Have Business Cycles Finally Died?

As the economic expansion moves into its eighth year, I have noticed some forecasters and economic observers predicting not only that we will not have a downturn in 1990, but also that recessions may be a thing of the past altogether. Since ups and downs of the business cycle have characterized industrial economies for as far back as we have data, this would be a remarkable development.

Although cycles have always been with us, it would be surprising if the stability or instability of the economy were somehow an immutable law of economics. Stability should depend on economic institutions and other structural characteristics of the economy. And, we would hope, it should depend on our understanding of how policy can help stabilize the economy. The economic expansion of the 1960s, which was as long as the present one and even more vigorous, was seen as an accomplishment of modern economic stabilization policy. That expansion ended when inflation became a problem.

Now, several structural differences between today’s economy and the economy of the past have been offered as reasons that the economy has become more stable. These include the declining importance of manufacturing relative to other sectors of the economy, the greater openness of the economy to foreign trade and the deregulation of financial markets. Consider each of these.

Some sectors of the economy are intrinsically more volatile than others. In particular, the demand for manufactured goods fluctuates more than the demand for many services or gross national product as a whole. Over the past 25 years, the share of manufacturing employment in total non-farm employment has declined to 18% from 30%. At the same time, because productivity growth in manufacturing has been more rapid than in the economy as a whole, there has been no important trend in manufacturing output as a share of total GNP.

As a result, a decline in manufacturing output--say, because consumers choose to buy fewer cars, as they did this fall--will have a proportionally smaller effect on total employment today than in the past. With employment and the incomes earned from it less affected, the initial decline in car sales will not spread as much to other sectors.

The greater openness to foreign goods of today’s economy is another change that reduces the follow-through from an initial decline in demand. Imports of goods and services are now nearly 13% of GNP, compared to less than 5% in the mid-1960s. More of an initial drop in demand now becomes a reduction in imports rather than in domestic production, so there is less impact on U.S. employment.

Although basically correct, the importance of these points should not be exaggerated. By 1979, manufacturing employment had already declined to 21% of total non-farm employment, and imports had risen to 11% of GNP. Yet over the next two years, the economy suffered the longest and deepest recession since the Great Depression.

The deregulation of financial markets raises different issues. Changing the availability of mortgages used to be one of the main channels through which monetary policy influenced the economy. When interest rates rose, funds left the regulated thrift institutions, which then reduced their mortgage lending and with it housing starts and construction. This and other forms of credit rationing are much less prevalent today, so a greater rise in interest rates is now needed to achieve any given reduction in lending. This change might contribute to stability by making the link between policy changes and their effects on the economy less abrupt, thus minimizing the risk of getting an accidental recession when policy-makers want only a slowdown.

Deregulation has been accompanied by a major expansion of financial markets, with greatly increased trading of bonds, mortgages and short-term debt instruments. Some believe that these markets now fine-tune the economy better than the Federal Reserve ever could, with interest rate fluctuations heading off either impending recession or overheating in the economy. The verdict on this kind of stabilizing effect is not in. The markets do react--some would say overreact--to news and to how monetary policy might respond to news, and they may deserve some credit for the relatively stable growth of recent years.

But these have not been difficult economic times. A decade ago, when the Organization of Petroleum Exporting Countries’ price increases contributed to rapid inflation, interest rates in actively traded financial markets eventually soared, helping to produce the huge recession of 1980-82. Market rates did not move ahead of the inflationary developments to head them off. Nor did markets react noticeably before the Fed’s policy moves.

In summary, the structural changes just reviewed have, in themselves, probably made the economy marginally more stable in response to shocks to demand. A poor year for car sales or housing is less likely to snowball into an economy-wide recession. And the long expansions of both the 1960s and 1980s suggest that postwar stabilization policy is better than its prewar predecessor. But whether we have banished the business cycle or seen the end of deep recessions is another matter.

Whether we can avoid recession is closely tied to whether we can avoid inflation. The Federal Reserve sees control of inflation as its first responsibility and will tighten monetary policy to fight inflation if it needs to. That is not only how the long expansion of the 1960s ended, but also how most recessions, certainly in the postwar period, have come about. The structural changes discussed above have nothing to do with preventing inflation so, at bottom, they have little to do with avoiding the kind of recession that we have usually experienced. For now, there is little sign of inflation accelerating badly. But that can change.

A second point is even more troublesome. As consumers, firms and investors come to see the economy as more stable, they react in their own affairs by taking on riskier financial positions. The huge increase in debt owed by firms and individuals and the lower quality of debt accepted by banks and other institutions during the past decade are quintessential examples of this kind of response. So there is a Catch 22 to stability.

If eventually things start to go bad for the economy, these greater private risks could lead to a deeper national recession.