krugmanwellscanadianmacro2

6.2 The Business Cycle

The Great Depression was by far the worst economic crisis in Canadian history. But although the economy managed to avoid catastrophe for the rest of the twentieth century, it has experienced many ups and downs.

On the positive side, the ups have consistently been bigger than the downs: most chart indicators used to track the Canadian economy show strong upward trends over time. For example, Figure 6-3a shows the levels of real GDP and employment (the number of adults who have paid jobs) between 1961 and 2011. Both real GDP and employment were much higher at the end of the period than at the beginning, and in most years both measures rose.

Figure6-3Growth, Interrupted, 1961–2011 Panel (a) shows two important economic numbers, the levels of real GDP and employment. Both numbers grew substantially from 1961 to 2011, but they didn’t grow steadily. Instead, both suffered from three downturns associated with recessions, which are indicated by the shaded areas in the figure. Panel (b) emphasizes those downturns by showing the annual rate of change of real GDP and employment, that is, the percentage increase over the previous year. The simultaneous downturns in both numbers during the three recessions are clear.
Source: Statistics Canada.

But they didn’t rise steadily. As you can see from the figure, there were three periods—in the early 1980s, in the early 1990s, and again in late 2008—when the percentage changes of both real GDP and employment turned negative. Figure 6-3b emphasizes these stumbles by showing the rate of change of real GDP and employment over the previous year. For example, the percent changes in real GDP and employment for 2007 were 2.2 and 2.4 respectively, because the levels of real GDP and unemployment in 2007 were 2.2% and 2.4% higher than they had been in 2006. The three big downturns stand out clearly. What’s more, a detailed look at the data makes it clear that in each period the stumble wasn’t confined to only a few industries: in each downturn, just about every sector of the Canadian economy cut back on production and on the number of people employed.

The economy’s forward march, in other words, isn’t smooth. And the uneven pace of the economy’s progress, its ups and downs, is one of the main preoccupations of macroeconomics.

Charting the Business Cycle

Figure 6-4 shows a stylized representation of the way the economy evolves over time. The vertical axis shows either employment or an indicator of how much the economy is producing, such as industrial production or real gross domestic product (real GDP), which will be discussed in the next chapter. As the data in Figure 6-3 suggest, these two measures tend to move together. Their common movement is the starting point for a major theme of macroeconomics: the economy’s alternation between short-run downturns and upturns.

A broad-based downturn, in which output and employment fall in many industries, is called a recession (sometimes referred to as a contraction). When the economy isn’t in a recession, when most economic numbers are following their normal upward trend, the economy is said to be in an expansion (sometimes referred to as a recovery). The alternation between recessions and expansions is known as the business cycle. The point in time at which the economy shifts from expansion to recession is known as a business-cycle peak; the point at which the economy shifts from recession to expansion is known as a business-cycle trough.

Figure6-4The Business Cycle This is a stylized picture of the business cycle. The vertical axis measures either employment or total output in the economy. Periods when these two variables turn down are recessions; periods when they turn up are expansions. The point at which the economy turns down is a business-cycle peak; the point at which it turns up again is a business-cycle trough.

Recessions, or contractions, are periods of economic downturn when output and employment are falling.

Expansions, or recoveries, are periods of economic upturn when output and employment are rising. Many countries use data on a single variable, output, as a proxy for overall economic activity.

The business cycle is the short-run alternation between recessions and expansions.

The point at which the economy turns from expansion to recession is a business-cycle peak.

The point at which the economy turns from recession to expansion is a business-cycle trough.

The business cycle is an enduring feature of the economy. As Figure 6-3 shows, the Canadian economy experienced expansions and recessions during the period between 1961 and 2011. Whenever there is a prolonged expansion, as there was in the 1960s and again in the 1990s, books and articles come out proclaiming the end of the business cycle. Such proclamations have always proved wrong: the cycle always comes back. But why does it matter?

The Pain of Recession

Not many people complain about the business cycle when the economy is expanding. Recessions, however, create a great deal of pain.

The most important effect of a recession is its effect on the ability of workers to find and hold jobs. The most widely used indicator of conditions in the labour market is the unemployment rate. We’ll explain how that rate is calculated in Chapter 7, but for now it’s enough to say that a high unemployment rate tells us that jobs are scarce and a low unemployment rate tells us that jobs are easy to find. Figure 6-5 shows the unemployment rate from 1960 to 2011. As you can see, the unemployment rate surged during and after each recession but eventually fell during periods of expansion. For example, it rose sharply in the early 1980s, the early 1990s, and late 2008, during periods of recession.

