Business cycles and growth rate cycles explained

With so much debate about hard landings and soft landings, recessions and slowdowns, it helps to clarify what those terms really mean. Part of the issue is that many who debate such matters are unclear about the basics.

Economic cycles are part and parcel of the way market-oriented economies function. This is why recessions and recoveries—which constitute business cycles—are features, not bugs, in market-oriented economies.

Alternating periods of expansions and contractions define classical business cycles. Yet, perhaps even more important to the markets are the alternating speedups and slowdowns that make up growth rate cycles.

Business Cycles

The National Bureau of Economic Research (NBER), founded in New York in 1920, pioneered research into business cycles. Wesley C. Mitchell, one of its founders, first established the working definition of the business cycle a century or so ago:

Business cycles are a type of fluctuation found in the aggregate economic activity of nations that?organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximating their own.

Today, expansion refers to the phase of the business cycle in which the key measures of aggregate economic activity—output, employment, income, and sales—are rising in concert, while recession (or contraction) is the phase in which they are falling in sync. Together, expansions and recessions make up the complete business cycle.

Defining Recession

A recession is a specific sort of vicious cycle, with cascading declines in output, employment, income, and sales that feed back into a further drop in output, spreading rapidly from industry to industry and region to region. This domino effect is key to the spread of recessionary weakness across the economy, dragging down these coincident economic indicators and resulting in the persistence of the recession.

On the flip side, a business cycle recovery begins when that recessionary vicious cycle reverses and becomes a virtuous cycle, with rising output triggering job gains, rising incomes, and increasing sales that feed back into a further rise in output. A recovery can persist and result in a sustained economic expansion when it becomes self-feeding due to this domino effect driving the spread of the revival across the economy.

According to a popular misconception—including among economists—a recession is defined simply as two consecutive quarters of decline in real GDP. That’s in spite of the fact that some officially recognized recessions don’t fulfil that criterion and periods that have seen two successive quarters of decline in GDP aren’t always recognized as a recession.

That pseudo definition looks to have originated in a 1974 New York Times article providing a long list of recession-spotting rules-of-thumb. Just one of these criteria was “two down quarters of GDP.” As sometimes happens with such things—perhaps mainly due to its simplicity—it’s been this single “rule” that seems to have survived, confusing generations of economists.

ECRI co-founder Geoffrey H. Moore, who worked closely with Mitchell and his colleague Arthur Burns at the NBER, explained why GDP isn’t enough to define a recession:

No single measure of aggregate economic activity is called for in the definition because several such?measures appear relevant to the problem, including output, employment, income and [wholesale and retail]???trade... Virtually all economic statistics are subject to error, and hence are often revised. Use of?several measures necessitates an effort to determine what is the consensus among them, but it avoids?some of the arbitrariness of deciding upon a single measure that perforce could be used only for a?limited time with results that would be subject to revision every time the measure was revised.

But fundamentally, the reason to use this more sophisticated approach instead of the two-down-quarters-of-GDP rule of thumb is that “an economy” is characterized by much more than any measure of output. It’s also because business cycles are marked by cyclical co-movements of the key coincident indicators, whose turning points collectively demarcate the periods of recession and expansion.

Recession Dates

Both because of the meaning of “aggregate economic activity” and issues around revision and measurement error, Moore advocated the determination of business cycle dates based on multiple measures. That’s precisely the approach used by NBER to determine official U.S. recession start and end dates, and by ECRI—co-founded by Moore in New York in 1996—to determine comparable business cycle dates for 21 other economies.

As such, regarding international recession dates referenced in research, the Bank for International Settlements (BIS)—the “central bank of central banks”—has noted that “the most widely used procedure” is to “take the recession dates from the National Bureau of Economic Research (NBER) or the Economic Cycle Research Institute [ECRI]. These rely on expert judgment based on the behaviour of several variables, such as output and employment.”

Growth Rate Cycles

In many economies, including the U.S., business cycle recessions had become less frequent, and expansions had lengthened substantially, by the late 20th century. In response, ECRI turned to a different cyclical concept—the growth rate cycle (GRC).

Growth rate cycles—also called acceleration-deceleration cycles—consist of alternating periods of cyclical upswings and downswings in the growth rate of an economy, as measured by the growth rates of the same key coincident economic indicators we use to determine business cycle peak and trough dates.

The GRC peak and trough dates are determined using an approach analogous to that used to determine business cycle peaks and troughs. The difference is that they are determined on the basis of the cyclical peaks and troughs in the growth rates – rather than the levels – of the key coincident indicators.

ECRI determines and has long maintained the GRC chronologies for 22 economies, i.e., the U.S. and the 21 economies for which it also determines the business cycle peak and trough dates. These dates are determined for the historical record well after the fact, allowing enough time for the data on the key coincident indicators to settle down, once they have been duly revised.

These international business cycle and growth rate cycle chronologies constitute the gold standard reference dates, in relation to which the performance of other economic indicators should be judged, and form an essential basis for rigorous research into international economic cycles. As Maya Angelou said, “You can’t really know where you’re going until you know where you have been.”