Matching investment with business cycles (page 1 of 2)

'Excursions into prosperity' and 'excursions into depression', as Joseph Schumpeter called economic expansion and contraction phases, have and will always continue to characterize economic life. To prove the existence of business cycles throughout history is the easy part. But, where much disagreement does arise is about what causes above trend-line expansions and below trend-line contractions in the economy.

Early economists thought that business cycles were caused by solar cycles. Later economists tried to explain business cycles with under-consumption, psychological, monetary over-investment, and innovation driven theories. I have always taken a less dogmatic approach to business cycles both in terms of their causes and their periodicity.

Some cycles, such as inventory or so called Kitchin cycles have a duration of about four years, others such as the Juglar cycle last between eight and twelve years, while the Kondratieff Long Wave is supposed to stretch over a period of 45 to 60 years.

Therefore, my view has always been that economic expansion and contraction phases are caused by a number of different factors, and that their durations can vary considerably depending again on a large number of social, economic and political conditions. But let me attempt to provide some explanations about cyclical movements in the economy, which will help understand the problems, which currently challenge the global economy.

Consider the 19th century US economy, which was still a predominantly agrarian economy and which, despite America's rapid industrialization, still employed in 1900 twice as many people in agriculture than in manufacturing. By then farm workers still made up for close to 40% of the US labor force, down from 70% in 1840. The relative importance of agriculture versus manufacturing in the 19th is also evident from American export figures. In 1850 over 83%, and in 1890 over 75% of exports were agriculture-based.

It is easy to see that, in the 19th century, movements in agricultural prices had a dominant impact on the entire economy. When farm prices rose, for whatever reason, the agricultural sector thrived as farmers' income would rise. Farmers then spent their rising purchasing power on manufactured products, which in turn boosted the economies of the then still small urban centres (the population in urban areas only began to exceed that of the rural territories in 1918).

Thus, we can say that, in the 19th century US economy, rising commodity prices usually led to periods of strong growth. However, when agricultural prices fell, farm income would decline. Hence the reduced purchasing power of farmers led to less demand for manufactured goods and periods of weak growth or recessions.

But to explain 19th century American business cycles only as a function of agricultural price movements is an oversimplification. Consider the following. In times of rapidly rising agrarian prices, what was the incentive for farmers to innovate and to lower costs by producing more efficiently with new production methods?

Compare this to periods of falling commodity prices, during which the only way to increase one's income was to produce more cost effectively through the application of new inventions and innovations. Therefore, we find all the great waves of innovations in periods of weak prices, such as the canal boom in the 1830s, the railroad boom of the 1870s, and also the 1920s electricity, chemistry and motor boom, during which commodity prices fell.

All these periods of great innovations were, however, not only driven by the desire to cut costs and improve productivity in order to boost profits, but also by a favorable environment for financial assets.