CHAPTER XXVIII

BUSINESS CYCLES

The Meaning of the Business Cycle.-"Business cycle" is a phrase used to designate the series of changes in business activity which are characterized by alternating prosperity and depression. The phrase serves to emphasize the observed fact that the typical condition in business is not permanent prosperity. Instead, it is a constant series of changes from prosperity to crisis, from crisis to depression, from depression to recovery, from recovery back to prosperity again. This succession of changes is not exceptional or unusual, but is the customary and expected round of business behavior. When business is at a peak of good times, it is on the verge of depression. When business is in the slough of despond, it is at the threshold of recovery. Ebb and flow between good times and bad times is the essential characteristic of the business cycle.

However, the ups and downs of business do not occur with the exact regularity with which a pendulum swings back and forth. No two business cycles are of exactly the same duration. No two cycles have exactly the same rise and fall of prices or production. No two cycles have exactly the same background of fundamental economic conditions. Each cycle has an individuality of its own. Nevertheless, in spite of all such individual differences and variations, all cycles run true to type. They follow well defined lines of general behavior. They have basic traits in common. They operate under the influence of similar fundamental forces. The individual peculiarities of each cycle exist within limits clearly defined by the basic common characteristics of all cycles. Two errors are equally to be avoided: the one, exaggeration of the notion that a cycle runs a stereotyped, fixed, and absolutely periodic course; the other, exaggeration of the notion that the ups and downs of business are chaotic or haphazard phenomena which obey no general laws.

Duration of Business Cycles.-Since 1810, American business has experienced a breakdown of prosperity sixteen times. Viewing the fact that such crises occurred in 1825, 1837, 1847, and 1857, and after the Civil War in 1873, 1884, 1893, and 1903, some authorities have concluded that a crisis is due to occur every ten years. However, during more recent years a seven-year cycle has been assumed, chiefly due to the fact that crises occurred in 1907, 1914, and 1920. Both of these historical assumptions, however, are too arbitrary and uncertain to be used as a basis for forecasting cycles of the present day.

The most commonly accepted modern fersion of the duration of business cycles is that periods of business dépression since 1890 have occurred at intervals of approximately forty to forty-four months. This conclusion is based upon a statistical study of the intervals between successive low points in interest rates and commodity prices. These low points from 1892 to 1914 recurred at intervals of thirty-four months, twenty-six, forty-four, forty-four, forty-three, forty-three, and thirty-six.

BUSINESS ACTIVITY OVER 50 YEARS, AS REFLECTED IN BANK CLEARINGS OUTSIDE NEW YORK CITY, CORRECTED FOR PRICE AND SEASONAL VARIATIONS, AND FOR NORMAL LONG TIME RATE OF GROWTH. THE COMPUTED TREND OF BUSINESS ACTIVITY EQUALS

100 PER CENT*

1875 1876 1877 1878 1879 1880 1881 1882 1883 1884 1885 1886 1887 1888 1889 1890 1891 1892 1893 1894 1895 1896 1897 1898 1899

The forty-three and forty-four-month cycle was of most common occurrence, with one as short as twenty-six months, and two midway between twenty-six and forty-four months. In general, therefore, a period of three to four years intervened between depression and de

pression.1 These historical observations would indicate that the duration of the business cycle is not sufficiently regular and fixed to warrant the precise forecasting of each stage of the cycle on the basis of a constant time interval.

The duration and recurrence of the oscillations of business may be visualized from the diagram of bank clearings (see page 580). Bank clearings are a valuable index of business activity because the bulk of business involves the use of bank credit and the changes in use of bank credit are reflected in the rise and fall of bank clearings. Bank clearings outside of New York City are used as a means of eliminating the heavy volume of bank credit used in New York for speculation on the stock exchanges. These outside clearings measure more strictly business activity, to the exclusion of speculative activity on the stock markets. The deviations above and below the line of 100 per cent show the divergence of business activity from the trend of normal growth. Allowance has been made for changes in the price level, so that the fluctuations measure actual physical volume of trade and not merely dollar values. The deviations from the line of regular increase, therefore, represent substantially the cyclical changes in the volume of the country's business.

Phases of the Business Cycle.-For convenience in analysis, the cyclical oscillations of business may be separated into their main phases or stages. The four main phases, in order of sequence, are prosperity, crisis, depression, recovery. Each phase represents a distinct stage of evolution into the succeeding phase. Prosperity sets in operation forces which develop into crisis, crisis develops into depression, depression into recovery, recovery into prosperity.

