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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:
- The purpose, the sources,
and the kinds of economic change.
- 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.
- 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.
- 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
- Generation (e.g.,
building boom, new commercial real estate, etc.)
- Destruction (a change
from a state of existence to a state of non-existence; e.g., business bankruptcies,
abortions, etc.).
- 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
- 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
- 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
- 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
- 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
- Borrowing increases and
liquidity decreases. Lenders, expecting assets (pledged as collateral) to appreciate in
value relax their credit standards.
- Short-term debt is rolled
over. Increasingly, debt is used to pay interest.
- 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.
- 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.
- Borrowers fail to roll over
loans. Lenders do not get paid. Financial distress spreads.
- Assets are sold at
distressed values. The number of insolvent businesses increases. Distress can become
contagious.
- Nonperforming loans
increase.
- 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.
- All "economic
units" decrease their spending. The economy slows down.
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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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