What You Should Know

Business cycles are natural and unavoidable, and arise out of the normal course of business. Government policy can smooth them or help them along, but it can’t create or prevent them. Cycles arise from two primary factors: the imperfection of information and the evolution of technology and tastes.

Imperfection of information refers to the fact that business leaders don’t have perfect information when they make decisions; they make too much, sell too little, and spend too much because they don’t have perfect crystal balls. The evolution of tastes and technology, a constant through history but occurring ever faster, creates new markets and eliminates old ones.

These two elements cause businesses to overshoot, overcorrect, and otherwise make flawed decisions. In a boom, that can lead to overproduction and the assumption of excess debt and risk—which then leads to a bust. The business contraction that follows eventually reduces supply, cleans up excess debt, and starts business over with a clean slate toward another boom. Through increased spending and lowered interest rates, government policy helps the process along. Business cycles bring new things and clean old, obsolete businesses off the economic floor.

As William Poole, former Federal Reserve Bank of St. Louis chairman, eloquently put it: “The world we live in is uncertain and cyclical because the U.S. economy is dynamic, inventive, experimental, and entrepreneurial. Some ideas are carried to excess, we discover after the fact. Look at the littered landscape of dead railroads, dead auto companies, and dead airlines to illustrate the point.”

Why You Should Care

Booms and busts are a natural part of your financial life. If you have a steady job, you might not have to worry too much, but it’s always good to be aware of what’s going on and how it might affect your behavior and your finances. People tend to become “giddy” during booms, taking on more risk without realizing they’re doing so (as in buying overpriced homes, no money down, during the real estate boom). To keep from getting in over your head financially, you should always tune your finances to the bust; then the boom will feel that much better.

9. DELEVERAGING

Deleveraging refers to the tendency for individuals and corporations to get rid of debt in a forced, untimely manner during a bust cycle, or recession. It is the opposite of adding leverage—that is, borrowing more and using those funds to buy assets, where perhaps one dollar of your own is matched to nine borrowed dollars to buy something worth ten dollars. The 9:1 leverage ratio is nice, so long as the asset continues to be worth ten dollars or more, but the first dollar lost is your dollar if asset prices go down. To deleverage, you would pay off your nine-dollar debt as quickly as possible to reduce your risk of loss.

What You Should Know

Desperate to repair the damage inflicted on their balance sheets by debt, financial institutions will sell assets during a deleveraging cycle. When they sell assets, guess what? Prices go down. That actually makes it worse, starting a vicious circle as forced sales push asset prices down further. This then spreads to more companies, more individuals, more balance sheets. Soon the government is left with the only balance sheet strong enough to keep buying.

The deleveraging that hit in late 2008 was severe and was a major contributor to the Great Recession. Banks laden with mortgage-backed securities were forced to sell them to make good on deposits by their customers; that selling process further cut the value of those securities, which were nearly impossible to value in the first place. As stock prices fell, hedge funds (see #72 Hedge Fund) were caught flatfooted by investors requiring redemptions, since the funds were borrowing money to juice their returns. Therefore, the hedge funds were forced to sell assets to meet those redemptions and pay down debt. That made stock prices fall faster than they otherwise would have.

Why You Should Care

The point is to never get into a situation where you have to pay back debt in a panic. The assets you borrowed to buy will be worth less, and it will be that much harder to raise the money you need to pay off the debt. Best place to be: no debt at all. If you have debt, it should be only in assets you would be unlikely to sell in most situations (for example, your house), and with interest and principal payments well within your budget even in tougher times

10. MISERY INDEX

Sometimes it helps to put the economic data you see, hear, and read about together and in context with a single indicator or two. It’s like taking all the weather data—temperature, humidity, precipitation probability, wind speed—and coming up with “it’s going to be a nice day.” Or, in this case, a bad day.

Some years ago, the economist Arthur Okun did this for us by creating a “misery index.” By adding together the inflation rate (see #18 Inflation) and the unemployment rate (see #5 Unemployment and Unemployment Rates), you arrive at the misery index.

What You Should Know

Taking the index apart for a moment, you can see that high inflation with low unemployment, or high unemployment with low inflation, is bad, but not as bad as things could be. The combination of high inflation and high unemployment occur in the unusual and painful combination of stagflation (see #20 Stagflation). This is the signal the misery index sends when it is at its highest.

It’s interesting to track the misery index through history, specifically through the times and policies of the various presidents. As you can see in Table 2.2, the misery index varies to a great degree during presidential terms, hitting an all-time high of 21.98 percent at one point during the Carter years as inflation hit double-digit levels at the end of his administration. This “misery” helps explain his loss to Ronald Reagan in 1980.

Table 2.2 Misery Index by President

Source: miseryindex.us

View a text version of this table

The misery index has been relatively stable since the mid-1980s, owing largely to government focus on moderating inflation rates and an absence of large oil price shocks. The sharp rise in the unemployment rate during the Great Recession drove the index over 10 during the Obama administration, but a low inflation rate has kept it from tracking higher—at least so far. The Federal Reserve has generally leaned toward controlling inflation at the expense of short-term rises in unemployment, as inflation—once imbedded in the economy—is more difficult to eliminate (see #18 Inflation). But more recently, the Fed has become more aggressive on unemployment, and has made it the target for most of its operations. The inflation rate is vulnerable but has stayed in check—in part due to moderated energy and commodity prices, and in part due to continued slack demand resulting from unemployment. The next administration may well see a misery index around 10, but with higher inflation and lower unemployment as components.

Why You Should Care

In most situations, economic policy is a tradeoff between inflation (a result of economic strength) and unemployment (a result of economic weakness). Policymakers make course corrections between the two in trying to smooth out the business cycle (see #8 Business Cycle). A high misery index indicates a loss of control—that is, some part of the policy arsenal isn’t working for one reason or another. That’s a sign of trouble ahead.

11. CONSUMER CONFIDENCE

Economists can look at actual numbers all they want, but most of those numbers simply reflect what’s already happened. Since such a large part of the economy is driven by consumer spending (see #4 Gross Domestic Product), and since economists like to see where things are going, many pay close attention to so-called consumer confidence measures. These findings follow and record how optimistic consumers are about the overall economy as well as their personal finances.