The behavior of each phase is exceedingly complex, and in order to thread a way through the complexity, a central clue or guide is necessary. This guide is contained in profits, present and prospective. Prosperity exists when the prospect of profits is good. Crisis comes when the prospect of profits collapses. Depression exists as long as the prospect of profits remains low. Recovery comes when the prospect of profits revives. The many forces which affect any phase of the cycle bring their influence to bear by altering in some way the prospect of profits. The waxing or waning of profits is the crucial center, the focal point, in each phase of the business cycle.2

If we start with the prosperity phase of the cycle, the natural inquiry is: Why does prosperity not tend to be permanent? In general, the answer is, because prosperity sets in operation forces which tend to bring a downfall of profits and the prospect of profits. The downfall of profits causes a downfall of prosperity all along the line. The reasons for this downfall of profits may be briefly traced.. As prosperity goes on, various business costs advance more rapidly than prices of goods

1 See Homer B. Vanderblue, Problems in Business Economics, pp. 18-19. 2 For statistical analysis of the phases of the cycle, see W. C. Mitchell, Business Cycles, pp. 44-558.

from which business income is derived. Expanded business requires the use of old machinery and poorly located plant. Labor costs per unit of product increase, partly because scarcity of hands requires the employment of the less effective classes of labor, partly because of rising wages and overtime pay, but probably mainly because of the declining efficiency of labor when there is no fear of being fired for slacking. Capital costs rise as interest rates advance in response to the demands of expanding business. Prices of raw materials tend to rise more than prices of finished products, thus increasing costs relative to income of manufacturers. Managerial costs increase due to waste, laxity, and extravagance born of the general spirit of buoyancy and optimism and the feeling that since money comes easy, there is no necessity for strict economy and frugality. When costs, of which these are illustrative, advance out of proportion to selling price, profits begin to suffer.

The check upon selling prices comes from various quarters. Many lines of retail prices cannot be raised further because custom and habit have become so ingrained that the public will not buy at higher levels. Other lines of prices, particularly public utilities, cannot be raised because public service commissions regulate their rates. Other lines of prices cannot be raised further because of price fixing laws, and of prosecution for profiteering or for conspiracy to raise prices in violation of anti-trust laws Still other lines of prices cannot be raised because over-production of those particular types of goods has occurred. In all such lines, the jacking-up of selling prices to cover rising costs comes to a halt.

This very fact of restraint in certain prices brings gross inequalities as between industries. Concerns that can no longer advance prices have to buy materials from concerns that "kite" their prices to extremes. These individual inequalities of prices are aggravated by the general unevenness of broad classes of price fluctuations. Retailers, for instance, find that wholesale prices tend to rise faster and higher than retail prices. Dealers find that prices of consumers' goods do not tend to rise as fast as prices of producers' goods. Manufacturers find that prices of raw materials tend to rise faster than prices of finished products. These accumulating inequalities in prices bring severe maladjustments between business costs and selling prices. The inevitable result is an encroachment upon profits. The concerns which are the hardest hit face the possibility of failure. This danger of failure is of the utmost importance to the banks, to the money markets, and to the security markets.

The acute situation which then arrests the attention of the banks is but the culmination of a series of banking phenomena which are characteristic of the prosperity phase of business. The financial aspect of prosperity is a fundamental part of the train of forces which tends to undermine business expansion. Demand for bank loans increases, partly because of the increasing volume of business and partly because at rising price levels more bank credit is necessary to conduct business.

The reaction of the banks to this growing demand for their funds is to advance the rates of interest. They cannot increase loans indefinitely because their reserves tend to become exhausted. The advance of interest rates restrains further loans and thereby protects the banks' reserves. But what is a device of self-protection for the banks is a burden upon business men in pursuit of profits. The rise of interest rates not only threatens their profits by imposing upon them heavier costs for capital, but acts as a psychological depressant and raises a doubt everywhere as to the prospective earnings of business. Business men have to give up plans for further expansion because at the higher interest costs they cannot hope to make a profit or because banks are reluctant to grant further accommodation even at the higher rates. When old loans come due, bankers are reluctant to grant renewals. Borrowers whose prospects of future earnings are poorest are pressed to pay off their loans at the banks. The liquidation of loans forces business men to turn their earning assets into cash. This means dumping goods on the markets for what they will bring, curtailment of productive activity, and a weakening of the whole business structure.

While the individual bankers are taking steps to protect their financial position, the official banking authorities are taking action looking to the protection of the banking system as a whole. The Federal Reserve banks in the United States-or the central banks in foreign systemsraise their discount rates as a means of conserving gold reserves and of limiting the unhealthy expansion of credit. The official advance of discount rates not only tends to increase interest costs to business but exerts a powerful psychological influence in warning business that the boom has reached a danger point. The prestige and leadership of official action thus reinforces the self-imposed restraints of the individual bankers, and both alike tend to halt the flood of prosperity.

The security markets usually assume an attitude of caution and restraint some months in advance of the commercial banks. The demand for loans for business purposes becomes so strong during boom timest that funds for speculation become scarce. As funds are drawn away from speculation, a liquidation of securities is initiated on the stock markets. This liquidation is accelerated by the anticipation on the part of speculators that profits are likely to diminish owing to the unhealthy condition of business and banking. Speculators seek to unload their holdings before dividends fall. Higher call loan rates increase the cost of speculation. When the stock markets assume this attitude, it is difficult for business to raise new capital on favorable terms, and business feels obliged to curtail its expansion. The security markets, like the banks, are closely linked at all points with the prospect of profits and with the causes of the downfall of prosperity.

These checks upon prosperity are augmented by maladjustments in the physical volume of production and trade. As industry expands, some lines over-produce while other lines under-produce. This does not necessarily mean over-production in the aggregate, but only an un