What is... | July 27, 2012

What is an economic cycle?

It will come as no surprise to those who have lived through the last decade that the rate at which an economy grows can vary. Growth can surge in the boom times, plummet in recessions or sit somewhere in between.

Knowing where we are in the “economic cycle” – or business cycle, as it is sometimes known – is important for spending, saving and investment decisions.

Is it sustainable?
The history of economic growth shows that countries get richer by growing at their sustainable rate. The sustainable growth rate is sometimes described using the analogy of the fairytale Goldilocks and the Three Bears. Like the bowls of porridge in the story, a growth rate that is “just right” is better than one that is “too hot” (growing too quickly) or “too cold”.

Boom and bust
The simplest way of looking at economic growth is to see it alternates between boom and bust, which is roughly the story of the first and second halves of the last decade. In the first half, say from 2002 on, the global economy was growing strongly but in 2007 things took a sharp turn and a global financial crisis took hold.
The standard definition of an economic cycle from Investopedia tells how in booms, economic growth, inflation, employment, interest rates and stock market values tend to rise. In a bust they tend to fall. The last decade was characteristic of this.

The wheels on the bus go round…
When the United Kingdom was growing strongly at the start of the 2000s, then Chancellor of the Exchequer Gordon Brown famously claimed the boom and bust cycle was over.
But economic historians have shown economies continually move between expansion, prosperity, contraction and recession. The experience since 2000 suggests the historians are right.
These cycles, however, do not always follow a smooth pattern.

Summer of LUV
An “alphabet soup” of models of recovery has been developed to spell out how recoveries often look. This includes L-shape, U-shape and V-shape (spelling out the cute-sounding LUV), as well as W-shaped recoveries and more.
A V-shape recovery implies a sharp fall and quick recovery, a U-shape indicates a slower turnaround and a W-shape points to a double-dip recession. An L-shape recovery is characterised by a steep drop then a particularly long and slow recovery and it tends to come with a growth recession.
Since the global financial crisis starting in 2007, economies in different parts of the world have followed different shaped recovery paths. The United Kingdom, for example, is facing a W-shaped double dip, having slipped into technical recession again in 2012.
This means that not only do cycles not follow regular patterns, they may also look different in different places.

Follow the cycle
Booms and busts have a wide range of implications for saving and investing.
During busts, inflation and interest rates tend to fall meaning that savers will likely earn a lower rate of interest on their basic saving accounts (and that borrowers on floating rates will likely pay a lower rate of interest).
Recoveries, as interest rates rise, can be particularly challenging environments for bond holders as an earlier eZonomics poll explains. Despite the importance of this, only 21% of 1500 people in a major survey in the United States knew the relationship between interest rates and bond prices.
Timing the buying and selling of shares is notoriously difficult, as this eZonomics poll says, with an earlier video about timing share market investments arguing investors should organise their savings first before considering buying shares, pay attention to diversification and think about how long they are willing to invest.
ING Group chief economist Mark Cliffe’s video lessons from the financial crisis offer insights into home buying, borrowing, volatility and more.


Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics