However, both the harvest and the trade cycles differed from the business cycle that emerged from around the middle of the nineteenth century. This cycle was longer, at closer to ten years' duration, and was associated with industry. Its was characterized by large changes in the production of investment goods. Industries such as iron and steel production fluctuated much more than did industries such as food or textiles. In the most severe recessions, for example, production of pig iron (the raw iron used throughout industry) fell by as much as 20 percent in a single year; while in boom years it might rise by 30 percent.
Before 1914 the most visible feature of business cycles was that the peak of the cycle was often accompanied by a financial crisis in which, because of the fragmented nature of the U.S. banking system, many banks failed. There were such crises in 1857, 1873, 1884, 1893, and 1907. The best way to understand the business cycle during this period is to consider some examples. The biggest cycle was the one involving the boom of 1873 and the subsequent depression. The heart of the boom was an enormous investment in railroads after the end of the Civil War. Between 1865 and 1873, U.S. railroad mileage doubled from 35,000 to 70,000 miles (56,000 to 113,000 kms.). Manufacturing production also rose greatly in the years leading up to 1873. There was immigration, many new households were formed, and much housing was built. This boom came to an end in 1873, when industrial production fell sharply and housebuilding declined, although statistics compiled later suggest that real gross domestic product (GDP) did not change much. Because the U.S. downturn coincided with the end of a boom in Britain, France, and Germany, world demand for commodities fell, resulting in a fall in commodity prices. Stock prices fell and for a while the stock market had to be closed. Panic spread to the banking system and 300 banks collapsed. The economy entered what was then seen as a prolonged period of severe depression. Although the figure is implausibly high, it was rumored among contemporaries that three million people were out of work. Industrial production did not begin to grow again until 1877. After that the economy grew rapidly till the next downturn in 1884.
While less severe, the boom of the late 1880s followed a similar pattern. It involved railroad building, immigration, residential building, and rising iron and steel production. Agriculture was less prosperous and it was during the 1880s that the share of the labor force in agriculture first fell below 50 percent. It ended, after a minor problem in 1890, with a major financial panic in 1893. Almost 500 banks failed. There was a shortage of money and credit for most of the 1890s and unemployment remained high.
The financial crises and bank failures associated with the business cycle brought pressure for reform of the financial system. Nothing happened after the 1873 crisis, but the 1893 crisis was followed by the repeal of the Silver Purchase Act of 1890, which had required the treasury to purchase 4.5 million ounces of silver per month. It was believed that these purchases, paid for with treasury notes, undermined confidence in the treasury's ability to maintain its obligation to redeem dollars in gold. The "free silver" issue (the demand that government should mint as much silver as was brought in, raising prices and assisting farmers) was the major issue in the 1895 election campaign conducted by William Jennings Bryan. It has also been argued that free-silver populism found literary expression in Lyman Frank Baum's The Wonderful Wizard of Oz (1900), which has been read as an allegory on the Free Silver movement. However, the crisis that produced the biggest change in policy was the one in 1907. While not as severe as previous crises, it resulted in a decision to transform the way the U.S. banking system operated through the establishment, in 1913, of the Federal Reserve System. This would prevent banking crises by acting as a regulator of the banking system and as a lender of last resort.
The twentieth-century business cycle was different. The 1920s was a period of great prosperity, to the extent that many people believed that prosperity had become permanent, right up to the Wall Street crash. This ushered in the Great Depression, which the Federal Reserve System failed to stop. Some economists have gone so far as to argue that the passivity of Federal Reserve policy turned what would have been a financial crisis into a calamity. The boom of the 1920s and the Great Depression had a profound effect on American society. Recovery came only with World War II. After the war economists feared a return to the depressed conditions of the 1930s, but this did not materialize. During the 1950s and 1960s contractions were very short and none was severe. The period was one of steady expansion. This changed in the 1970s, when the business cycle returned with the severe recession of 1973–1975. This was the worst recession since the 1930s. Its causes were the worldwide over-expansion that took place in 1971‒1973, fueled by spending on the Vietnam War, and the decision of the Organization of Petroleum Exporting Countries (OPEC) to raise oil prices by over 100% in 1974.
Further severe recessions followed in the early 1980s and early 1990s. The first of these came in 1980, when consumer price inflation rose above 12 percent and there was widespread concern that it was spiraling out of control. President Jimmy Carter had appointed Paul Volcker as chair of the Federal Reserve Board in late 1979, and Volcker proceeded to tighten the growth rate of the money supply, which led to very high interest rates. Inflation fell from 1981‒1982, but the price was that unemployment rose sharply. Toward the end of 1982, policy was eased and growth resumed, boosted by Ronald Reagan's cuts in taxes and his inability to reduce government spending, which created a large budget deficit. By the end of the decade, the economy had been growing rapidly, despite the massive stock market crash of 1987. Recession came in 1990–1991, with some economists arguing that the expansion had carried on for too long. After a slow recovery from the recession, the pattern of a decade-long period of growth was repeated in the 1990s. President Bill Clinton's policy of balancing the budget was credited for the growth, together with the policies of Alan Greenspan at the Federal Reserve, which kept inflation and interest rates low. It ended with the emergence of a recession in 2001. For the following couple of years, the economy was stimulated by tax cuts and a high level of antiterrorist and military spending.
