'Is the Business Cycle obsolete

Over the past century the Federal Reserve authorities in the U.S. have controlled money supply and the rate of interest. Changes in the rate of interest have led to changes in consumer spending and investment, hence, adjustments in aggregate demand and output. Furthermore, Tobin’s quantity theory of investment has led to greater certainty for businesses regarding investment and for consumer. The sense of ‘money illusion’ has disintegrated. Overall greater control of monetary policy has led to greater certainty and lower inflation in the investment and consumption market.

On the other hand, Stock and Watson (2003) concluded that enhanced monetary policy accounted for only a minute fraction of the reduction in the variance of output growth from pre-1984 period to post-1984 period in the U.S.

Also, fiscal policies such as the implementation of automatic stabilisers by the U.S government have been employed. This has been in the form of progressive taxation to counter cyclical expenditure measures such as unemployment, and to moderate fluctuations in consumption spending. As Burns discovers, the U.S. government post-war period increased borrowing to smooth fluctuations in the business cycle.

Burns makes a final comment that the business cycle is not obsolete, but has dampened post-war period in the U.S. He concludes that the structural changes in the U.S. economy have ‘served to moderate and humanise the business cycle, and will continue to do so’. 

Economic theory suggests that something as vast as the business cycle cannot become obsolete but can me moderated vastly. Moreover the implementation of monetary and fiscal policy has helped to counter vast cyclical fluctuations.

On the other hand Romer argues that business cycles are as predominant as they were a century ago however, the magnitude of the business cycle depends on the metric used to assess it. Studies conducted by economists such as Baily (1987) and DeLong and Summers (1986) use pre GNP movements to conclude that cycles have become less rigorous in the post-war period, but not obsolete. Historical measures of GNP play a crucial part in the analysis of the business cycle over the past century.

Romer (1989) adapts the Kuznets estimates of GNP to evaluate the business cycle prewar. ‘This description suggests that while these estimates may provide a good indication of long-run trends in gross output, they may not represent cycles accurately’. Romer suggests that the Kuznets estimates of GNP may accentuate the actual size of the cyclical fluctuations, therefore it is evident that the prewar business cycle is more volatile. ‘The reason for this is that the value added to a good not reflected in producer prices includes the less cyclically sensitive components such as distribution and transportation’. Romer (1986) takes Kuznets measurement and the Legbergott unemployment series and finds that the prewar economy was dramatically more volatile than the postwar economy.

Furthermore Romer (1986) states that the type of date or series (old or new prewar series) changes the fluctuations of the business cycle. It is difficult to definitely state that the business cycle is obsolete, as different data and series are used by different economists when evaluating the business cycle.

Indeed, overall results show that the U.S. economy prewar was extremely volatile compared to post-war economy. It is evident that ‘nearly all macroeconomic series have accounted for the dampening of cyclical fluctuations between prewar and postwar eras’. Romer adapts historical production data by using Frickey’s index in conjunction with the Federal Reserve Board (FRB) index of industrial production in manufacturing. When compared to the modern FRB index of the industrial production, Frickey’s index is substantially more volatile. Romer concludes with empirical evidence that using Frickey’s index has overstated the cyclical movements in the U.S. economy postwar.

Romer (1999) goes on to argue that postwar the business cycle has dampened due to changes in macroeconomic policy. The business cycle has not become totally obsolete, but less volatile particularly in the past 10 to 15 years. Most financial bodies and governments around the world have ‘replaced uncontrolled random shocks from a wide variety of sources with controlled policy shocks that explain the changes we do and do not see over time’. Moreover, changes in monetary policy after a peak in the business cycle have helped to increase the stability of the business cycle. A key finding was that monetary policy has played a key role in the post war period in stabilising the business cycle. The main result that Romer deduces is the fact that ‘both monetary and automatic fiscal policy have served to moderate postwar recessions’. 

The phenomenon of a ‘new economy’ has been a major result from Romer’s findings. Romer suggests that the potential for the business cycle to become non-existent is there, although this will take a number of years. Overall, the application of monetary policy to control inflation with the aggregate demand policy of using automatic stabilizers have been the main source of greater stability of the business cycle.

