The causes of booms and busts

Recorded data on business cycles go back to the early 19th century, but economists still cannot agree about what causes contractions and expansions in economic activity.
Economists have come up with all sorts of explanations. The current preference is to look for more down-to-earth causes, which come in two main varieties: those that explain the business cycle as a self-perpetuating process, and those that blame recessions on shocks or policy mistakes. The main theories are:

Exogenous shocks
Recessions, it is argued, are caused by unexpected events, such as the rise in oil prices in the; mid-1970s or, as some (incorrectly) tried to argue, the terrorist attacks on September 11th last year. If so, recessions are, by definition, totally unpredictable. They cannot be prevented, but once they have arrived governments can use fiscal and monetary policies to cushion demand.

Keynesian theory
John Maynard Keynes blamed recessions on the inherent instability of investment caused by “animal spirits”: swings in the mood of producers, from optimism to pessimism. As investment slumps, jobs and household incomes fall, amplifying the initial drop in demand. Unemployment rises because workers will not accept the pay cuts required to price the jobless back into work. So, to bring the economy back to full employment, the government needs to pursue expansionary policies.

Real business-cycle theory
This theory, which emerged in the early 1980s, sees productivity shocks as the cause of economic fluctuations. For example, if productivity falls, current returns decline, says the theory, so workers and firms choose to work less and take more leisure. Rather than explaining the cycle in terms of market failure, as Keynes did, real business-cycle theory views a recession as the optimal response by households and firms to at shift in productivity. If so, there is no point in governments stimulating the economy. But most economists find this theory hard to swallow.

Policy mistakes
The rate Rudi Dornibusch, an economist at the Massachusetts Institute of Technology, once remarked: “None of the postwar expansions died of old age, they were all murdered by the Fed.” Almost every recession since 1945, with the exception of last year’s, was preceded by a sharp rise in inflation that forced central banks to raise interest rates.

The first mistake was to allow economies to overheat; the second to slam on the brakes too hard. This theory gave rise to the popular belief that recessions could be avoided so long as governments pursued prudent monetary policies to keep inflation low and stable. Yet the recessions in Japan after the 1980s bubble and America more recently suggest that price stability does not prevent booms and busts.

Austrian business-cycle theory
This is the oldest, developed by Austrian economists such as Ludwig von Mises and Friedrich Hayek in the early 20th century. Unlike Keynes, who thought recessions were: caused by insufficient demand, these economists put them down to excess supply brought about by over investment. As a result of mutually reinforcing movements in credit, investment and profits, each boom contains the seeds of the subsequent recession and each recession the seeds of the subsequent boom.
According to Hayek, output fluctuates because the short-term interest rate. For loans diverges from the “natural” or equilibrium interest rate the rate at which the supply of saving from household equals the demand for investment funds by firms. If central banks hold interest rates below this rate, credit and investment will rise too rapidly, and consumers will not save enough. This creates a mismatch between future output (which will increase as a result of higher investment) and future spending (which will fall as a result of lower saving today). Cheap credit and inflated profit expectations cause both over-investment and “malinvestment” in the wrong kind of capital. The mismatch between saving and investment will eventually push up interest rates, making some previous investments unprofitable. Too much capacity will also reduce profits. Investment collapses, ushering in a recession. As excess capacity is cut, profits rise and investment eventually recovers.
According to this theory, central banks would not be able to avoid a downturn by heading off a rise in interest rates. The only way to prevent the cycle from turning is to inject ever more credit, which becomes unsustainable. A recession is inevitable, and necessary to correct the imbalance between saving and investment.