By Dr Frank Shostak
In the 1930’s the National Bureau of Economic Research (NBER) introduced the economic indicators approach to clarify the essence of business cycles. A research team led by W.C. Mitchell and Arthur F. Burns studied about 487 pieces of economic data. The team had concluded that,
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.
The research team had also concluded that because the causes of business cycles are complex and not properly understood it is much better to focus on the outcome of these causes as manifested by the economic data. According to the NBER methodology a careful inspection of the economic data enables the establishment of peaks and troughs in general economic activity. By convention, the NBER classifies the peak month as the last month of the expansion and the trough month as the last month of the recession.
The peaks and troughs that are identified by the NBER, serve as a guide in the classification of the various pieces of the individual data as leading, coinciding and lagging.
Once the data is classified it is grouped into leading, coincident and lagging indices. (The grouping is done using a special standardization method labelled as the amplitude adjustments).
These indices are seen as economic markers that are expected to alert analysts and policy makers regarding the state of a business cycle. When the leading index starts to display signs of weakening this is seen as a possible indication of weakness ahead in economic activity.
The confirmation that the peak of the cycle might have reached is established by means of the coincident index, whilst the lagging index provides the final OK that this might be the case. Hence, it is held that by means of these three indices the state of an economic business cycle can be established.
The economic indicators approach that was inspired by the NBER methodology was designed to be as impartial as possible in order to be seen as purely scientific.
According to Murray Rothbard,
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.
Interpreting economic indicators
By mere inspection of the leading index, it is not always straightforward to ascertain the state of the business cycle.
Should we regard any decline in the leading index as a precursor for the future decline in the economy? For how many months must the index decline before one could be certain for an upcoming economic recession?
Some economists are of the view that a decline in the index for three consecutive months is a signal for an upcoming recession. Why, however, is three consecutive months and not two or five required in verifying a recession?
Also, if one were to wait for the confirmation of the leading index signal from the coincident index signal, what is the point then of having the leading index? After all, it is supposed to alert policy makers and businessmen before the boom, or bust, has started. Furthermore, on this way of thinking we still require the final “OK” from the lagging indicators index.
Therefore, it would appear that until the final verdict is made the economy could be either in a deep economic slump or in a strong economic boom.
If the driving factors of boom-bust cycles are not known, as the NBER underlying methodology holds, how is it possible to make a sense of the movements in the leading index?
How could the government and the central bank introduce measures to counter something that is unknown?
Contrary to the NBER methodology, data doesn’t “speak by itself” and never issues any “signals” as such. It is the interpretation of the data guided by a theory, which generates “signals”.
By stating that business cycles are about fluctuations of the data, one says nothing what business cycles are. One only describes but does not explain the phenomenon.
In order to establish what business cycles are, there is the need to identify the driving force that is responsible for the emergence of the economic fluctuations.
Are the business cycle causes unknown?
What characterizes the emergence of an economic slump that businesses that were once thriving come to experience difficulties or go under. They do so not because of specific entrepreneurial errors but rather in tandem with whole sectors of the economy.
Individuals who were wealthy yesterday have become poor today. Factories that were busy yesterday are shut down today, and workers are out of jobs. Businessmen are confused and they cannot make sense of why certain business practices that were profitable yesterday are losing money today.
Bad business conditions emerge when least expected — just when all businesses are holding the view that a new age of steady and rapid progress has emerged. An economic slump emerges without much warning and in the midst of “good news”.
Boom-bust cycles are not about the strength of the data as such. It is about activities that emerged on the back of the expansionary monetary policies of the central bank. Thus, whenever the central bank relaxes its monetary stance, it sets in motion an economic boom by means of the diversion of wealth from wealth generators to various activities that a free unhampered market would not facilitate.
Whenever the central bank tightens its monetary stance, this slows down or puts to an end the diversion of wealth towards these activities, and that in turn undermines their existence. Hence, the trigger to boom-bust cycles is central bank monetary policies.
Consequently, whenever an easier stance by the central bank is introduced this should be regarded as the beginning of an economic boom. Conversely, the introduction 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 false economic boom. The greater the distortions are 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 or fiscal stimulus is going to weaken the pool of wealth thereby weakening the economy. Since it is the central bank’s policies that set the boom-bust cycles in motion obviously then it is these policies that lead to fluctuations in the economic data.
Whenever the central bank changes its interest rate stance the effect of the new stance doesn’t assert itself instantaneously – it takes time. The effect starts at a particular point and shifts gradually from one individual to another individual and from one market to another market. The influence of the previous monetary stance on the economy may dominate the economic scene for many months to come before the influence of the new stance starts to assert itself.
Just by following the growth rate of money supply, one could get some idea regarding the boom-bust cycles in the months ahead. Given that the time lag from the money supply growth and the growth rate in economic activity is variable obviously, the assessment as far as the future is concerned can be only qualitative. Even if we don’t know the length of the lag, we suggest that an analyst who has identified the primary causes of boom-bust cycles is likely to be on a firmer ground than an analyst who employs a “black box” approach. He can make a better sense of what various economic data imply once the major cause has been identified.
Summary and conclusion
The economic indicators approach to ascertain the state of an economy was popularized by the National Bureau of Economic Research (NBER). On this approach, the state of the economy can be established by the inspection of a large amount of data. According to the NBER way of thinking, given the complex nature of economic cycles it is much better to deal with the symptoms rather than identifying causes, which for the time being are of a mysterious nature. We hod that notwithstanding the NBER the key cause of the boom-bust cycles is the monetary policies of the central bank.
