Classical Economics Series: #3 The Business Cycle

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This economic series is meant to be educational. It will cover: Economic Growth, The Business Cycle, Supply, Demand, Prices, Inflation, Unemployment, Imports, and Exports. It is mostly academic so it will have a school-vibe, but without the homework or tests! Unlike school though, the tests we face are real-world tests such as pursuing our own financial improvements to reach financial freedom. It will not include much of my own opinion or analysis because that is not the goal for this series. The goal for this series is for you to understand the economics of a nation (macroeconomics), so you can use that understanding to become good investors!

What is a business cycle? It’s the ups and downs of Real GDP as it follows its overall trend. Here’s a picture:

I’m pretty much an artist.

The overall trend is upwards, which you can see from the black arrow going up and right (through the J). But as it works its way upward the economy has ups and down. The ups are marked in green and the downs are marked in red. You can see the ups and downs and the overall upward trend. This is a good, and normal, economy; it is good at what it does so it grows and performs well (upward trend), but it also encounters challenges along the way (the downs marked in red) and responds to them to “fix” the economy/solve the challenge (the ups marked in green). The US has been very good at fixing its economy as it meets challenges, plus we have a huge collection of smart and hardworking businesses full of good people and resources to fix their business (their slice of the economic pie).

As you can guess, economists measure business cycles 😉 These macroeconomists measure many variables to paint a picture and understand the past, present, and future economy. An example of a variable that is measured is Unemployment. Another example of a variable that is measured is Real GDP. There are tons of variables measured. But these variables are measured at regular intervals (perhaps once per week, once per month, once per quarter, once per year, etc.) When you measure a variable at consistent intervals it’s called a time series.

When you look at the time series (collection of data for one variable taken at regular intervals), you can see trends. Real GDP, Prices, and Unemployment are three massively important trends for economists. When the Real GDP trend shows increases for two (or more) quarters (3-month interval/a quarter of a year) then the economy is in expansion. If that expansion lasts for a long, long time (years) it is considered a boom. But when the Real GDP trend shows decreases for two (or more) quarters then the economy is in contraction. Historically, if the Real GDP is contracting then it was called a recession, but nowadays many economists look at more the just Real GDP before labeling the economy as being in a recession. (They will look at income, unemployment/employment, etc for an overall feel before using the word recession.) So, expansion and contraction are not debatable: either your Real GDP continues to grow every quarter and you’re expanding (your economy), or your Real GDP continues to shrink every quarter and you’re contracting (your economy). Obviously, government is interested in having tools to end contraction, avoid recession, and restore expansion/growth — more on that later. The NBER (National Bureau of Economic Research) can officially declare a recession, but as an improving investor gathering your data do you want to just move with the herd and wait for the NBER to declare a recession or end of a recession? Or do you want to be one step in front of it? And even if you do wait, just understanding that it was coming can keep you emotionally calm and rational (buying low and selling high takes emotional control and sound reasoning). “I saw that coming from a mile away” is a powerful feeling as an investor. It takes time to develop that — and you will still get surprised from time to time too. But since you’re winning more than you’re losing you deal with it better.

The NBER is typically full of Nobel Laureates and past members of the President’s Council of Economic Advisors. But, you know, good investors still ensure what they are reading/hearing makes sense to them.

Many economic factors correlate (match) with each other very well. For instance, Real GDP and Unemployment rates match very, very well. In other words, when Real GDP is going up then Unemployment is going down. When things move together but go in opposite directions that is called “an inverse relationship.” It is like they do opposite things, but at the same time; this can also be called countercyclical. (A direct relationship is when two things move in the same direction at the same time; this can also be called procyclical, or just cyclical.) You could look at it the opposite way too: when Unemployment is going down then Real GDP is going up. The NBER looks at this closely when deciding if we are in a recession. If Real GDP is declining, but Unemployment is not changing then they may not call it a recession. There are indeed times when things that are highly correlated (like Real GDP and Unemployment) do not move “correctly.” This is always odd for economists and investors, and you need to pursue the reason (or at least a theory) why. Remember, the economy is very dynamic and complex, so there are many things that are usually true but not always true. Economists are just gathering info and painting pictures. Not every picture is a Monet and easy to understand.

