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CHAPTER 4

Business Cycle Dynamics

 

Just about everyone can be affected by economic change. Therefore, it is vital for the citizen to acquire a thorough understanding of why things happen. To protect his or her economic interests, the citizen must understand the dynamics of the business cycle -- and the economic and social changes the cycle can entail. Specifically, the citizen must understand all the elements of cyclical change:

  1. The purpose, the sources, and the kinds of economic change.
  2. The nature, the form, the duration, and the intensity of the change -- possible behaviors, effects, and outcomes over time. The lagging of effects behind their causes. The kinds of response to change -- which changes are proportional, which are inelastic, which are hysteretic (i.e., depends on past history), etc.
  3. The pattern of the change. What follows what, by necessity. The sequence of possible events and their unfolding in time. The phases of the cycle. The periodicity of the change. The influence of historical changes on subsequent changes.
  4. The process of causing the change -- especially who can do what to whom.

Data for the last business cycle in Canada, and associated possible "chains of causation," are revealed in Chart form in Appendixes B through G. The Charts identify sequences of possible "causes" and "effects," and reveal how these succeed one another. They also reveal important connections between the links in the chain. Institutional data (e.g., data from Canada's largest bank, from CMHC, etc.) are used exclusively to order and calibrate the effects we seek to investigate. In this connection, it is extremely important to note, that evidence of correlation is not proof of causation.

The Business Cycle at Canada's Largest Bank. The Royal Bank of Canada was not the only player that was involved in real estate overinvestments. But, it was, and still is, Canada's largest bank. It should, therefore, be most interesting to use the phases of the last two business cycles at the Royal Bank to order and calibrate the effects (up side and down side) we seek to investigate. The phases of the business cycle in commercial real estate at the Royal Bank (derived from data in Royal Bank annual reports) are depicted in Plate C-1.

Evidence of Parallelism at Canada's Top Three Banks. Powerful evidence of structural imbalances in Canada's economy is provided in Plate B-1. Powerful evidence corroborating "parallelism" in the behavior of Canada's three largest banks -- Royal Bank of Canada, Canadian Imperial Bank of Canada, and Bank of Montreal -- is provided in Plate B-3. Powerful evidence corroborating the occurrence of a "credit crunch" at Canada's top three banks around 1989 is provided in Plate B-4.

Aristotle distinguished between three kinds of change:1

  1. Generation (e.g., building boom, new commercial real estate, etc.)
  2. Destruction (a change from a state of existence to a state of non-existence; e.g., business bankruptcies, abortions, etc.).
  3. Variation (e.g., increase or decrease in non-accrual loans, in the property crime rate, in personal saving or debt, in the deficit, etc.).

All three kinds of change are manifest in the Charts. Note that every change can have more than one cause and several phases (an earlier phase, one or more intermediate phases, and later phases); and that every phase has a starting-point and an end-point.

Schumpeter's Business Cycles. Schumpeter, distinguished between several classes of business cycles. The three major classes, each named after its discoverer, are:2

  1. Kondratieff. These "Long Waves" are "characteristic of the capitalist process"; they last about 60 years, and are the result of major industrial or technological revolutions.3 The first Kondratieff spanned the period from the 1780's to 1842; the second, the period from 1842 to 1897.4 It is interesting to note that U.S. historical energy consumption patterns, for the period from 1850 to 1992, show clear transition patterns from wood to coal to petroleum, each shift requiring about 60 years.5
  2. Juglar. These last about 10 years. They have been associated with innovative processes in industry and trade, with unemployment, and with the number of business failures.6
  3. Kitchin. These last about 40 months and may be, according to Schumpeter, "waves of adaptations." Initial evidence corroborating the existence of such cycles was obtained from movements of monthly commercial paper rates (New York, 1866-1922),7 of bank clearing and wholesale prices, and of interest rates (Great Britain and the U.S., 1890-1922).8

Another category of cycles, labelled "special cycles," includes cycles of crop production.9 Another class, mentioned but not explicitly addressed by Schumpeter, is the Kuznets class.10 Kuznets are building cycles lasting about 15 to 25 years.

Schumpeter distinguished between four phases of the business cycle: prosperity, recession, depression, and recovery or revival.11 For Schumpeter, the economic change process in all cycles is driven by a combination of "innovation" and borrowing by entrepreneurs -- that is, by innovation financed by "credit creation."12 Innovation is not restricted to technology, but can include new production functions and new forms of organization. The vicissitudes of the cycle can result from "malinvestments" -- "speculative overdoing," "overproduction," "underconsumption," "overinvestment," etc.13 The effects of depression can include "[p]hysical destruction," "wastage," "plunder," "dislocation," and "inflation."14 All cycles coexist and operate simultaneously, producing together a highly complex composite cyclical movement, with possible interference effects.