In addition, empirical evidence on international stabilisation has shown increasing economic stability over time, and confirms that the modern decrease in U.S. GDP volatility is part of a broader long-term development shared by all the industrialised countries, mainly the G7. First, the amplitude of output volatility cycles has been decreasing over time. Secondly, the long run trend in output volatility is negative for all countries considered. Finally, the empirical results present evidence that there have been numerous structural breaks in the countries studied, leading to larger stability over time. Moreover, the amplitude of the cycles has been decreasing over time, both during expansions and recessions.

Taking results from average international volatility from the first quarter in 1949 to the fourth quarter in 1999 it is evident that cycles have been decreasing over time. For example, in recessions before 1979 the mean was 36.4, which, decreased to 34.5 for recessions after the first quarter in1980.

In the U.S., business cycle reference dates are produced by the National Bureau of Economic Research (NBER), which evaluates the effects of macroeconomic fluctuations. This is done by identifying peak and troughs of the business cycle. Indeed, economists such as Romer and Burns note that this is a difficult procedure and the severity of the business cycle can be exaggerated. NBER dates for the U.S. show a decline in fluctuations postwar. Nonetheless, dates identified by the NBER are thought to be reliable. On the other hand, Romer identifies evidence of inconsistencies with the NBER chronology of the business cycle peaks and troughs. There have been more inconsistencies with using date from the prewar period and algorithms used to obtain dates have been inconsistent with postwar dates. Nevertheless, when taking away such inconsistencies it is shown that recessions have become shorter over time.  

Both findings from Romer and Burns have not given definite evidence that the business cycle is now obsolete. Moreover the majority of empirical evidence suggests that postwar, the business cycle has dampened immensely.

Blanchard and Simon (2001) argue that there has been a large underlying decline in output volatility. They compute empirical evidence to portray that the standard deviation of quarterly output growth has declined by a factor of three over the period 1950 to 1990. This is thought to be enough evidence to account for the increased length of expansions. The also mention like Romer and Burns that monetary policy has a major part to play in this decrease in cyclical volatility. Moreover, improvements in financial markets have helped to reduce consumption and investment volatility.

An article written by Stock and Watson (2003) look at the G7 countries when evaluating whether the business cycle has changed. They find that output volatility has declined across the G7 countries although timing and details of peaks and troughs differ across countries. For example, the standard deviation of the growth rate of GDP in the U.S. was one third less during 1984-2002 than it was during 1960 to 1983.

Nonetheless, the most vital finding has been the change in the business cycle over the past three decades becoming less volatile across all G7 economies. The vast majority of decline occurred in the late 1980’s and early 1990’s.

Indeed, it is evident that there is empirical evidence to show that there has been a clear cut decline in cyclical volatility in Germany, Italy, Japan, the United Kingdom and the U.S. Complications arise as the size and timings differ from one country to the next, therefore it is difficult to conclude that the business cycle is obsolete in each and every country. The magnitude of the business cycle will different for each economy. Whilst the business cycle may be near enough obsolete in one country, it may not be in another.

An increased in synchronicity of the business cycles of different economies have been due to increase the vast integration of trade and the financial markets. Date computed by Stock and Watson illustrate the fact that there have been increased correlations between the G7 countries which, inevitably has resulted in highly synchronised business cycles.

Stock and Watson go on to deduce the effects of monetary in controlling inflation and expectations. They argue that the short run trade off between inflation and unemployment illustrated by the Phillips curve has become flatter. It is believed that the reduction in output required for a given reduction on inflation increased post-1984. Moreover, volatility is still taking place, however, recent evidence shows that inflationary expectations have been moving with a sharp reduction in volatility throughout the 1990’s.

Many economists have put forward the case that the business cycle is becoming more obsolete due to small shock in the economy. The main shock that has highly diminished is oil shock. Post-1984 oil shocks have not been known to cause major shocks to the economy. The decline in supply shocks to economies has helped to stabilise the business cycle in most economies. It is apparent that business cycles of most economies have not become obsolete but more stabilised.

Empirical evidence found by different economists has shown widespread results on the notion of the business cycle. For instance, Heller (1966), Gordan (1969) and Baily (1978) have found strong evidence of reduced volatility from the prewar to the postwar period, whereas Romer has found mild evidence and bases most of the differences to discrepancies in the way the data were measured across periods.

