What Is the Boom and Bust Cycle?
The boom and bust cycle is a process of economic expansion and contraction that occurs repeatedly. The boom and bust cycle is a key characteristic of capitalist economies and is sometimes synonymous with the business cycle.
During the boom the economy grows, jobs are plentiful and the market brings high returns to investors. In the subsequent bust the economy shrinks, people lose their jobs and investors lose money. Boom-bust cycles last for varying lengths of time; they also vary in severity.
Key Takeaways
- The boom and bust cycle describes alternating phases of economic growth and decline typically found in modern capitalist economies.
- First anticipated by Karl Marx in the 19th century, the boom-bust cycle is driven just as much by investor and consumer psychology as it is by market and economic fundamentals.
- The cycle can last anywhere from several months to several years, with the average length being approximately 5 years going back to the 1850s.
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Understanding the Boom and Bust Cycle
Since the mid-1940s, the United States has experienced several boom andbust cycles. Why do we have a boom and bust cycle instead of a long, steady economic growth period? The answer can be found in the way central banks handle the money supply.
During a boom, acentral bank makes it easier to obtain credit by lending money at low interest rates. Individuals and businesses can then borrow money easily and cheaply and invest it in, say, technology stocks or houses. Many people earn high returns on their investments, and the economy grows.
The problem is that when credit is too easy to obtain and interest rates are too low, people will overinvest. This excess investment is called “malinvestment.”There won’t be enough demand for, say, all the homes that have been built, and the bust cycle will set in. Things that have been overinvested in will decline in value. Investors lose money, consumers cut spending and companies cut jobs. Credit becomes more difficult to obtain as boom-time borrowers become unable to make their loan payments. The bust periods are referred to as recessions; if the recession is particularly severe, it is called a depression.
According to the National Bureau of Economic Research, there were 34 business cycles between 1854 and 2020, with each full cycle lasting roughly 56 months on average.
Additional Factors in Boom and Bust Cycles
Plummeting confidence also contributes to thebust cycle. Investors and consumers get nervous when the stock market corrects or even a crashes. Investors sell their positions, and buy safe-haven investments that traditionally don't lose value, such as bonds, gold, and the U.S. dollar. As companies lay off workers, consumers lose their jobs and stop buying anything but necessities. That exacerbates thea downward economic spiral.
The bust cycle eventually stops on its own. That happens when prices are so low that those investors that still have cash start buying again. This can take a long time, and even lead to a depression. Confidence can be restored more quickly by central bankmonetary policyand governmentfiscal policy.
Government subsidies that make it less expensive to invest may also contribute to the boom-bust cycle by encouraging companies and individuals to overinvest in the subsidized item. For example, the mortgage interest tax deduction subsidizes a home purchase by making the mortgage interest less expensive. The subsidy encourages more people to buy homes.
What Causes the Boom and Bust Cycle?
Although there are many variables that affect economic cycles, one of the significant factors is the cost and availability of capital, as well as future expectations. When it is easy to borrow money, businesses are more likely to invest in new equipment and higher workers, thereby providing employment and contributing to higher consumption. When borrowing becomes expensive, businesses are likely to cut costs, thereby leading to less economic activity.
How Does the Fed Regulate Economic Cycles?
Like other central banks, the Federal Reserve attempts to moderate economic cycles by adjusting interest rates. When unemployment is high, the Fed lowers interest rates, making it easier for businesses to borrow money and expand their operations. When inflation is too high, the Fed raises interest rates, incentivizing businesses to limit their operations.
How Do Economists Predict the Boom and Bust Cycle?
Economists watch a variety of economic metrics to anticipate future changes in economic activity. In particular, changes in the producer prices and durable goods production may act as leading indicators of business activity, since companies are likely to reduce production when they expect a downturn. Another important metric is the monthly jobs report, which reflects both employer sentiment and consumer buying power.
The Bottom Line
The boom and bust cycle is an informal term for the economic fluctuations between periods of prosperity and depression. When the economic climate is favorable, businesses are likely to see high profits, resulting in higher spending and employment. When businesses are less profitable, the wider economy is likely to see higher prices and lower employment. The effective prediction and moderation of boom and bust cycles has been a major focus of economists and policymakers.