As an investor, you want procyclical investments when the economy is good (restaurants, airlines, auto-makers) and countercyclical investments (discount retail and alcohol) when the economy is bad.

An easy to understand painting:

Monet – I get you. This is people by the sea!

A tough to understand painting:

Jackson Pollock – You’re in my feels but I’m not sure I understand it… and do I need to? And what’s the meaning of life? And, wait… I’m trying to invest. Can I get a different picture? No? This is how things are? Hrm.

So before the NBER declares a recession they look for: a decline in total GDP, a decline in income, a decline in employment, and a decline in trade. So they want to see that the economy is bad/down in many regards — and I would tend to agree with this. The term recession should be reserved for when many bad things are happening within the economy. Otherwise, people might think every bit of bad news is a recession, which reduces their participation in the economy (less iPhones, restaurants, and Disney+) which then would lead to more problems — because they got spooked.

You can also have a scenario where you are in a growth recession. What does that mean? It means you used to be growing at 3% but are now growing at 2.5%. See how you are growing slower now? The growth (growth rate) contracted. But you are still growing. It is like the kid in middle school who hits a growth spurt and grows 12″ in a year versus the kid who grows 6″ in a year. They are both healthy. Look at the data for yourself, hear what is actually happening, and don’t just listen to people worried that we are growing slower. It happens. Should we look at why? Yes. Should you panic? No. In fact, you should never panic. Because you are a rock. Not dumb like a rock… steady like a rock lol! Moral of the story: continue to learn so you can decide for yourself what is good and bad. (Hint: there are opportunities in every market.)

So we know what contraction is, and we know a recession is more than a Real GDP contraction, but what is a depression? Simply put a depression is when you are in a big recession for a long time (years and years). Since The Great Depression economists have been steadfastly dedicated to preventing another depression! Heck, we already covered Keynes and his effort to develop macroeconomics because the world was suffering through The Great Depression. (There are other great contributions from others too in economics.)

Economies have momentum and inertia. The momentum is how much change is happening (a lot of upward or downward change in the Real GDP for instance) and inertia is the economy’s resistance to change. This does not mean that when government takes action it is useless; instead, it means that a train slows down slowly. You won’t get a barge to turn on a dime. You can put rudder inputs in, and a turn will start, but it isn’t a fifth generation fighter jet.

You may think you want quick changes, but you don’t. What you want is a bunch of small inputs that are on-time from the government so you don’t get a runaway train in the first place — so you don’t need to do a 180 degree turn with a aircraft carrier — but instead a little left or a little right to stay on target.

Small, on-time rudder steers.

As instructor pilots say, “small corrections sooner.” The USG has been pretty good at this compared to the rest of the world, especially when you consider how big, complex, and dynamic our economy is. BUT LET’S STAY GOOD AT IT! 😉

Not hard turns that cause the economy and investors to g-lock!

Oh, that economic inertia is called persistence.

It is also important to note that there are social indicators to the economy too! For instance, when the economy is contracting crime increases, poverty increases, the unemployment rate increases, and unemployment duration increases. Is crime a cause of a worse economy or a reaction to a worse economy? Well, you can show both to be true. Crime in an area means people open less successful businesses in that area, and the types of businesses that survive areas of bad crime is far fewer than the types of businesses that survive less crime, so that reduces the contribution to Real GDP. You can also see that crime increases as a reaction to a poor economy. This is true all over the world. The interplay of social economic measurements is important. Remember, even in a growth recession people panic, make bad decisions, and feel increased stress!

This series uses resources such as Investopedia.com, Wikipedia.com, and my college textbook “Macroeconomics”, 2nd edition, Roger EA Farmer that came with a free CD inside! Now that ages me. But the fact that the textbook is old shows two important things: 1. I have loved all things economics, business, finance, and investing for decades! 2. The study of economics does evolve but what is classic is still powerful and important to understand, and knowing where things have been, and currently are, helps you project where they will be! A priceless skill to hone for investors! I mean, countless people were very sure electric vehicles such as Tesla $TSLA made no sense investment-wise. Maybe they should have opened up their mind to include more economic material! So here’s some classic foundational material for you, and from there we can begin to see changes, directions, and opportunities!

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