Most economists are of the view that by means of economic indicators it is possible to identify early signs of an upcoming recession or prosperity. What is the rationale behind this opinion?
The National Bureau of Economic Research (NBER) introduced the economic indicators approach in the 1930s. A research team led by W. C. Mitchell and Arthur F. Burns studied about 487 economic data to ascertain the mystery of the business cycle. According to Mitchell and Burns,
Business cycles are a type of fluctuation found in the aggregate economic activity of nations. … a cycle consists of expansion occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic.
Business cycles are seen as broad swings in many indicators, which upon careful inspection permit the identification of peaks and troughs in general economic activity. The research team concluded that because their causes are complex and not properly understood it is much better to focus on the outcomes of business cycles as manifested through economic data.
The indicators approach was designed to be as impartial as possible in order to be seen as purely scientific. This is what Murray Rothbard had to say about the NBER methodology:
Its numerous books and monographs are very long on statistics, short on text or interpretation. Its proclaimed methodology is Baconian: that is, it trumpets the claim that it has no theories, that it collects myriads of facts and statistics, and that its cautiously worded conclusions arise solely, Phoenix-like, out of the data themselves. Hence, its conclusions are accepted as unquestioned holy "scientific" writ.
If the driving factors of boom-bust cycles are not known, as the NBER underlying methodology holds, how could the government and the central bank introduce measures to counter these unknown phenomena? Contrary to the NBER philosophy, data doesn’t talk by itself or issues any “signals” as such. It is the interpretation of the data guided by a theory that generates various “signals.”
By stating that business cycles are about swings in the data, one says nothing what business cycles in fact are. In order to define what business cycles are, the driving force that is responsible for the emergence of economic fluctuations needs to be ascertained.
Are the Sources of Business Cycles Unknown?
Contrary to the indicators approach, boom-bust cycles are not about the strength of the data as such. (For instance, for the NBER a recession is a significant decline in activity spread across the economy lasting more than a few months). It is about activities that sprang up on the back of the loose monetary policies of the central bank. Thus, whenever the central bank loosens its monetary stance, it sets in motion an economic boom by means of the diversion of real savings from wealth generators to various non-wealth-generating activities that a free, unhampered market would not facilitate. Whenever the central bank reverses its monetary stance, it slows or puts to an end the diversion of real savings towards non-wealth-generating activities, and that in turn undermines their existence. The trigger to boom-bust cycles is central bank monetary policies and not some mysterious factor.
Consequently, whenever a looser stance is adopted, it should be regarded as the beginning of an economic boom. Conversely, the adoption of a tighter stance sets in motion an economic bust, or the liquidation phase.
The severity of the liquidation phase is dictated by the extent of distortions caused during the economic boom. The greater the distortions, the more severe the liquidation phase is going to be. Any attempt by the central bank and the government to counter the liquidation phase through monetary stimulus only undermines the pool of real savings, thereby weakening the real economy further.
Since it is central bank policies that set the boom-bust cycles in motion, obviously, then, it is these policies that lead to economic fluctuations. Whenever the central bank changes its monetary stance, the effect isn't felt instantaneously — it takes time. The effect starts at a particular point and shifts gradually from one market to another, from one individual to another. The previous monetary stance may dominate the scene for many months before the new one asserts itself.
Economic Slowdown versus Recession
Contrary to popular thinking, recessions are not about declines in various economic indicators as such — they are about the liquidation of business errors brought about by previous loose monetary policies. They are about the liquidation of activities that sprang up on the back of previous loose monetary policy. The ensuing adjustment of production may or may not manifest itself through a negative GDP growth rate.
As a rule, symptoms of a recession emerge once the central bank tightens its monetary stance. What determines whether an economy falls into a recession or just suffers an ordinary economic slowdown is the state of the pool of real savings. As long as this pool is still expanding, a tighter central bank monetary policy will culminate in an economic slowdown. In other words, notwithstanding that various non-wealth-generating activities will suffer, overall economic growth will be positive, the reason being that there are more wealth generators versus non–wealth generators. This is reflected by the expanding pool of real savings.
As long as the pool of real savings is expanding, the central bank and government officials can give the impression that they have the power to prevent a recession by means of monetary pumping and the artificial lowering of interest rates. In reality, however, these actions only slow or arrest the liquidation of activities that emerged on the back of easy monetary policy, thereby continuing to divert funding from wealth generators to wealth consumers. What in fact gives rise to a growth rate in economic activity is not monetary pumping but the fact that the pool of real savings is actually growing.
The illusion that through monetary pumping it is possible to keep the economy going is shattered once the pool of real savings begins to decline. Once this happens, the economy begins its downward plunge, i.e., the economy falls into a recession. The most aggressive loosening of money will not reverse the plunge (for money cannot replace bread). In fact, rather than reversing the plunge, loose monetary policy will further undermine the flow of real savings and thereby further weaken the structure of production and thus the production of goods and services.
In his writings, Milton Friedman blamed central bank policies for causing the Great Depression. According to Friedman, the Federal Reserve failed to pump enough reserves into the banking system to prevent the collapse in the money stock and thus in economic activity. For Friedman, the failure of the US central bank is not that it caused the monetary bubble during the 1920s but that it allowed the deflation of the bubble.
An economic depression, however, is not caused by the collapse of the money stock as suggested by Friedman, but rather by the collapse of the pool of real savings. The shrinkage of this pool is set in motion by the monetary pumping of the central bank and fractional reserve banking. Moreover, a fall in the pool of real savings triggers declines in bank lending and thus in the money stock. This implies that previous loose monetary policies cause the fall in the pool of real savings and trigger collapses in economic activity and in the money stock.
Declines in stock prices and the prices of goods and services follow declines in money supply. Most economists erroneously regard this as "bad news" that must be countered by central bank policies. However, any attempt to counter price declines by means of loose monetary policies further undermines the pool of real savings. Moreover, even if loose monetary policies were to succeed in lifting prices and inflationary expectations, this cannot revive the economy while the pool of real savings is declining.
Lastly, it is erroneous to regard falls in stock prices as causing recessions. The popular theory argues that a fall in stock prices lowers individuals' wealth and in turn weakens consumers' outlays. Since the theory holds that consumer spending accounts for 66 percent of GDP, this means that a fall in the stock market plunges the economy into a recession.
Again, the pool of real savings, and not consumer demand, permits economic growth to take place. Furthermore, prices of stocks mirror individuals' assessments regarding the facts of reality. Because of monetary pumping, these assessments tend to be erroneous. However, once the central bank alters its stance, individuals can see much more clearly what the facts are and scale down previous erroneous evaluations. Observe that while individuals can change their evaluations of the facts, they cannot alter the existing facts, which influence the future course of events.
