Business cycles, a recurring yet enigmatic phenomenon in capitalism, involve periods of economic expansion and contraction. This analysis explains business cycles, minimizing economic jargon to ensure understanding for all readers, exploring why perpetual economic prosperity remains elusive and why economies experience downturns like the Great Depression and stagflation. We’ll explore explanations for pre-1930s depressions, post-1940s recessions, the stagflation of the 1970s, and the booms of the 1980s and 1990s.
Income is generally divided into consumption and savings. Consumption covers necessities (food, clothing, toiletries) and discretionary purchases (vehicles, books, entertainment). After allocating income to consumption, the remaining portion is saved and invested in stocks, bonds, or fixed deposits.
Correspondingly, the economy is divided into consumption and investment sectors. Excluding government spending, the consumption sector constitutes approximately 80% of the economy, encompassing consumer goods and services. The investment sector, comprising roughly 20%, focuses on activities such as constructing new facilities and housing. While a three-sector model incorporates government spending, we’ll exclude it here because free markets are more directly related to consumption and investment. These figures are approximate and vary.
How does the consumption sector generate profits? It consistently produces a surplus, exceeding immediate consumer demand. Capitalists and households in the consumption sector save portions of their income, which are then invested in the investment sector. These savings become earnings for investment sector workers and capitalists, who spend their income on consumer goods. This circular flow means the investment sector’s income fuels the consumption sector’s profits. Crucially, the size of the investment sector determines the profits within the consumption sector. Large investments yield higher profits, while smaller investments result in lower profits. All savings must be invested; uninvested savings lead to lower investment, decreased profits, production cuts, rising unemployment, and potential recession. Uninvested savings can disrupt the equilibrium between supply and demand, leading to unsold inventory and economic downturn.
Economic growth causes consumption to rise: more cars, televisions, and computers are purchased. Suppliers expect their surplus (profit) to increase proportionally, but this requires a corresponding rise in investment, funded by savings. If consumption grows faster than investment or savings, producers’ surplus remains unsold, causing economic disequilibrium.
The equilibrium condition is:
Periodic growth percentage of Consumption = Periodic growth percentage of Investment = Periodic growth percentage of Savings.
If Consumption grows by X%, Savings and Investment must also grow by X%. Otherwise, disequilibrium occurs, even if Investment equals Savings.
Recessions often involve substantial uninvested savings due to lack of investor confidence. At the business cycle’s lowest point, consumption is low, and uninvested savings are high. As economic activity increases, these savings are invested, enabling consumption sector producers to realize their expected surpluses. The size of the investment sector mirrors the consumption sector’s surplus. High savings, when fully invested, generate large surpluses, accelerating economic activity.
As the economy expands, producers compete for market share, prioritizing sales over savings and investment. Consumption may then accelerate faster than savings, disrupting the equilibrium. While this imbalance may not cause immediate disequilibrium, producers eventually adjust their expectations toward normal profits. However, after some time, savings become insufficient to meet the consumption sector’s expected surplus, even with full investment. Unsold inventories rise, and profits diminish, necessitating a correction: consumption cuts and savings increases.
However, the required correction might not materialize because capitalist economies prioritize consumption. If consumption declines, investment is unlikely to increase. A decrease in consumption might increase savings but would not raise investment. Investment often follows consumption and also enters a downward spiral. As a result, the increased Savings are not invested and the disequilibrium takes on a relatively permanent position and we have a recession! The increased savings remain uninvested, causing prolonged disequilibrium and recession. Reduced production leads to further consumption declines, creating a downward spiral until the economy stabilizes at low output with high unemployment. Eventually, innovation or entrepreneurial activity stimulated by low-interest rates may trigger investment, initiating a new expansion. Post-1940s recessions in the US and Europe frequently follow this consumption-led pattern.