The Credit Cycle Model. Debt and speculation can play a major role in the business cycle. This role has been investigated by Irving Fisher, Hyman Minsky, and others. More recently, Richard Cantor and John Wenninger analyzed how the credit cycle leads to a "credit crunch," and how finance and economic activities interact.15 Their analysis covered six "credit crunch" episodes and associated recessions (1966, 1969, 1974, 1980, 1982, and 1990). Evidence from vast amounts of empirical data (covering aggregate credit, commercial and industrial loans, commercial real estate loans, etc.) is used to provide strong corroboration for the credit cycle model. According to Cantor and Wenninger, the credit cycle process consists of ten steps. Following Cantor and Wenninger, these can be summarized as follows:16

  1. Demand for capital assets increases. Investments increase. Possible causes include: An "expansionary monetary or fiscal policy," a "boom in the stock market," or an "upward shift in inflationary expectations ."17
  2. Borrowing increases and liquidity decreases. Lenders, expecting assets (pledged as collateral) to appreciate in value relax their credit standards.
  3. Short-term debt is rolled over. Increasingly, debt is used to pay interest.
  4. Capital assets fail to generate the expected profits. Possible causes include: a tightening of monetary or fiscal policy to control inflation coupled with a decrease in demand, an external shock to the economy, or an oversupply of assets.
  5. The prices of assets, and, therefore, collateral values decline. The interests of debtors and lenders diverge: borrowers are forced to refinance; but lenders want their money back, fearing a deterioration in the borrowers' equity position. The "credit crunch" begins.
  6. Borrowers fail to roll over loans. Lenders do not get paid. Financial distress spreads.
  7. Assets are sold at distressed values. The number of insolvent businesses increases. Distress can become contagious.
  8. Nonperforming loans increase.
  9. The "credit channel" (Bernanke-Blinder Model)18 is partially or fully blocked. The credit crunch spreads to other sectors of the economy. Highly leveraged banks take a hit. Many sound companies cannot get loans.
  10. All "economic units" decrease their spending. The economy slows down.

 


Navigator
1 See Aristotle, Physics, translated by Robin Waterfield, with an Introduction and Explanatory Notes by David Bostock, 1996, at xlvii, and 118-121, especially 120 (224b35).

2 See Joseph A. Schumpeter, Business Cycles (1939), abridged with an Introduction by Rendigs Fels, 1964, at 144, 173, and 173-176 (simultaneous waves), and 330 and 432-433 (three-cycle schema); see also J.J. van Duijn, The Long Wave in Economic Life, 1983, at 1-19, especially 6-7 (cycles are associated with investment types as follows: Kitchin -- inventory investments; Juglar -- investments in machines and equipment; Kuznets -- investments in buildings; and Kondratieff -- investments in big projects related to basic capital goods).

3 Joseph A. Schumpeter, Business Cycles, 1964, at 140 (Long Wave).

4 Ibid., at 144-147 (Kondratieff and Kitchin cycles), and 182-200 (Kondratieff cycles).

5 See D. Allan Bromley, The President's Scientists, 1994, at 144 (Fig. 12: U.S. Energy Consumption Patterns, 1950-1992).

6 See Joseph A. Schumpeter, Business Cycles, 1964, at 140-141 (Juglar cycles), 146 (Note 2, U.S. business failures, 1867-1932; cited sources: B. Greenstein and Dun's Review, Econometrica, April 1935 ).

7 Ibid., at 140 (W.L. Crum's periodogram analysis, 1923).

8 Ibid., at 140-141 (J. Kitchin's analysis).

9 Ibid., at 152 ("harvest cycle"), 153 and 435 (special cycles).

10 Ibid., at 140 (S.S. Kuznets cycles).

11 Joseph A. Schumpeter, Business Cycles, 1964, at 114 (cyclical process), 126 (prosperity, revival, recession and depression).

12 Ibid., at 85 and 179-180 (business cycle and credit creation; innovation financed by borrowed money), 197 ("the financing innovation by credit creation"), 425-426 ("credit creation and entrepreneurial innovation), and 147 (cycles: "[i]nnovations . . . are the common 'cause' of them all . . . ").

13 Ibid., at 303-305.

14 Ibid., at 185.

15 Richard Cantor and John Wenninger, Perspective on the Credit Slowdown, Federal Reserve Bank of New York Quarterly Review, Spring 1993, Vol. 18, No. 1, at 3-36, especially 29-32 (The Credit Cycle Literature), 33-34 (Definitions of Terms), and 34-36 (References).

16 Ibid., at 31-32 (credit cycle-credit crunch process).

17 Ibid., at 31 (Tobin's Q model or Minsky's two-price model).

18 Ibid., at 31("credit channel").

  

 


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