Greater Opportunity Through Innovative Change
WHITHER THE BUSINESS CYCLE?
Whatever Happened To The New Paradigm?
By: Greg Kaza
It became popular on Wall Street and in Washington in the late 1990s to hear securities analysts and politicians speak of a so-called 'New Paradigm' in economics. The U.S. economy, it was alleged, had become immune from recession and the business cycle.
Various explanations were advanced to explain the 'New Paradigm.' These included productivity increases fueled by technological advances and inventions; and political leadership that created budget surpluses.
The former reason was cited by analysts to justify the purchase of securities overvalued by any historical norm. The latter was cited by career politicians to create the fiction that large budget surpluses exist that justified dramatic spending increases on government programs.
Many in the popular news media played a crucial role promoting the 'New Paradigm.' Pundits ignored or discounted fundamental securities analysts; gave ample publicity to the view the dot.com, telecommunications and hi-tech bubbles were justified by a new metrics of valuation; and told the middle-class investing public recession can be abolished by monetary policy in the form of the Federal Reserve. The business cycle was banished by the pundits to that region of the netherworld where it is said only classical economists live.
Declines in stock market indexes, coupled with the ongoing global economic slowdown, has led more than a few middle-class Americans to question the premises behind the 'New Paradigm.' This development is a welcome and healthy trend that should be encouraged.
There never was a 'New Paradigm' nor will there ever be given the nature of humans to make mistakes and err.
Economic conservatives and libertarians, trained in the classical tradition, were always skeptical of 'New Paradigm' claims. The business cycle could be as ancient as the Bible's Old Testament. In Genesis 40:41, the prophet Joseph interprets Pharaoh’s dreams, and seven years of plenty are followed by seven years of famine. Economic forecasters today might describe this process as "expansion" followed by "contraction."
Even those classical economists working in the government sector, like Fed Chairman Alan Greenspan, have questioned the 'New Paradigm' in testimony before Congress. The Fed, Mr. Greenspan explained recently, cannot eliminate the business cycle.
Political liberals embraced the Fed during the speculative boom of the late 1990s. Yet they are confused by the reappearance of the business cycle. They need not rely on economic libertarians like Mr. Greenspan for analysis. There is always the secular British economist John Maynard Keynes (1883-1946), a liberal whose own views influenced U.S. presidents from FDR to Richard Nixon and some Fed policy makers even today.
Mr. Keynes accepted the business cycle's existence.
"The Trade Cycle (original emphasis)," he wrote in 1936, "is best regarded, I think, as being occasioned by a cyclical change in the marginal efficiency of capital ...” Terming the cycle "highly complex" to dissect, Mr. Keynes observed "the later stages of the boom are characterised by optimistic expectations."
(The General Theory of Employment Interest and Money)
One irony of today's political liberals is their discounting of Mr. Keynes the liberal economist and his solution to the business cycle's recession phase: fiscal policy. Today's political liberals are converts to the specious notion the Fed alone can manage the business cycle. Ironically, their opposition to tax cuts in recession ("it would cause greater budget deficits") is anti-Keynesian. Fiscal policy stimulus in the form of capital gains tax cuts is exactly what the U.S. economy needs to spur investment and job creation.
Political liberals confused by today's stock market would benefit by rereading Mr. Keynes. He wrote of a boom's later stages: "It is of the nature of organized investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yield of capital markets, that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with a sudden and even catastrophic force." (Pp. 313-16) Mr. Keynes wrote more than a half-century ago but he could have been describing today's events in the financial markets.
They might also consider the words of liberal Keynesian Arthur Burns, the Nixonian Fed chief. Mr. Burns wrote in a 1970 essay, "Economic change is a way of life. It appears ... that business cycles have existed in the United States, Great Britain and France for nearly 200 years, and that they have marked the economies of other modern nations practicing free enterprise since the latter part of the 19th century if not longer." ('The Nature & Causes of Business Cycles.') The National Bureau of Economic Research, which conducts formal research on the business cycle, has identified 32 since 1854.
"Business cycles," Mr. Burns noted, "are not merely fluctuations in aggregate economic activity. They are also fluctuations that are widely diffused throughout the economy, and this fact distinguishes them from the convulsions of economic fortune that characterized earlier times as well as from the other short-term variations of our age."
Corporate annual reports are replete with examples of these short-term fluctuations. "The aluminum industry is highly cyclical," notes the management of Alcoa, the world's leading aluminum producer of aluminum and a Dow 30 component. "The markets" Nucor, a major steel producer, "serves are tied to capital and durable goods spending and are affected by changes in economic conditions." Other manufacturers operating in the economy's higher-order capital goods sector make similar points to shareholders. These include General Motors, the U.S.' largest industrial firm; and the Ford Motor Co.
Why is this important? Accepting the business cycle’s existence is easier than analyzing when short-term fluctuations develop into a full-blown recession. Or developing a framework for understanding why business cycles occur.
Two views of the business cycle originated in the 20th Century amongst economists. According to Mr. Keynes, the trouble was lack of demand or underinvestment. The other, or so-called Austrian view, correctly identified the problem as overinvestment during the boom phase of the cycle. The London School of Economics was a bastion of this idea popularized by the Austrian economists Ludwig Von Mises and Friedrich Hayek, a Nobel laureate. Their interpretation is in the classical tradition.
In brief, Hayek and Mises believed in the idea, 'To err is human.' They saw recession originating in "high-order capital goods" like the manufacturing sector. The misinterpretation of interest rates set by central banks by businesses and individuals leads to "malinvestments," i.e., investment mistakes in the expansion phase. A modern example: too much venture capital flowed into dot.com's with unrealistic business models. The Austrian Joseph Schumpeter termed the process that followed "creative destruction." We are witnessing this today; malinvestments are being liquidated in dot.com, telecomm, and hi-tech and other sectors. The worst policy government could take would be to intervene in the economy and subsidize these failures. The best policy is to accept the business cycle's existence and learn from the mistakes of those who mistakenly placed their faith in a 'New Paradigm.'
Greg Kaza is executive director of the Arkansas Policy Foundation.