Think of times when the national economy was very prosperous. Periods such as the “roaring” 1920s, the 1990s, or the mid-2000s may come to mind. But not long after these eras of prosperity, there came a time of economic downturn. After the “roaring” 1920s, the Great Depression struck the United States. Following the successful 1990s, there was a brief recession in 2001. While the mid-2000s was a time of economic prosperity, a sharp downturn occurred in 2008 and gave way to the Great Recession.
It's almost like there’s a systemic rise and fall in the economy. In fact, it’s a real economic phenomenon known as the business cycle. It’s characterized by the downward and upward movement of gross domestic product (GDP) over time in an economy. A period of excessively high GDP is often referred to as a “boom,” while the following period of economic decline is known as the “bust.” Therefore, this is also called the boom-bust cycle.
With the U.S. economy still recovering from the Great Recession, people are left wondering why these recessions occur. Often the causes of these downturns are shallowly diagnosed by politicians and pundits as “capitalism run amok.” However, this is a serious generalization that allows many to ignore deeper investigations into the real causes of these downturns. In the economics world, this topic is the center of hot debate between several different schools of thought. Examples of notable economic schools of thought that have their own theories of what causes economic downturns are the Keynesian, Monetarist, and Austrian Schools.
The Keynesian School was popularized by the influential British economist John Maynard Keynes. A central theme of Keynesian theory is the importance of total spending in the economy, often referred to as aggregate demand. This is composed of Consumption + Investment + Government Spending + Net Exports. When aggregate demand is high, businesses have more revenue, can afford to hire more workers, and pay the existing workers more. This in turn puts more money into workers' pockets, which they will then use to spend and further stimulate the economy. However, when there is a decrease in aggregate demand, revenues for businesses decrease, causing companies to lay off workers, which takes away money they could be spending, which further decreases the revenues of several other businesses. This continued cycle further sharpens a downturn, causing a recession.
The Monetarist School was popularized by the renowned economist Milton Friedman. An important theme of Monetarist theory is the belief that the money supply in the economy affects the business cycle. Monetarists believe that the money supply growth in an economy should be even with its GDP growth. If the money supply were to expand too much, there would be an inflationary boom in the economy, and if the money supply were to contract, it would cause business revenues to shrink, causing the economy to contract.
The Austrian School was popularized by famous economist Friedrich Hayek. An important theme of Austrian theory is the role of credit extension in the boom-bust cycle. Austrians believe that when the central bank increases the money supply and lowers interest rates, credit is easier for businesses to get. This causes businesses to seize an opportunity to more cheaply expand their operations and take on projects (such as housing or construction) they may not really be able to afford. After a period of time, interest rates are raised, and projects become more expensive to fund. A huge amount of these projects have to be relinquished, and all the labor employed for it has to be released, causing unemployment, bank runs, and a severe contraction in the economy.
Each of these theories of the business cycle deepens our understanding of the economy. They also allow each of us to investigate what really causes its ups and downs, instead of relying on superficial and faulty diagnoses from politicians and pundits.
