Recession and the Business Cycle

By Colin (Huaizhi) Chen

There is one word that haunts the dreams of economists and feeds on the tears of broken politicians. Some believe that it is only a legend, invented by Allan Greenspan as an old wife’s tale to keep investment bankers in check of their unruly excesses. Yet those who have been in its remorseless grip cannot deny the certainty of its affects and the truth of its existence. Over the eons, many charismatic young defenders of wealth and economy have joined in crusades against its might. They celebrate their temporal victory only to cower in fear in old age as it returns again and again. There is one word to rule over all other words (about the economy). Guessed it yet? It starts with an “R” and ends with an “ecession.”

Ok… this is probably not the first time you came across the concept of a recession. In fact, if you’re a working age adult, you most likely have heard at least one of its two common definitions. One definition is simply two or more consecutive quarters of zero or negative economic growth. However, if you tell this to a NBER economist, he’ll likely tell you to grab a seat so he could lecture about the growth of the American economy and his love of Milton Friedman. He would then go on to dictate that recession, as defined by the National Bureau of Economic Research, is a significant decline in economic activity, and serves as the period between economic growths. He would then proceed to linearly-regress the number of times someone gives up a seat on a public bus to the incarceration rate for public indecency, but more on the oddities of economists later. So what makes the hairsplitting so important, and what makes recession so fearsome in the economy?

To answer that, we will have to look at the broader picture. Most free market economies in history have followed periods of expansions and slow downs. We call the sequence of economic growth and declines, the business cycle. More specifically, the Juglar cycle, based on its name sake, Clement Juglar, who as far as in 1860, foresaw the periods of expansionary prosperity, crisis, and liquidation in various economies. Assuming that an economy is growing steadily, investors would become gradually overconfident about their choices of investments. As this confidence becomes irrational and capital grows in an unsustainable manner for less productive industries, a slowdown in growth would occur, bursting the investor confidence. This in turn spirals a dramatic decrease in economic output as capital owners transfer resources from the unsuccessful enterprises to more productive ones. We call this a recession. Correcting inefficiencies in the market, ideally leads to an economic recovery. However, many Keynesians believe that the dramatic decline in production can lead to a spiraling decline of consumer spending, which in turn creates more decline of production leading to a depression. To prevent this, we tend to see loose money monetary policies and fiscal stimulus to stimulate the economic recovery.

“So what?” Evaluating which stage of the business cycle an economy is in helps guide our investment decisions. If we are currently in the recovery stage of the business cycle, investments like commodities and growth stocks are attractive because they would fuel the coming economic expansion. As the economy recovers, it enters an early expansionary stage. We would then look at common equities and real estate as they have historically benefited the most from steady growth. As expansion continues, the fed sets high interest rates to fight inflationary pressures and a possible equity balloon, we would start moving our stocks to bonds and interest rate related securities in expectation of a recession. In a recession, the feds would start cutting the interest rate, generating a nice profit for our fixed income investments. In turn, we’ll prepare to transfer our investments into commodities and growth company stocks in expectation of the coming recovery.

So perhaps recession isn’t the four legged monster many have made it out to be. To a keen investor, it may even present some opportunities.

- H