Booms and Cycles Revisited

Booms

The business or economic cycle is the periodic but irregular up-and-down movements in economic activity and other macroeconomic variables. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), alternating with periods of relative stagnation or decline (contraction or recession). These fluctuations are measured using the real gross domestic product. Traditional business cycles undergo four stages: expansion, boom, contraction, and recession
. After a recessionary phase, the expansionary phase can start again. The phases of the business cycle are characterized by changing employment, industrial productivity, and interest rates. Another way of presenting it is shown in the diagram below:

The cyclical fluctuations or output gap can be caused by shocks to aggregate demand and to aggregate supply. An aggregate supply shock is a shock that alters the cost of producing goods and services and, as a result, the prices that firms charge. An aggregate demand shock is a shock that shifts the demand for goods and services and, as a result, changes the equilibrium prices. Measures of potential GDP were initially devised to guide decisions about monetary and fiscal policy, generally for a one- to two-year horizon. If the economy was estimated to be below potential--meaning that labor or capital was not fully employed--then monetary or fiscal policy could be used to speed up the growth of output without incurring the risk of significantly higher inflation. The concept of potential output was seen as a tool to help policymakers manage aggregate demand and thus maintain steady economic growth. Thus, over the medium term, the estimated trend in potential output helps determine the pace of sustainable growth

With these basics at hand, we can easily discard such assertions that a)  interventionist government policies cannot affect or reverse the direction of the cycle, ( which is in contradiction with such statements that “the itch …of the ruling majority to control economic phenomena might inhibit growth”) and that China cannot experience a future downturn; b) as the economic cycle evolves towards the services industry, the Mauritian economy will become less volatile; and c) economic disequilibrium is caused by lax monetary policy and that equilibrium can be restored only by an inevitable but necessary recession. Moreover, our understanding of the mechanism of the economic cycle allows us, as depicted in figure 2, to question another controversial assertion that the “Mauritian economic cycle is flat”.

 One of the oldest conjectures in economics holds that self-fulfilling shifts in optimism or confidence can destabilize aggregate economic activity. Change in expectations for example cause the economy to cycle back and forth between periods with high levels of investment and rapid GDP growth and periods with low levels of investment and slow GDP growth. Almost ten years ago a financial typhoon ripped through East Asia, battering markets, uprooting businesses and shattering lives, currencies and political regimes. It also destroyed the myth of the invincibility of Asia's "tiger" economies, (that progress cannot be stopped,) which had until then enjoyed decades of vigorous and uninterrupted growth. For two generations the state in China, South Korea and Japan intervened in the economy to funnel the financial resources into favoured firms, mainly in heavy industry, and coddled those companies through cartels and protectionism. The 1997 crisis laid bare the results of this system- overcapacity, wasted money, insolvent firms, troubled banks and lack of funding for new, innovative firms.

It seems quite simplistic to single out the lax monetary stance as the precursor or the main indicator of an unavoidable recession. Besides the parameters that we have stressed above, there are other cyclical indicators that help to define the business cycles. Leading indicators are series that tend to shift direction in advance of the business cycle, Coincident indicators are series that measure aggregate economic activity and Lagging indicators tend to change direction after the coincident series—they are used to confirm turning points and to warn of structural imbalances that are developing within the economy. (Average weekly hours, manufacturing, building permits, new private housing units, unit labour costs, capacity utilization etc.)

Bubbles: Identifying a stock market crash is easy: “When you see it, you know it” (Mishkin and White). However, it is more difficult to “see” and “recognize a bubble than a crash, even ex post.”  We have to be very careful in our affirmation of the existence of a bubble on the basis of either flimsy or limited data (like share of corporate profits or operating surplus to GDP). A bubble reflects growing misalignments from fundamental values. Detecting a bubble entails asserting knowledge of the fundamental value of the assets in question. Bubbles are attributable to: passive accommodation of booms by the banking system or monetary policy; poorly designed monetary policy—e.g., interest rate policy without commitments to a steady long-run inflation rate; misplaced expectations: e.g., investors’ overconfidence; micro factors: Information asymmetry and short-sale constraints—e.g., stock prices can rise above their fundamental value with dispersion of investor belief.

A simple and widely used yardstick is the historical evolution of price-earnings (P/E) ratios. A P/E ratio of 15, which entails an earnings yield of close to 7 percent a year, which we may  gauge as fair or near equilibrium stock value. But we may wish to support it with the Gordon valuation formula to calculate equity risk premium by averaging the P/E ratio, the dividend yield (D/P), real GDP growth (which can be thought of as a proxy measure of the expected growth of real earnings), the interest rate, and the inflation rate. If historical risk premium > implied risk premium, it may indicate the existence of a bubble. We can also use trend analysis to compare the moving averages of the stock price index, output, productivity, and credit or monetary aggregates. Or interpreting financial imbalances through the credit gap measured by deviations of credit growth from trend .Persistent deviations from the long-run relationship are associated with the risk of bubbles

Measures: We have also to be as careful in our suggestions for pricking the bubble. A bubble is dangerous to prick, since there is a risk of creating further financial instability. Alan Greenspan (Economist, Sept. 7-23, 2002,) took a quite conservative stance on this “Central bank cannot use interest rates to prick bubbles in their early stages because they can never be sure if there is a bubble or not. Moreover, a rise in rates sufficient to prick a bubble could push the economy into recession.” Some of proactive responses that have been suggested to asset price bubbles, helpful for macroeconomic stability, are :  monetary policy should respond to—but not target—movements in asset prices; monetary policy tightening is optimal in response to “irrational exuberance” in financial markets and higher interest rates could be accompanied by an explicit commitment to fight bubbles. At the micro-level, the proposed financial policies to reduce bubble incidents and enhance economy’s resiliency to shocks are effective regulatory frameworks and good financial structures, including healthy balance sheets.

            Monetary policy reactions to movements in asset prices are complicated and may exacerbate the problem because of the difficulties in identifying bubbles in advance, the lags in monetary policy effects and the expectations of future policy settings. To conclude I’ll add that that monetary ease is neither necessary nor sufficient to produce bubbles. Bubbles are made in financial markets, not in central banks. If an economy is likely to grow at the rate below its potential and inflation expectations are low and stable, there is no economic justification for thinking that a simulative monetary policy somehow creates a growing debt that has to be made up later. In my next article, I’ll address the issue of the sustainability of the forecasted Mauritian boom.