Barbro Wickman-Parak: Is there a typical business cycle?
Speech by Ms Barbro Wickman-Parak, Deputy Governor of the Sveriges Riksbank, at
Nordea, Stockholm, 7 October 2008.
* * *
The expression "economic downturn" is often used in the media and general debate, but
there appears to be some confusion as to what the term actually means. Sometimes the term
is used to describe generally less prosperous times, on other occasions it is avoided and
people talk instead of a recession.
The academic definition focuses instead on deviations from a long-term trend.1 One
imagines that GDP has a natural long-term equilibrium level that shows a growth trend over
time and in periods when the economy is below the trend we have a recession and in periods
above the trend we have a boom. This sounds simple, but in practice many questions
remain. Many of the shocks that affect the economy can for instance be lasting and in this
case they affect the long-term equilibrium level. As the long-term equilibrium level is not an
observable variable, it is difficult to know in practice what point in the economic cycle the
economy is currently at.
There are patterns that often recur in economic cycles and which are therefore studied
closely by forecasters. For instance, it is normal to have an over-investment in housing and
for commodity prices to rise during an economic boom, just as in the current cycle. However,
on each occasion there are also factors that dominate over the common pattern, for instance
the current mortgage crisis in the United States and the ensuing contagion effects on the
financial markets as a whole. It is partly because of this that the forecasts become uncertain.
In addition, it is particularly difficult to predict the turning points in the cycle.
As monetary policy acts with a time lag, it must nevertheless be based on forecasts of how
we believe that growth and inflation will develop. As time passes, new information is received
which may cause us to reconsider our earlier analyses. This means that the forecasts we
make regarding, for instance, the repo rate are not promises, but a forecast that is just as
uncertain as the other parts of the forecast.
I shall try to put some perspective onto the current situation by first going over what we know
about Swedish cyclical patterns and then discussing the prominent features of this particular
recession.
Do we know what governs economic cycles?
At the beginning of the 20th century economic cycles were regarded as natural and
unavoidable, often in the light of the variations in agricultural production. Then came Keynes
in the 1930s with his classical analysis2 where fluctuations in economic activity were
regarded as a result of fluctuations in demand. According to Keynesianism, recessions
should be combated by an active policy.
At the same time as Keynes' analysis began to be questioned on the basis of economic
theory3, the world suffered deep recessions in the wake of the oil price shocks of the 1970s,
which led to a more pessimistic view of the ability of economic policy. People realised that
fiscal policy measures often came too late and that attempts at an active economic policy
often merely resulted in high inflation. An alternative interpretation began to emerge;
fluctuations in economic activity were regarded as the result of changes in production
conditions.
The 1980s saw the advent of RBC-models4, which stands for Real Business Cycle. The
characteristic of these was that they considered fluctuations in the production of goods and
services to be natural consequences of externally caused changes in production conditions.
This could be changes in technology; IT is one example. It could also be sharp swings in the
oil price, terrorist attacks or war, but also more natural examples such as the weather. They
assumed that the markets themselves were best suited to adapt to the changed conditions.
There was thus no scope for stabilising monetary and fiscal policies.
Since then the pendulum has swung back a little with the neo-Keynesianism, which has
reintroduced some of the elements of the classical Keynesian analysis. Due to different
reasons it can take time before the economy returns to its long run equilibrium after a shock.
Monopolistic competition and sticky wages are a few examples. The participants'
expectations can play a major role according to these theories. Monetary and fiscal policy
can therefore be used to stabilise the economy.
Macroeconomic analysis is often carried out with the aid of general equilibrium models
(DSGE models, Dynamic Stochastic General Equilibrium).5 The Riksbank, like a number of
other central banks, uses one of these models for forecasts and simulations. The Riksbank's
model is called Ramses (Riksbank's aggregate macromodel for studies of the economy in
Sweden). In Ramses, goods and labour markets are assumed to be in monopolistic
competition and wages and prices are sticky.
However, the Ramses model analysis is only part of the forecasting process, which is also
based on other statistical analyses and of course assessments. In the short term, that is to
say the current quarter and one quarter ahead - what is usually called "now-casting" - we
use different statistical models and indicators to make an assessment of the current situation.
This analysis strives for the best possible accuracy in the forecasts and is often only vaguely
anchored in economic theory. However, this type of forecast has a relatively good accuracy
in the short term (up to one year ahead).6
The forecast produced by the now-casting is then entered into the large DSGE model and
forms a basis for the model's longer-term forecasts. The international forecast for all quarters
is then also made outside of Ramses and entered as input into the model. As all models are
simplifications of reality, however, the final analysis must always contain elements of
assessment that correct the results from the model. In addition, some markets, for instance,
the financial markets, are not entirely reflected in these models.7 The latter play an important
role in the current stage, which is affected substantially by the financial turbulence.
General equilibrium models are an important analysis tool as they provide a consistent
picture of the economy. They can therefore also be used for policy analysis and to analyse
alternative scenarios.