Furthermore, Diebold and Rudebusch (1992) find evidence of longer expansions and smaller contractions in the postwar period. On the hand, Watson (1994) argues that changes in the duration of business cycles phases are a figment of data due to the way the NBER business cycle reference dates were chosen across periods. Overall, their findings suggest that the prewar and interwar real output fluctuations are uniformly larger than those in the postwar period, although the magnitude of differences varies across the countries.

On the whole, the severity of economic fluctuations in the U.S. has decreased sharply following World War II. Not only in the U.S. but in most economies around the world, the extent to which business cycles fluctuate has stabilised.

It is a far-reaching to conclude that the business cycle is obsolete, however, much of the evidence presented throughout the essay has led to the conclusion that the business cycle has stabilised and dampened post World War II.  

This has been the overall picture from empirical evidence computed by several economists over the past decades. ‘Christina Romer challenged the controversial belief in the decreased severity of economics fluctuations and argued that the apparent decrease arose from inappropriate techniques in data construction’. Moreover, Burns concentrated more on the influence of monetary and fiscal policy in stabilising the business cycle and the magnitude of fluctuations.

Indeed, empirical evidence is strongly on the side of the New Keynesian view that cycles are often the result of changes in economic policy. Monetary policy, in particular, appears to have played a crucial role in causing business cycles in the United States since World War II. The severe recessions of both the early 1970’s and the early 1980’s, for example, were directly attributable to the Federal Reserve's decisions to increase interest rates. On the positive side, the booms of the 1960’s and the 1980’s were both at least partly due to monetary ease and falling interest rates.

The role of money in causing business cycles is even stronger if one considers the era before World War II. Many of the worst prewar depressions, including the recessions of 1908, 1921, and the Great Depression, were to a large extent the result of declines in the money supply and the related high real interest rates. In this earlier era, however, most monetary swings were engendered not by conscious monetary policy, but by financial panics and international monetary developments.

But appearances are deceiving. The kind of statistics that economists use to measure the severity of business cycles, such as data on the unemployment rate, real gross national product, and industrial production, have been kept carefully and consistently only since World War II. Therefore, the conclusion that government policy has smoothed business cycles is based on a relationship of fragmentary prewar evidence among sophisticated postwar statistics.

For economists to say the business cycle is obsolete is merely ambiguous as there has been no empirical evidence to date to prove this phenomenon.

Bibliography

1. Baily, M. N. (1978) ‘Stabilization Policy and Private Economic Behavior’, Brookings Papers on Economic Activity, (1)11-50.
3. Burns, A. F. (1960) ‘Progress Towards Economic Stability’, American Economic Review, 50(1) 1-19.

4. De Long, J. B. (1999) ‘Introduction to the Symposium on Business Cycles’, Journal of Economic Perspectives, 13(2) 19-22.
6. Diebold, F. X. and G. D. Rudebusch (1992) ‘Have Postwar Economic Fluctuations been Stabilized?’, The American Economic Review, 82( 4) 993-1005.

7. McConnell, M. M. and G. Perez-Quiros (2000) ‘Output Fluctuations in the United States: What Has Changed Since the Early 1980’s’, The American Economic Review, 90(5) 1464-1476.
9. Romer, C. (1986) ‘New Estimates of Prewar Gross National Product and Unemployment’, The Journal of Economic History, 46(2) 341-352.
11.  Romer, C. (1989) ‘The Prewar Business Cycle Reconsidered: New Estimates of Gross National Product, 1869-1908’, The Journal of Political Economy, 77(1) 1-37.
13.  Romer, C. (1994) ‘Remeasuring Business Cycles’, The Journal of Economic History, 54(3) 573-609.

1. Romer, C. (1986) ‘Is the Stabilization of the Postwar Economy a Figment of Data?’, The American Economic Review, 76(3) 314-334.
3.  Romer, C. D. (1993) ‘The Nation in Depression’, Journal of Economic Perspectives, 7(2) 19-39.

4.  Romer, C. D. (1999) ‘Changes in Business Cycles: Evidence and Explanations’, Journal of Economic Perspectives, 13(2) 23-44.

5. Stock, J and  Watson, M. (2002) “Has the Business Cycle Changed and Why?” Working Paper.
7. Zarnowitz, Victor, (1999) ‘Theory and History Behind Business Cycles: Are the 1990s the Onset of a Golden Age?’ Journal of Economic Perspectives, 13(2) 69-90.

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