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Why do we have these cycles?

When the economy approaches a peak the following events are typical:

• spending and confidence are high;
• production is strong and capacity is heavily utilised;  and
• unemployment is decreasing to much lower levels

When these factors are strong and pronounced (e.g. very high production growth, limited spare capacity and low rates of unemployment), the economy is said to be in a BOOM.

What normally accompanies a peak (particularly a Boom) is:

• increased wage pressures;
• higher interest rates (demand for money is high relative to supply);
• rising inflation (both demand and cost); 
• overvalued asset prices (such property and shares);
• higher import levels as a result of production exceeding capacity;  and
• a growing reliance on debt.

These factors then normally result in a contraction or downturn in the level of economic activity for reasons such as:

• increased costs via higher interest rates and wage pressures;
• a realisation that debt levels become unsustainable and asset prices are too high;
• reduced competitiveness of exports;
• lower confidence of consumers and producers;  and
• decreased AD via lower Consumption, Investment, Exports (and higher imports). 

The contraction is then characterised by:

• slow or declining rate of growth in production;
• underutilisation of capacity;
• high unemployment;
• low inflation and falling interest rates;  and
• reduced wage pressures.

In this environment, with lower inflation, declining interest rates and falling wage pressures, the economy will eventually rebound (or recover) and the cycle inevitably continues.

If the contraction in the level of economic activity is protracted enough the situation is referred to as a RECESSION (technically defined as two consecutive quarters of negative GDP growth). The last time this occurred in Australia was during 2020 (due to the effects of the coronavirus) and before that during the early 1990’s, following the Boom of the late 1980’s.  A prolonged recession is referred to as a DEPRESSION (e.g. Australia in the 1930’s)

While a BOOM is normally characterised by strong production, high inflation and low unemployment and recession by weak production, low inflation and high unemployment, since the 1970’s economies have, at various times, experienced situations of low production growth, high inflation and high unemployment.  This is referred to as a period of STAGFLATION, which occurred in Australia between 1973 and 1983, with unemployment reaching a peak of 10.2% in 1983 and inflation averaging 11.6% per annum over the entire period!  [Over 2022-3, with surge in commodity prices such as oil, gas and wheat (due to the conflict in Ukraine) and the ongoing supply constraints caused by the lingering effects of COVID-19 (e.g. shortages of labour and other key inputs into the production process), there was a possibility that stagflation would reoccur as cost inflationary pressures accelerated and AD declined in response to the erosion of purchasing power, declining confidence, lower investment (in addition to the tightening of monetary policy).]

The change in economic activity that took place over 2008-9, was a perfect example of the economic cycle in action.  In early 2008, the government was still concerned about capacity constraints, excessive growth and inflation – signs that Australia was at the peak of the economic cycle.  However, the USA sub-prime mortgage crisis that commenced in mid-2007 eventually developed into the GFC, with Australia’s corporate sector (particularly banks) heavily exposed to losses on loans that could not be repaid (because debt levels became unsustainable in the sense that the money was being used to purchase ‘overvalued assets).  By the middle of 2008 it became very clear that shares, and property, were overvalued and that interest rate levels were too high.  The Australian economy (like many other economies) quickly entered the downward phase of the economic cycle (i.e. a contraction).  Business and consumer confidence dipped to historically low levels, share prices crashed, property price growth moved into negative territory in most markets and inflationary pressure became relatively insignificant such that the RBA quickly moved to reduce the cash rate (the key interest rate in the economy) from 7.25% in March 2008 to 3.00% by April 2009.  Since Australia reached the trough in the economic cycle in December 2008, its growth rate has been both positive, and larger than anticipated, a sign that we entered the recovery phase of the economic cycle earlier than most other developed economies.  This is despite the negative growth experienced in early 2011, which was largely attributable to the natural disasters.