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Business Cycle Theories

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The most widely known theorist about the business cycle may be Joseph Schumpeter, an Austrian-born economist. Schumpeter was originally a prominent economist in Austria, and he was once took charge of the nation’s financial administration. But he taught at Harvard after defecting to the United States under the Nazi regime.

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Schumpeter thought of entrepreneurs as the driving force behind the capitalist economic system. When entrepreneurs with innovative ideas destroy equilibrium, the capitalist economic system evolves and grows to find another equilibrium. He named this innovation as a ‘creative destruction’. He thought recession is just a temporary phenomenon in the course of innovation, and it is a sign that the economy was ultimately evolving. It meant that innovation does not emerge out of recession, but that innovation had to inevitably go through recession.

It was the Great Depression in the United States in 1929 that drew keen attention to the study of the business cycle. Economists mocking stock market concerns disappeared with it, and everyone needed an explanation for the recession that had already happened. They wanted to know whether this terrible experience could happen again and, if so, how to avoid it.

Schumpeter compiled theories about the business cycle in his 1939 book, Business Cycles ↗. This included theories of Juglar, Kitchin, Kondratiev and Kuznets, which explained the different cycles of the economy, and he integrated them to provide a clear analysis of the recession that people wanted so badly.

1. Juglar Cycle

The starting point of the business cycle theories was the Juglar Cycle. It is is the most widely known theory of business cycles, which describes a cycle that repeats approximately every 10 years. French economist Clement Juglar introduced it in his book A Brief History of Panics ↗ in 1862.

Juglar looked into prices, interest rates, bank loans, and central bank balance data in the United Kingdom, the United States, and France between 1803 and 1882. He observed a repetitive pattern of boom, recession and bankruptcy in every 10 years, and concluded that changes in employment, income and production were the causes, which were resulted from changes in fixed capital investment by enterprises. In other words, when companies invest in fixed capital, the profits of the companies that produce the fixed assets will increase, pushing up the prices and interest rates. But the price and interest rates will decrease until the companies reinvest in such fixed assets, which comes up once the depreciable life of the fixed assets ends.

It was a meaningful step in the history of economics as the first voice to interpret recession as a stage that is inevitable in the course of the business cycle instead of an object of avoidance or suppression. Also, spread widely and became influential rapidly as the 10-year cycle was short enough for anyone to observe without difficulty. Based on these, it became the prevailing theory for the business cycle in the United States and Europe.

2. Kitchin Cycle

Following Juglar, the Kitchin Cycle came out, explaining the much shorter cycle of the economy. Joseph Kitchin, a British statistician and entrepreneur, discovered an approximately 40-month economic cycle out of changes in city clearings, wholesale prices and interest rates in Britain and the United States between 1890 and 1922, which he analyzed in a thesis Cycles and Trends in Economic Factors ↗ and published to a journal in 1923.

Kitchin analyzed that the time delay in the flow of information affecting business decisions leads changes in inventories, which eventually resulting in a business cycle. Companies want maximum productivity out of their assets, which leads to a surplus in production or oversupply. Once the surplus inventory builds up, companies are put in a situation where production needs to be controlled or reduced. This is when the time delay kicks in to create a business cycle. It takes a considerable amount of time for the companies to recognize the oversupply situation, and it takes even more time for them to actually reduce production. However, when they actually cut back on production, the supply becomes short of demand, and they are put back in a situation to increase production again.

The Kitchin Cycle was born as a complementary theory, not a counter-argument to the Juglar Cycle, and it dealt with a short-term business cycle that anyone could easily observe as well, even more that the Juglar Cycle. In fact, in the United States, the Juglar Cycle was adopted as the major cycle and the Kitchin Cycle as the minor cycle to understand and explain various cyclical patterns across the industries.

3. Kondratiev Wave

Meanwhile, theories for the business cycle in the capitalist economic system came out even in the heart of the communist economic system. Nikolai Kondratiev, an economist of the Soviet Union, analyzed a much longer economic cycle, and published it into a book The Long Waves in Economic Life ↗ in 1925. It was named as the Kondratiev Wave by Schumpeter in 1939.