Figure6-5The Canadian Unemployment Rate, 1960–2011 The unemployment rate, a measure of joblessness, rises sharply during recessions (which are indicated by the shaded areas) and usually falls during expansions.
Source: Statistics Canada.

Because recessions cause many people to lose their jobs and also make it hard to find new ones, recessions hurt the standard of living of many families. Recessions are usually associated with a rise in the number of people living below the poverty line, an increase in the number of people unemployed and collecting employment insurance (EI), a rise in bankruptcies, and an increase in the number of homeowners who lose their homes because they can no longer afford their mortgage payments.

You should not think, however, that workers are the only group that suffers during a recession. Recessions are also bad for firms: like employment and wages, profits suffer during recessions, with many small businesses failing, and do well during expansions.

All in all, then, recessions are bad for almost everyone. Can anything be done to reduce their frequency and severity?

DEFINING RECESSIONS AND EXPANSIONS

Some readers may be wondering exactly how recessions and expansions are defined. The answer is that there is no exact definition!

In Canada and many other countries, economists adopt the rule that a recession is a period of at least two consecutive quarters (a quarter is three months) during which the total output of the economy shrinks. The two-consecutive-quarters requirement is designed to avoid classifying brief hiccups in the economy’s performance, with no lasting significance, as recessions.

Sometimes, however, this definition seems too strict. For example, an economy that has three months of sharply declining output, then three months of slightly positive growth, then another three months of rapid decline, should surely be considered to have endured a nine-month recession. However, this kind of output growth would not be considered a recession according to this rule. Consequently, other countries use other methods to identify episodes of recession. The most notable example is the United States, in which an independent panel of experts at the National Bureau of Economic Research (NBER) determines when a recession begins and ends.

This panel looks at a variety of economic indicators, with the main focus on employment and production. But, ultimately, the panel makes a judgment call, often with quite a time lag.

Sometimes this judgment is controversial. In fact, there is lingering controversy over the 2001 U.S. recession. According to the NBER, that recession began in March 2001 and ended in November 2001 when output began rising. Some critics argue, however, that the recession really began several months earlier, when industrial production began falling. Other critics argue that the recession didn’t really end in 2001 because employment continued to fall and the job market remained weak for another year and a half.

Taming the Business Cycle

Modern macroeconomics largely came into being as a response to the worst recession in history—the 43-month downturn that began in 1929 and continued into 1933, ushering in the Great Depression. The havoc wreaked by the 1929–1933 recession spurred economists to search both for understanding and for solutions: they wanted to know how such things could happen and how to prevent them.

As we explained earlier in this chapter, the work of John Maynard Keynes, published during the Great Depression, suggested that monetary and fiscal policies could be used to mitigate the effects of recessions, and to this day governments turn to Keynesian policies when recession strikes. Later work, notably that of another great macroeconomist, Milton Friedman, led to a consensus that it’s important to rein in booms as well as to fight slumps. So modern policy-makers try to “smooth out” the business cycle. They haven’t been completely successful, as a look at Figure 6-6 makes clear. It’s widely believed, however, that policy guided by macroeconomic analysis has helped make the economy more stable.

INTERNATIONAL BUSINESS CYCLES

This figure shows the annual rate of growth in industrial production—the percent change since the same month the previous year—for four economies from 1991 to 2011: Canada, Japan, the United States, and the eurozone. Do other economies have business cycles similar to those in Canada?

The answer, which is clear from the figure, is yes. Furthermore, business cycles in different economies are often, although not always, synchronized. The downturn of Canadian industrial production of 2001 was paralleled by the recessions in the other three economies; the U.S. Great Recession of 2007–2009 caused a severe slump around the world, including Canada. But not all business cycles are international phenomena. Japan suffered a fairly severe recession in 1998, even as the economies of Canada, the United States, and the eurozone continued to expand.

Sources: OECD, Dataset: Production and Sales (MEI).

Although the business cycle is one of the main concerns of macroeconomics and historically played a crucial role in fostering the development of the field, macroeconomists are also concerned with other issues. We turn next to the question of long-run growth.

