Business Cycles – Where They Come From and Where They Are Headed

Economies do not grow steadily or at a constant pace; instead, they move in business cycles. They fluctuate up and down, and only after a downturn do they typically rise again to an even higher level.

Economists use the term business cycle to describe overall economic progress, measured by real GDP and its growth rates. In a functioning economy, technological progress and innovation are constant: new methods allow raw materials to be extracted more cheaply, new machinery enables the production of more goods with fewer inputs in less time—production becomes more efficient. When the essential foundations of an economy are in place—credit and insurance markets, public administration, and economic incentives that allow individuals and businesses to benefit from their achievements—the economy can grow continuously.

However, there are regular short- and medium-term deviations from this long-term growth trend—these are called business cycles.

The Four Phases of the Business Cycle

Economic growth does not move forward at a constant pace when one observes GDP growth rates over time. Instead, there are recurring periods of expansion and contraction. This is similar to our personal experience: productivity may be high on Monday but lower by Friday, and it drops completely over the weekend. Likewise, our energy levels differ throughout the year—often low in winter and high in summer.

The same pattern appears in the overall economy, both within a year and across longer periods. These short- or medium-term deviations from the average path are called business cycles; the long-term average forms the steady growth trend.

A business cycle generally consists of four phases:

Figure 2: Schematic representation of the course of a business cycle

Expansion:

During an expansion, the economy grows faster than average. Companies receive increasing numbers of orders and therefore boost production. To do so, they need additional workers and machinery, leading to a decline in unemployment and to more orders for other businesses that supply inputs—from screws to car doors. This phase is accompanied by mild inflation and low interest rates, which make it easier to finance new machinery and buildings through loans. Optimism about economic conditions prevails.

Boom:

In this phase of high economic prosperity, demand is strong, and nearly everyone who wants a job has one. Even if companies wanted to, they would find it extremely difficult—and costly—to hire additional workers. Production facilities operate at full capacity, making it equally difficult to order new machinery—and even if possible, only at very high prices. This increases risk for companies because it is unclear whether customers will continue buying goods at such prices. Banks respond to these risks by raising interest rates.

Moreover, banks have only limited funds available for lending. They must ration credit, meaning only those willing to pay higher interest rates receive loans. The market is saturated.

Recession:

Eventually, the boom reaches its peak. Companies raise prices but struggle to find buyers. As a result, they must reduce capacity: workers who are no longer needed are laid off. Households have less income to spend, which further reduces demand for goods and services. The downturn continues like a spiral: companies cut back on investment, buy fewer machines, and suppliers also lay off workers. Overall, fewer goods and services are produced, and economic output shrinks.

A recession is commonly defined as economic decline for at least two consecutive quarters. Interest rates also fall—banks have money to lend, but fewer borrowers are willing to take out loans.

Depression:

Eventually, the bottom of the recession spiral is reached. At this low point, the economy stagnates for an extended period. Idle labor and unused production facilities wait for demand that does not materialize. People prefer to save money for emergencies rather than spend it on restaurant visits or new smartphones—the savings rate increases.

There is even a danger of deflation as companies try to undercut each other's prices to attract buyers, while consumers delay spending in hopes of even lower prices in the future.

Eventually, the economy reaches its lowest point—the depression. From there, it begins to recover for the same fundamental reasons that caused it to slow down but under different conditions: wages and prices are low, there is plenty of unused production capacity, and consumption begins to rise again.

During the COVID-19 pandemic, the world economy was suppressed by lockdowns and mobility restrictions but rebounded strongly once these measures ended in 2022:

Figure 3: Not just theory—virtually all countries experience business cycles of varying intensity. Increasing interconnectedness and globalization lead to synchronized business cycles.

While every country and every economic region is subject to business cycles, the same is true for the global economy as a whole, especially as supply chains become increasingly interconnected across the world. Famous examples of worldwide depressions include the Great Depression starting in 1929, which led to unemployment rates of up to 25 percent in industrialized countries. Industrial production fell by about half in the United States, Canada, and Poland. In Germany, the devastation of the crisis even contributed to the rise of National Socialism.

In the 1990s, Latin America and various Asian countries became the focal points of major depressions. More recently, the Global Financial Crisis of 2008 had severe impacts, particularly on Southern European countries and the American working class. Government debt exploded due to bailout packages, unemployment rates surged, and most countries experienced deep economic contractions. The Global Financial Crisis also triggered a series of additional crises: the sovereign debt crisis, the banking crisis, the Greek crisis, and ultimately the Eurozone crisis.

