to adverse results.

What Can We Learn?

Businesses are learning that short-term profit motives don’t usually pay off. Businesses need to make decisions that will help them survive in the long run. This means making solid and sound investments that carry a reasonable risk. And it may mean forgoing short-run profits in order to avoid overly high risks so as to survive in the long run. Households are learning that borrowing is okay as long as they can pay off the loan; borrowing is not okay when there is insufficient expected future income. Many households are also learning about the virtues of saving. Recently, the savings rate in the United States increased from .2% to nearly 5%. A higher savings rate may slow economic spending and business activity somewhat in the short run, but will pay great dividends for our economy in the long run. Many homeless families currently regret that they didn’t save more during the time that they had a job and a home. If they had saved significantly instead of going into deeper and deeper debt (from purchases of expensive electronics, vacations, cars, overly expensive houses, etc.), they would have weathered the economic crisis much better and probably prevented their foreclosure.

The government is learning that it needs to more effectively oversee the financial services industry. There are rules in traffic and there are rules in the business world and they are necessary to ensure a smooth flow. But the rules need to be strictly and effectively enforced by the government agencies in charge (Federal Reserve, SEC, FDIC, CFTC, Office of the Comptroller of the Currency and the Office of Thrift Supervision). Because of the non-profit nature of government, many government departments operate inefficiently and ineffectively.

After the crash, the U.S. federal government (and governments around the world) spent trillions of dollars bailing out companies and stimulating the economy. Congressional spending has given the U.S. a national debt that keeps breaking record highs. This is worrisome because it will inevitably lead to forced cutbacks in future government spending and/or higher future taxes and a subsequent slowdown in future economic activity. In addition, the U.S. Federal Reserve has injected hundreds of billions of dollars in the financial markets in order to provide liquidity. These injections equate to large increases in the money supply and causes inflation (both in consumer product prices and asset (stocks, bonds, houses, etc.) prices). We will look at the relationship between money supply increases and inflation in Units 7 and 9.

Excessive and irresponsible borrowing and lending by the private sector (in the stock market) were the primary causes of the Great Depression of the 1930s. Excessive and irresponsible borrowing and lending by the private sector (in the real estate market) were the primary causes of the 2008/2009 economic crisis. Will excessive borrowing (student loans, government borrowing, etc.)  and excessive monetary expansion by governments around the world burst the next bubble?

The Pandemic Recession

The pandemic has drastically altered the economic landscape. Many industries, including the hospitality, restaurant, entertainment, travel, brick and mortar retail stores, and oil and gas, and education, have suffered big losses. Other industries, such as online sales (Amazon, Instacart, Door Dash, etc.) , technology (Netflix, Zoom, social media companies, etc.), hardware and lumber,  have benefited. On balance, the economy has suffered and nations’ unemployment rates  increased during 2020. Governments stimulated their economies by increasing spending and handing out generous unemployment compensation packages. This helped people in the short run, but caused harm in the long run by adding to national debts. It also caused inflation as the government spending was financed by increases in the money supply. Central banks injected large amounts of money in 2020 and 2021 to keep interest rates low and to stimulate the economy. This again stimulated the economy in the short run, but harmed it in the long run as evidenced by high rates of inflation (close to 10%) the years following.

In most countries the pandemic has largely been contained due to people’s improved immunities, better covid treatments, and vaccinations. Consequently, industries including entertainment, cruises, restaurants, and travel, have experienced a sharp rebound in economic activity.