Some facts about economic cycles
According to economic theory, fluctuations in growth thus arise as a result of various external
shocks affecting the economy. The size of the fluctuations is in turn affected by the
functioning of the economy. I now intend to describe briefly what we know about how
economic cycles manifest themselves and what consequences they have.
1. International developments
International studies show that fluctuations in economic activity have become somewhat less
dramatic over the past 20 years, a phenomenon usually known as "the Great Moderation".8
In Sweden the situation is slightly different because of the unusually profound crisis we
suffered in the early 1990s. However, since then the fluctuations appear to have also
declined here, although the period of time has been too short to draw any definite
conclusions. If one studies the volatility in world growth since 1970 and onwards, one can
see that it has declined since the mid-1980s.
There are many possible reasons as to why economies have become more stable. One
reason that is usually put forward is that the world economy has quite simply suffered smaller
shocks in recent decades. Often the significance of modern economies having larger service
sectors is put forward as a reason, because these are not as affected by international
developments as the industrial sector. Improved stocks management can also have had a
positive effect. Deregulated financial markets have made it easier to obtain credit and
thereby smooth consumption over time. Finally, it is often pointed out that the changeover in
fiscal and monetary policy, with budget targets and greater focus on price stability, is a
contributory factor. To summarise, probably all of these factors have had some significance
in stabilising the world economy. However, one must remember that 20 years is a short
period when analysing economic cycles. Perhaps the current downturn will give us reason to
reconsider the conclusion that the fluctuations have declined?
In this context one usually mentions the importance of the extended period of high growth in
some emerging economies. First and foremost China, but also India, has had an increasing
significance for the world economy over the past decade. If domestic demand can be
sustained in these countries, despite declining economic activity in the United States, Japan
and Europe, it may lessen the downturn for the world as a whole. However, their growth
opportunities should slow down as the economies enter a more mature phase. In the long
term, they cannot support world growth.
2. Sweden
As each economic cycle is to some extent unique, one can never say exactly what will
happen in any phase of a cycle. There is quite simply no such thing as a typical economic
cycle. But it may nevertheless be interesting to look at how different variables can vary in the
economic cycle in Sweden. As Sweden is a small, open economy with a large export sector,
we are very much affected by what happens abroad. It is therefore often claimed that
Swedish economic cycles are "imported". However, looking at studies of Swedish data
covering the period from the end of the 19th century up to the mid-1990s, it is difficult to find
evidence of this.9
If one looks at the period from 1980 to 2008, however, the turning points in the economic
cycle appear to systematically occur a few quarters earlier in the United States than in
Sweden.10 This could imply that international developments have also gained increased
significance in recent years as capital markets have been deregulated and the exchange rate
has been allowed to float. One can also see that exports often show a turnaround a quarter
or so before GDP. However, there have been few cycles since 1980 and it is therefore
difficult to reach any conclusions.
Let me illustrate how the components of GDP in Sweden move in the example of a "normal"
economic downturn. Export growth often turns around a few quarters before the turnaround
for GDP. To begin with, companies adapt to the change in demand by adjusting production
using their existing resources. For instance, they cut down on overtime and stand-ins rather
than making staff redundant. At the same time, they invest less. Productivity falls and unit
labour costs rise, as wages are sticky in the short term. In the end companies have to adjust
their costs to the lower demand and after a few quarters employment begins to fall. Now
consumption is also beginning to be affected; the leaner times are making people hold more
firmly onto their money.
When unemployment rises, wage demands are subdued, which slows down the increase in
unit labour costs. This in turn leads to companies' profit margins gradually increasing. When
the effects of the negative shock that caused the downturn fade away, growth gradually
returns to the normal trend level. Companies respond to the rising demand by increasing
production and investment, which in turn leads to unemployment falling and to consumption
accelerating again.
However, I would like to repeat that an economic cycle does not always follow this average
example. It is often the case that one of the components does not show its usual pattern and
sometimes the economy "settles" for an unusually long time in one phase of the cycle. A few
years ago, for instance, there was much talk of "jobless growth" when employment failed to
accelerate despite a high growth rate. In addition, the length of an economic cycle varies
considerably. It can be anything from three to ten years11, and the turning points therefore
become difficult to predict. Economic downturns, that is, the period when the economy
moves from a peak to a trough, are usually shorter. The normal condition for the economy is
thus a growth phase.12
The current economic cycle
After this review of common cyclical patterns I shall take up some specific features that
characterise the current downturn. Following the recent turbulence in the financial markets it
can easily be forgotten that there are also elements of a "normal" slowdown in economic
activity on this occasion, too. Even before the financial crisis took a serious hold in summer
2007 it was possible to see in the Riksbank's and other analysts' forecasts that a slowdown
in economic activity was expected both in Sweden and abroad. Since then the world
economy has been exposed to major shocks that have led the Riksbank, like other
forecasters, to revise down the growth forecasts for the coming years.