As this article is written, the outlook is very uncertain. Stock prices have been depressed since the bursting of the high-technology bubble during the 1990s, and things worsened with the series of financial scandals that led to a number of major corporate collapses (including Enron, Worldcom, and Arthur Anderson). There remains great uncertainty about the outcome of military intervention in Iraq. It is tempting to view all this as a confluence of unique events rather than as anything that deserves to be called a cycle. However, this typically has been the case. It has always been possible to view fluctuations in economic activity as the outcome of a series of historically unique events that contribute either to stimulate or to depress the level of activity. That has led some economists to deny that there is anything that could be called a cycle. Against this it can be argued that fluctuations have persisted over centuries and that, despite the uniqueness of many of the shocks to the economy, there are persisting mechanisms that underlie the movement from one phase of the cycle to another, for which economists need to develop a theory.
Theories of the modern business cycle date from the late nineteenth century. French economist Clément Juglar and British economist William Stanley Jevons are often credited with being the first to identify a regular ten-year cycle. Jevons tried to explain it in terms of the harvest (which he believed was linked, via the weather, to sunspot activity) and Juglar focused on the financial crises that occurred when expansions turned into contractions. The first economist to see fluctuations in business investment as the driving force behind the cycle was Karl Marx. He argued for an over-investment theory. In the expansion, capitalists undertook so much investment that they would eventually create a shortage of finance. Loans would become scarce relative to the demand for them and the rate of interest would rise. Investment would then be curtailed and demand would fall. Firms would find that they could not sell the goods they had produced, prices would fall and production would collapse. The recession would continue until demand had risen sufficiently to stimulate further investment, which would lead to a new period of expansion.
In the first decade of the twentieth century, many economists developed Marx's ideas, adding explanations of why it was impossible for output to rise smoothly. Two economists were particularly influential: Russian, Mikhail Tugan-Baranovsky and Austrian Joseph A. Schumpeter (who later moved from Vienna to Harvard). The reason Schumpeter gave for the cycle was that inventions came in waves. A new product would be developed, creating opportunities for profitable investment. Investment would rise and a boom would develop. Eventually, however, competition would reduce profits and the expansion would cease—until a new innovation came along. Many business cycles could be associated with particular innovations: for example, the boom of 1906 was associated with the invention of the motor car.
After World War I, there was an explosion of research into business cycles, with the establishment of statistical research institutes all over Europe and in the United States. One of the most influential was the National Bureau of Economic Research (NBER), established in 1919, of which Wesley Clair Mitchell was the first director. More than any other body, the NBER was responsible for creating the detailed statistical data necessary to analyze the business cycle. More than anyone else, Mitchell was responsible for popularizing the phrase "the business cycle." Because the business cycle was central to the NBER's analysis of economic activity, it worked on the methods for dating the cycle discussed above. During this period theories of the business cycle proliferated. Many economists turned to monetary explanation for the 1920s boom: the over-expansion could be attributed to the authorities keeping interest rates too low, causing stock prices to rise and stimulating a volume of investment (in construction, machinery, and so forth) greater than the level of savings in the economy could sustain. The result was the Wall Street crash and the Great Depression.
Through the 1920s and 1930s, economists began to develop theories in which the level of aggregate demand (total spending on goods and services) played an important role. This line of inquiry culminated in John Maynard Keynes's The General Theory of Employment, Interest and Money (1936). Although this offered an explanation of the business cycle, its effect was to shift economists' attention away from the problem of the business cycle towards thinking, in more static terms, about what determined the level of employment. His explanation was that aggregate demand, driven by firms' investment decisions, determined employment. This theory attracted an unprecedented amount of attention and by the 1950s had become the orthodox way to view the behavior of the economy as a whole. It encouraged the view that policy makers could control the level of employment by adjusting interest rates and the amount of government spending, thereby eliminating the business cycle. There were models of the cycle but, in contrast to the situation in the 1920s, they were peripheral to the theory of employment.
In the 1950s Milton Friedman challenged the Keynesian consensus, claiming that money played an important role in the business cycle. However, it was not until the 1970s, when inflation escalated and it became clear that the business cycle had not been defeated, that his ideas were taken seriously by the profession as a whole. Using arguments that converted most of the profession, Friedman argued that the demand-management policy could affect the level of unemployment only for limited periods of time. In the long run, there was a "natural" rate of unemployment that could be changed only by policies such as reforming the labor market or raising productivity (so-called supply-side policies). During the 1970s new theories of the business cycle emerged that took Friedman's line of argument even further. Using the assumption that agents were completely rational, and taking full advantage of all available information and all opportunities for profit, Robert Lucas argued that the business cycle was caused by unpredicted monetary shocks (the "New Classical Macroeconomics "). When it became clear that this was not consistent with the data, Fynn Kydland and Ed Prescott developed "Real Business Cycle" models. These returned to the old idea that the cycle was driven by technology shocks, but using the "New Classical" framework. The implication of this approach was that Keynesian stabilization policy did not make sense. Real Business Cycle theory is now arguably the most widely held theory of the business cycle, though there are many economists who do not accept it. It is arguable that it fails to explain the data and that the assumptions made about individuals' rationality are so strong that it is hard even to begin to take it seriously as a theory of the business cycle. Real business cycle models are already being modified to account for market imperfections, and it seems likely that these will, sooner or later, be superceded by more plausible models.
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