Figure 4: Business cycles can be observed not only through GDP development but also in other indicators, such as consumer confidence, industrial sentiment, and retail sentiment. Each sector responds with varying intensity. Note especially the downturns in 2008 during the Global Financial Crisis originating in the United States, as well as the economic crisis following the COVID-19 pandemic.(Source: European Commission, 2023)

Theories on the Causes of Business Cycles

Economics has produced various theories to explain the causes of business cycles and has derived several—sometimes contradictory—policy recommendations for practical economic policymaking.

Figure 5: Even though economists disagree about the causes of fluctuations within economic growth, they do agree on one consequence: during a downturn, inventories become depleted.(Source: pexels.com, 2022)

According to the Austrian School’s Business Cycle Theory

A crisis begins with an interest rate that is set too low. The so-called “natural interest rate” emerges in a free market through supply and demand for capital. However, in modern economies, interest rates are not freely formed; they are set by central banks.

If the price of capital (the interest rate) is lower than the market price, demand exceeds the available supply of resources and consumption. More investment takes place than would occur at a natural interest rate.

The state or central bank stimulates the economy beyond its capacity for labor, inputs, and resources. At some point, inflation must increase because the economy overheats and demand becomes excessive due to overinvestment.

The central bank is then forced to intervene by raising interest rates. This leads to investments that were profitable at low interest rates suddenly becoming unprofitable. As a result, unprofitable business models must be shut down, one after another, triggering a domino effect that ends in a crash.

Joseph Schumpeter’s Perspective

For the Austrian outsider Joseph Schumpeter, innovation is the main driver of the business cycle. Innovation triggers an upswing. The economy adjusts to the new innovation. This adjustment process causes the downturn: outdated production structures are abandoned, obsolete technologies are no longer used, and the economy is “cleared out.”

Schumpeter calls the moment between expansion and the abandonment of outdated projects a crisis. This crisis leads to economic progress and technological advancement. Fundamentally, he believes in the economy’s ability to self-regulate and recover from crises on its own.

John Maynard Keynes’ Perspective

Keynes sees the causes of business cycles in fluctuations of employment, income, and output. Income and output depend on employment, which in turn depends on profit rates, interest rates, and the propensity to consume.

Consumption and interest rates remain largely stable in the short and medium term. Thus, the main factor driving employment fluctuations in a business cycle is the profit rate of capital.

• During expansion, profits are high: incomes rise, employment is high, investment increases, and optimism prevails.

• Over time, production costs for new capital goods rise due to shortages and material bottlenecks.

• Competition keeps overall profits below expectations.

Optimism soon gives way to skepticism and eventually to pessimism. Returns on capital collapse, investments decline. The downturn reinforces itself because every decline in investment causes a multiplied decline in income.

The economy heads toward crisis and depression. In this low point, part of the long-lasting capital stock wears out and excess inventories accumulated during the depression are gradually depleted.

As excess goods and capital become scarce again, profits and expected returns begin to rise, and recovery starts. The economy expands once the profit rate increases again.

Keynes argues that the duration of such business cycles is comparable across eras because depreciation and obsolescence of capital (buildings, machinery) occur over a relatively similar timeframe.

From this, Keynes derives the principle of countercyclical fiscal policy:

• The state should save money in good economic times.

• These funds should then be spent during downturns to stimulate the economy through public expenditure.

  
  

Karl Marx’ Perspective

According to Marx, a business cycle begins with a below-average price level and below-average profit rate. This encourages capitalists to invest massively in improved production technologies.

Marx assumes that new technologies are highly costly and capital-intensive. These innovations trigger an upswing. Early adopters earn extra profits (monopoly gains). Producers using outdated technologies imitate the innovators, and the new production methods spread.

However, there is a time delay: A long period passes between deciding to invest in new technologies and bringing the products to market. During this time, capitalists lack key information:

• How much should actually be invested?

• What is the real demand for the products?

• How much will competitors supply?

  
  

This leads to overaccumulation: producers invest more than necessary. The result is overproduction, and supply exceeds demand. Prices fall, workers are laid off, factories close. The result is an economic downturn marked by lack of demand and shrinking profits.

Stagnation ends only when new production technologies are introduced again, and the cycle restarts.