business cycle

DEFINITION: The “business cycle” is the historically observed tendency of market economies to go through alternating phases of expansion and contraction.

ETYMOLOGY: The word “business” was formed in the fourteenth century from the word “busyness”—the noun form of the adjective “busy”—and meaning a “purposeful activity.”

“Busy” derives, via Middle English, from the Old English word bisig, meaning “full of activity” or “busy.” Bisig is connected to the Middle Low German word besich, meaning “active,” “occupied,” “diligent,” or “industrious.”

The word “cycle” derives, via Middle English and French, from the Late Latin word cyclus, meaning a “fixed period of time (especially years).” The word cyclus entered Latin from the Greek word kuklos, meaning “ring,” “circle,” or “wheel.”

USAGE: The study of the business cycle—that is, the proposal of theories that attempt to explain the business cycle as an empirical phenomenon—forms one of the most important subfields of academic economics.

The first thinkers to identify the business cycle as an important object of study were the English utopian socialist, Robert Owen, and, especially, the French economist, Jean Charles Léonard de Sismondi, who discussed it in his 1819 Nouveaux principes d’économie politique [New Principles of Political Economy].

Broadly speaking, there are two general types of business-cycle theories that have competed with each other for favor over the course of economic history. We may call them the “exogenous” and the “endogenous” classes of theories (with multiple variants of each).

In a nutshell, exogenous business-cycle theories claim that unusual expansions (or “booms”) and contractions, also known as “recessions” (or “busts”), are caused by shocks to an economic system emanating from the outside.

A prime example that was frequently discussed during the nineteenth century was warfare. And wars can indeed affect an economy for better or for worse, depending on a multitude of factors.

For example, war may impact a country’s economy negatively if it has to redirect valuable resources to its defense or if its agriculture, its industry, and/or its labor force are subjected to physical devastation.

On the other hand, war may impact a country’s economy positively if it is not itself a party to the war, but rather sells weapons, food, or other supplies to the warring parties.

From this example, it should be obvious how complex the problem of exogenous shocks to the economy may be.

Even so, the business cycle did not appear to disappear, or even noticeably lessen, during times of peace. Therefore, not all economists were satisfied that exogenous shocks alone could explain the business cycle.

In the later nineteenth and early twentieth century, some economists—especially, Friedrich A. Hayek and others associated with the Austrian school of economics—developed an endogenous theory of the business cycle.

The basic idea of the Austrian theory was that the business cycle is caused by the misallocation of resources, which in turn is usually caused by perverse (uneconomic) incentives to market actors through government policies relating to subsidy, taxation, and/or regulation.

The misallocation of resources due to government interference in the economy leads business owners to turn in a direction away from the one indicated by market signals. Over the long term, this necessarily results in forgone profits, unsold stock, and business failure.

Now, of course, businesses fail all the time due to misjudgments made by their owners without any help from perverse government incentives. However, such failures are scattered at random throughout the economy.

What makes government interference in the economy particularly insidious is that it causes many business owners to misallocate resources in the same way at the same time, leading to many simultaneous business failures in the same sectors.

Austrian economists say that this type of endogenous shock is the main driver of the business cycle under conditions of government interference in the economy.

Note that government interference counts as “endogenous” if one views the government as internal to the economic system (as one clearly must, since it is an economic actor in its own right).

More recently, economists have attempted to resurrect the exogenous-shock theory of the business cycle under the name, “real business-cycle theory,” which argues that the business cycle results from the efficient response of business owners to expected exogenous changes to the economic environment.