What Is the Business Cycle?

When we talk about the business cycle, we’re referring to the repeating booms and busts we see in the economy over time. There are many theories as to what causes these cycles. We embrace what is known as Austrian Business Cycle Theory.

In a nutshell, the boom bust cycle is driven primarily by government and monetary policy. In simplest terms, easy money (artificially low interest rates that encourage borrowing) blows up bubbles. Bubbles pop and set off a crisis. Rinse. Wash. Repeat.

In practice, when the economy slows or enters into a recession, central banks like the Federal Reserve drive interest rates down and launch quantitative easing (QE) programs to “stimulate” the economy.

Low interest rates encourage borrowing and spending. The flood of cheap money suddenly available allows consumers to consume more — thus the stimulus. It also incentivizes corporations and government entities to borrow and spend. Coupled with quantitative easing, the central bank can pump billions of dollars of new money into the economy through this loose monetary policy.

In effect, QE is a fancy term for printing lots of money. The Fed doesn’t literally have a printing press in the basement of the Eccles Building running off dollar bills, but it generates the same practical effect. The Federal Reserve digitally creates money out of thin air and uses the new dollars to buy securities and government bonds, thereby putting “cash” directly into circulation. QE not only boosts the amount of money in the economy; it also has a secondary function. As the Federal Reserve buys US Treasury bonds, it monetizes government debt. The central bank can also buy financial instruments like mortgage-backed securities as it did during QE1 in 2008. This effectively serves as a bank bailout. Big banks get to remove these worthless assets from their balance sheets and shift them to the Fed’s. Theoretically, this makes the banks more solvent and encourages them to lend more money to ease the credit crunch that occurs when banks become financially shaky.

Surging economic growth, shrinking unemployment, and rising stock markets driven by money-creation give the illusion of a healthy economy. But the monetary policy hides the economic rot at the foundation.

In order to sustain an true economic expansion, you need capital goods — factories, machines, natural resources. Capital goods are produced through savings and investment. When central banks juice consumption without the requisite underlying capital structure, it will eventually become impossible to maintain. You can print all the dollars you want, but you can’t print stuff. At some point, the credit-driven expansion will outstrip the available stock of capital. At that point, the house of cards begins to collapse.

Imagine you plan to build a giant brick wall. With interest rates low and credit readily available, you borrow all the money you need to complete the job. But two-thirds of the way through, a brick shortage develops. You may have plenty of money, but you’ve got no bricks. You can’t finish your project.

This scenario provides a simplified picture of what happens in the economy during a Fed-fueled economic expansion. Flush with cash, investors begin all kinds of projects they will never be able to complete. Eventually, the malinvestments become apparent and the boom teeters and then collapses into a bust.

Of course, the Fed helps this process along as well.

Once the apparent recovery takes hold, in order to keep inflation under control, the Fed must tighten its monetary policy. It ends QE programs and begins to nudge interest rates back up. When the recovery appears to be in full swing, the central bank may even shift to quantitative tightening — shrinking its balance sheet. During the boom, governments, consumers and companies pile up enormous amounts of debt. Rising interest rates increase the cost of servicing that debt. They also discourage new borrowing. Easy money dries up. This speeds up the onset of the next recession and the cycle repeats itself.

You can take a deep dive into ABS theory HERE.