The financial crisis has proved to be more profound, more prolonged and to have more
ramifications than one might initially have expected. In the most recent phase of the crisis the
unease has also more tangibly spread to European banks and government agencies in
several countries have felt obliged to intervene.
We have tried to take into account the effects of the financial crisis in our forecasts. But it is
of course difficult to know to what extent we could have captured all the effects the crisis may
have had so far on the real economy. Moreover, we cannot know how the financial crisis will
develop in future and how long it will last.
Falling house prices have affected not just the United States, but many other countries. We
have not been affected by this, although there appears to be a cooling in the housing market
here, too.
Another shock that has occurred during this downturn is that energy and commodity prices
have risen substantially. Last summer the oil price reached new top levels and inflation rose
around the world. However, since then prices have fallen. Seen in a longer-term perspective,
rising commodity prices are not an uncommon feature prior to a turnaround in the economic
cycle. This was the case, for instance, in the 1970s. As a consequence of the rising inflation,
central banks around the world have been faced with a difficult situation, where the risk of
contagion effects on other prices and wages must be assessed in an uncertain economic
situation with receding growth.
Another common cyclical pattern that is now repeating itself is that labour productivity is low,
which is significant for cost pressures. Productivity growth usually slows down when
economic activity slows down, but in recent years productivity growth has been unusually
low. It is also unusual that productivity growth falls as long as eight quarters in a row, as it
has now.
It is difficult to find a simple explanation for the low productivity growth in recent years. The
National Institute of Economic Research has studied the composition effects, to put it simply,
if the composition of industries with different rates of productivity has changed, and it finds no
great effect on productivity.13 Another possible explanation could be that the recent increase
in employment has meant that new groups with a lower productivity than others have entered
the labour market. For instance, it can take time to train new employees. It may also be the
case that companies have prepared for coming retirements by employing additional staff so
there are currently two to a job in some cases.
When productivity slows down, unit labour costs increase, and this puts further pressure on
companies to raise prices. There is thus risk of higher inflation. We are currently facing a
situation where it is difficult to predict how companies will adjust to high unit labour costs. It is
always difficult to dismiss staff, but indicators such as job vacancies, redundancies,
companies' employment plans, etc. point towards an adjustment having begun. At the same
time, a general decline in demand makes it difficult for companies to pass on cost increases
to consumers.
Commodity prices have also begun to fall, which reduces inflationary pressures not just in
Sweden but also abroad. If this development does not reverse, it will make things easier for
the central banks, as they will have greater scope to meet the slowdown in economic activity
with monetary policy actions.
I would like to take the opportunity here to talk about what we can and can't achieve with
monetary policy. No one wants the economy to fall into a deep decline or a lengthy recession
like the one we experienced in the 1990s. However, Sweden has dearly-bought experiences
from the 1970s and 1980s when we tried to use fiscal and monetary policy to stabilise
fluctuations in economic activity. These experiences were part of the reason why the
Riksbank became independent and the inflation target was established.
The problem with rising commodity prices is a result of high demand that has arisen after the
long growth period the world has just undergone. Perhaps this problem has been aggravated
by the fact that many countries subsidise food and energy. Now we are in a situation where
some adjustment is probably needed. A stimulative monetary policy that allows inflation
expectations to soar would possibly help the economy out of the current growth slump in the
short term. However, this could be at the cost of an even larger adjustment further ahead to
bring down inflation expectations again. This was what happened in Sweden in the 1970s
and 1980s.
Although economic downturns cannot be avoided, fiscal and monetary policy can be
conducted in such a way that the consequences for the economy are as small as possible.
The impact of monetary policy is long-term and it is therefore important that confidence in the
Riksbank's ability to stabilise inflation is maintained. This does not prevent us from taking into
account developments in the real economy when we make our decisions on the repo rate.
The Riksbank conducts what is known as "flexible" inflation targeting. Our aim is that
inflation, when it deviates from the target, will normally return to the target level within a
couple of years. If the shocks affecting the economy entail large deviations, it may take
longer before the target is achieved in order to attain a smoother sequence of events for
production and employment.
When we were to make a decision on the interest rate in September, we faced a situation
where the declining economic activity in Sweden and abroad needed to be placed in a
context where many factors could conceivably affect inflation. The slowdown in economic
activity has probably had a subduing effect on inflation. However, we have seen that
economic cycles are not sufficiently regular to enable us to forecast how profound or
prolonged a downturn will be. The relationship between economic activity and inflation is not
particularly stable either. In the difficult deliberations we had to make in September we
Executive Board members reached different conclusions, with a majority voting to raise the
repo rate while the minority to which I myself belonged voted to hold the interest rate
unchanged. On this occasion I shall not go into the various reasons for my stance in depth;
they were clear from the separate minutes of the monetary policy meeting and I discussed
them in a speech I held a couple of weeks ago.