Q: What are the phases of a business cycle?
A: A business cycle passes through four phases.
Contraction. When the economy starts slowing down, it is usually accompanied by a bear market. GDP growth slows to the one to two percent level before actually turning negative.
Trough. While the economy continues to decline in a recession, GDP’s negative performance each period eventually gets smaller and the economy gets ready to turn the corner.
Expansion. When the economy starts growing again, it’s usually signaled by a bull market. GDP growth turns positive again and should be in the healthy 2 percent to 3 percent range. If the economy is managed well, it can stay in the expansion phase for years.
Peak. When the economy gets into a state of “irrational exuberance,” with overly high expectations, inflation starts to appear. The peak phase is when the economy’s expansion slows. There is usually one last healthy growth quarter before the recession starts. If the GDP growth rate is 4 percent or higher for two or more quarters in a row, the peak is just around the corner.
Q: What factors generally precipitate a business contraction?
A: Much of the business cycle is explained by changes in the level of business, investor, and consumer confidence. Periods of economic growth occur when investors, businesses, and consumers have a positive outlook on the economy. Consumers buy when they can depend on their income level and home value. Even a little inflation can encourage consumers to buy sooner before higher prices set it. High consumer demand leads businesses to hire new workers and make further investments. Investors may take on riskier investments to gain some extra return. There is much capital and liquidity available, many people are making good money, and everyone believes that the good times will continue. All this suggests that the peak is not far off.
There are early signs that tell that an economy is getting overheated. Usually there is too much borrowed money going into a major “hot” area. The dot-com boom in the 1990s was followed by a dot-com bust (1999−2001), when speculative investors realized that many of the new dot-com companies were making little or no money. The next “hot” area turned out to be the 2003−2006 boom in housing, with many mortgages being taken by people without the means to pay them if they lost their job.
In these two cases, consumer and investor debt increased substantially. The late MIT economist Charles Kindleberger said that bubbles can’t exist without borrowing: “Economic disasters are almost always preceded by a large increase in household debt.”
Specific downturns can be precipitated by different combinations of factors. A contraction can start as a result of poor earnings, job cuts, major strikes, ballooning inventories, inflation fears, and other factors. Business, investor, and consumer confidence is shaken and the contraction phase begins. Investors start selling stocks, buying bonds and gold, and hoarding cash. The contraction is marked by businesses laying off workers and others hoarding cash rather than spending it. Stock prices fall drastically and inventories pile up.
Economists have long worked on the idea of putting together indicators of economic activities that would help predict changes in the economy. Leading indicators are those that change before a change occurs in economic activity. Lagging indicators are those that change after the economy has changed. Coincident indicators are those that change at approximately the same time as the whole economy. Among the indices used by these three indicators are earnings reports, the unemployment rate, the quits rate, housing starts, the consumer price index (a measure for inflation), industrial production, gross domestic product, bankruptcies, broadband Internet penetration, retail sales, stock market prices, and money supply changes.