Kondratiev dealt with much more fundamental changes compared to earlier business cycle theories. After analyzing economic trends since 1789, he concluded that the capitalist economy repeats expansion and contraction approximately every 50 years. He pointed to inequality, opportunity, and social freedom as the underlying causes of the business cycle, resulting in technological advances, birth rate changes, and revolutions. In particular, he said a revolution becomes necessary due to the phenomena such as racism, political or religious exclusivity, failed freedom and opportunities, imprisonment rate and terrorism, which occur along the way.

He said inflation, technological advances and productivity improvement appear at the beginning of a business cycle, and the growth starts to slow down at the peak when the market is full of happiness. After that, the stock market plunges, and the resulting deflation and economic downturns lead to a sharp rise in the default rate and unemployment rate, while the overall debt of the market decreases.

However, based on these observations, he diagnosed that the economic downturn played a good role in cleaning up the economy, which made Stalin, then the leader of the Soviet Union, uncomfortable, as it implied that the capitalist economic system would not eventually fail. He ended up purged by Stalin in 1938.

4. Kuznets Swing

The subsequent business cycle theory is the Kuznets Swing that describes a relatively short period of business cycle, compared to Kondratiev, while still long. He introduced the Kuznets Swing in his book Secular Movements in Production and Prices ↗, published in 1930.

He noted changes in population and construction in explaining the causes of the business cycle. He thought they are caused by the income gap, changing over stages of economic growth. For example, the income of people living in cities near ports increased rapidly, and the income gap between urban and rural areas increased. Then a large number of rural residents moved into the city and more buildings began to be built in the city. That’s when the income gap peaked, and the soaring real estate prices started to push people away. As a result, the construction industry slows down and the income gap narrows down again.

He observed that this business cycle was repeated approximately every 20 years, and devoted himself to research on the relationship between income distribution and capital accumulation. After continuing his research at Harvard after Johns Hopkins, he was awarded the Nobel Prize in Economics in 1971. It’s quite a different ending as compared to Kondratiev.

5. Fourier Transform

Honestly, the theories illustrated above are so old and not easily read. It may take quite some time and effort to fully digest them. Also, you may wonder if such time and effort are worth if not doing any good to your real life. But if you look at the people around you who made money in the stock market, which seems to stay free from COVID-19 situation, you may feel awkward to pass it either. Whether you use these theories in real life or not, it would not be bad just to understand how to use them.

You may remember what you learned in math class as a child, but a function that represents cyclical waves is called a trigonometric function, specifically sine and cosine functions. Each of the cyclical waves shown in the graph above can be expressed as a sine function with different cycles: here, the independent variable ‘x’ represents the year, and the coefficient ‘a’ indicates the amplitude of each wave and how much ripple effect each cyclical wave had.

Fourier Transform is a mathematical tool to decompose a seemingly complex cycle function into several simple cycle functions, such as the trigonometric function above. And the conversion of multiple, simple cycle functions into a single, complex cycle function is called Inverse Fourier Transform. One thing to note here is that Fourier Transform, as a type of integral transform, assumes infinite intervals, and has a prior step, the series defined in finite intervals. In other words, each component function is defined in finite intervals first, and they are integrated in an infinite interval.

To describe Schumpeter’s achievement in a mathematical language, he created a single function explaining the business cycles by integrating Juglar, Kitchin, Kondratiev and Kuznetz functions, using the Inverse Fourier Transform. It is like drawing the dotted line out of solid lines in the graph above, all of which are based upon cyclical functions. You may not necessarily be familiar with this concept, but there are a variety of apps available to conduct Fourier Transform, and Microsoft Excel has data analysis tools to do so. So it’s not as bad as it sounds.

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However, when the above conceptual theories are applied to real life through a tool called Fourier Transform, the outcome may be surprisingly different by user. This is because the shape of the function can vary completely depending on how you determine the variables, coefficients and constants. Also, the patterns that actually appear in real life are not as simple as the above illustrations. In some cases, the cycle may be asymmetric, the amplitude may change constantly, and the trend may be dramatically different. Eventually, the function’s performance is bound to vary widely, depending upon variables, coefficients and constants.