The global economic community is now experiencing and talking about recession. It is a deceleration and decline of economic activity reflecting lower growth in real gross domestic product (GDP) and in some instances, negative growth. In order to appreciate the meaning of the word recession in the economic context, it should be useful to review the basic textbook definitions of the business cycle. Recession is a phase in the so-called cycle. Fortunately, recovery can be the next phase if the right policies are implemented.
Phases of the Business Cycle
Economists have observed cycles of economic activity at the Macro level since the nineteenth century. They are simply referred to as the phases of economic expansion, crisis, recession, recovery and expansion again. These cycles have been observed to occur within a period of ten years more or less. The reader may have noticed that the D word or depression was not included. The reason for this is that since, the great depression of 1929 through 1933-34, macro economic policies have been developed and implemented to counteract or temper the movements in the business cycle. We can best understand how macro economic policies work in managing the business cycle by first briefly describing the phases in the cycle.
Expansion or sometimes referred to as the boom period is characterized by a sense of prosperity in the population with low unemployment rates and high capacity utilization of the manufacturing plants. The stock markets would be very buoyant.
However the symptoms of weaknesses in the economy start to show after some time of the "boom". Since the capacity cannot cope with the demand, inflationary pressures increase which pull up the prices of industrial and consumer goods. Interest rates tend to move up and the stock markets are adversely affected. While this description is highly simplified, the reader should easily be able to relate this to what has happened over the past year: Prices of energy, food and steel were going up. The sub prime credit problems in the United States started to surface principally because the growth in real estate prices peaked and began to decline. This was precipitated by the rise in interest rates. While the US stocked market indices peaked only in October of 2007, volatility had already increased by the first quarter, banks started to report declines in quarterly profits and even losses in the case of some due to valuation losses arising from their sub prime investments.
Recession officially occurs when a country reports two consecutive quarters of negative growth in the Gross Domestic Product (GDP) of a country. For practical purposes and in order to understand the business cycle and its phases, we may look at the phase of lower economic growth as the recessionary phase even if the GDP is still growing. There is now less utilization of productive capacity and business start to worry about excess inventories oftentimes acquired at costs higher than current market prices. And of course, stock market indices go down and investors move to government and other high grade securities. . The unemployment rate tends to increase and investor and consumer confidence goes down. This description must seem familiar with the current situation.
Recovery follows recession and the opposite of the symptoms of recession can be observed. Confidence comes back. The stock market bottoms out and starts to recover. Business investments start to accelerate in response to rising demand.
Expansion. We are back to the early stage of expansion when confidence is high and businesses are raising capital at the stock and bond markets to finance expansion of capacity and new ventures.
John Maynard Keynes and Counter Cyclical Macro Economic Policies
Keynes was an Economist from Cambridge, the United Kingdom who was around during the depression years. His theory was that government can and should intervene in smoothing out and reducing the volatilities in the business cycle. …