COMPARING RECESSIONS

The alternation of recessions and expansions seems to be an enduring feature of economic life. However, not all business cycles are created equal. Similarly, the same business cycle may have a quite different impact on distinct economies. Let’s talk about how the “Great Recession” began and how it affected the economies of Canada and the United States.

Figure6-6Unemployment Rates and Percentage Change in Industrial Production
Source: International Financial Statistics.

The recession began in the U.S. in 2007 and in Canada in late 2008. It was precipitated by a crisis in the U.S. sub-prime mortgage market. Basically, during the 2000s, a large number of U.S. mortgage lenders, fighting for greater market share and profits, undertook riskier and riskier loans. In some cases, loans were made to people with no income, job, or assets—loans that only made any sense as long as house prices continued to rise. In 2006, U.S. house prices began to fall. Fearing the increased risk this fall in prices entailed, lenders tightened lending criteria. Consequently, some borrowers could not renew their loans or obtain a loan easily. So, they were forced to sell their homes, and housing prices dropped even further. Many financial institutions that held significant amounts of assets backed by mortgages suddenly feared for their future. The crisis intensified significantly when Lehman Brothers, the fourth largest investment bank in the U.S. at that time, filed for Chapter 11 Bankruptcy Protection on September 15, 2008.

The shockwaves from the crisis quickly spread to other sectors in the American economy and the rest of the world. It became a full-blown financial crisis that pushed the world economy into its worst recession since the Great Depression (see Chapter 17 for detailed discussion on this financial crisis). However, the severity of the crisis varied between countries, as this comparison between Canada and the United States shows.

Figure 6-6a shows the unemployment rates for Canada and the U.S. from the first quarter of 2005 to the fourth quarter of 2011. Figure 6-6b shows the annualized rates of change in industrial production for these two countries for the same period. From these graphs, it appears the Canadian and American economies had similar experiences during this time; that is, they moved up and down at roughly the same time. But there are important differences.

Before the 2007–2009 recession, the U.S. had a lower unemployment rate and a higher growth rate in industrial production than Canada did. However, when the crisis hit, the U.S. experienced a much larger increase in its unemployment rate. So, while both countries’ unemployment rates peaked in the first quarter of 2010, the increase in the unemployment rates was quite divergent. For example, Canada’s unemployment rate increased by 3.2 percentage points compared to its lowest level in this seven-year period, while the U.S. unemployment rate rose by 6.2 percentage points. Also, by the end of 2011, Canada’s unemployment rate had decreased almost to its pre-recession level, while America’s unemployment rate remained well above its pre-recession level and the rate in Canada. (Note that in Canada unemployment statistics include people who are 15 years of age and older, while in the U.S. they include people who are 16 years and older, so the comparison is not quite exact.)

The story for industrial production is similar. Starting in the fourth quarter of 2007, both economies experienced a slowdown in their industrial production, but the growth rate turned negative sooner in the U.S. (in the second quarter of 2008) than in Canada (the fourth quarter of 2008). Moreover, Canada experienced a smaller drop in the growth rate of industrial production and thus in industrial production itself, than the U.S. did.

So the recent financial crisis and the recession it spawned had less impact on Canada than it did on the U.S. Furthermore, Canada was able to recover from the crisis more quickly than the U.S. could.

Quick Review

The business cycle, the short-run alternation between recessions and expansions, is a major concern of modern macroeconomics.
The point at which expansion shifts to recession is a business-cycle peak. The point at which recession shifts to expansion is a business-cycle trough.

Check Your Understanding 6-2

CHECK YOUR UNDERSTANDING 6-2

Question 6.3

Why do we talk about business cycles for the economy as a whole, rather than just talking about the ups and downs of particular industries?

We talk about business cycles for the economy as a whole because recessions and expansions are not confined to a few industries—they reflect downturns and upturns for the economy as a whole. In downturns, almost every sector of the economy reduces output and the number of people employed. Moreover, business cycles are an international phenomenon, sometimes moving in rough synchrony across countries.

Question 6.4

Describe who gets hurt in a recession, and how.

Recessions cause a great deal of pain across the entire society. They cause large numbers of workers to lose their jobs and make it hard to find new jobs. Recessions hurt the standard of living of many families and are usually associated with a rise in the number of people living below the poverty line, an increase in the number of people who lose their houses because they can’t afford their mortgage payments, and a fall in the percentage of Americans with health insurance. Recessions also hurt the profits of firms.