I present my theory on business cycles and explain why fiscal and monetary policies can fail during recessions and crises. I wrote, organized, and combined many known economic facts into a cogent, logical story, explaining the impact of economic expansions and recessions upon an economy. I show two characteristics – two and seven – as new deductions while everyone knows the other characteristics well.
As an economy traverses along the business cycle, people, businesses, and government experience good times. Companies are earning profits, and they hire and expand their workforce. Moreover, they invest in machines, equipment, and structures. Consumers are optimistic because they experience growing incomes, job prospects, and feel good about their futures. They spend a large portion of their after-tax income, called the marginal propensity to consume (MPC) and save the remaining portion, called the marginal propensity to save (MPS). Subsequently, banks freely lend to businesses and families. Businesses invest in machines, equipment, and structures while families buy houses, cars, and appliances. Finally, government collects more tax revenue as business activity keeps expanding. Then it usually spends the tax revenue to build roads, to improve infrastructure, to expand government, and so on.
Marginal propensities to save and to consume become the vital concepts. If we would give a person $1 more dollar of after-tax income, then that person saves the MPS part and spends the MPC portion. Moreover, economists believe these propensities remain constant while I believe they vary with the economy's state. For example, households and families raise their savings or MPS and reduce their spending or MPC during a recession or a crisis. Consequently, the changing propensities affect the Keynesian multipliers.
The Keynesian multiplier effect starts with consumers spending most of their incomes in the economy as consumers inject money into the economy. This increased spending causes companies to sell more goods and services, and they earn profits, and expand the labor force. Companies hire additional workers, who earn wages. These workers become consumers who spend a large portion of their salaries in the economy, contributing to economic growth.
The multiplier effect boosts the activity in the economy as the government boosts spending, or businesses raise investment in the economy. For example, a computer company builds a new factory in Small Town, U.S.A. The computer company directly affects the economy by investing $30 million in building the facility and hiring new employees. The construction workers and newly hired employees earn wages. With more income, the employees and construction workers spend more in the economy. They buy new houses, new cars, appliances, and electronic gadgets. Moreover, they dine more at restaurants, watch movies at the cinemas, and frequent coffee shops.
Then the multiplier effect kicks in. These companies serve more customers and make more profits and income. Thus, these businesses hire more workers and work their workers longer. These employees earn greater incomes and increase their spending and savings, and the process continues indefinitely. The $30 million investment in Small Town, USA could generate more than $30 million in incomes as the injection increases the business activity in the economy.
The multiplier effect could create other benefits. For instance, a computer company employs more white-collar workers, and people gain and acquire computer skills. The economy gains a more educated workforce. Furthermore, government collects more tax revenue as a community's income rises. Then government usually raises its spending and provides more services to the community.
The Keynesians, unfortunately, view the savings as leaking from the economy because they treat savings as if people hide their money under their mattresses, or inside the walls while businesses squirrel away their savings in massive, impregnable vaults. However, workers, consumers, and businesses in well-developed countries deposit their savings into banks. Thus, the banks become critical to economic development as they inject the savings into the economy via lending. Banks use the savings to grant loans to businesses, so companies can invest in machines, buildings, and equipment. In addition, the banks grant loans to consumers to buy houses, cars, and appliances. Thus, banks become the first Characteristic of the boom-bust cycle because the banks channel savings into investments in the economy.
Characteristic 1: : A strong banking and financial system lays the foundation of healthy economic growth.
Our economy continues growing and flourishing. Rising incomes fuels consumers' optimism. So consumers continue spending and saving. Businesses experience increasing sales and continually hire workers. Subsequently, the people and businesses continue depositing their savings into banks while the banks lend out the savings. Many economists believe the total savings must equal total investment. However, the banking system as a whole creates and expands the money supply.
For example, a person deposits $20,000 into his savings account and earns a tiny interest rate. The bank puts this money to work. It must retain a small portion of the funds and can lend out the remainder because a central bank imposes reserve requirements. A bank must hold onto a portion of the funds, ensuring this bank has money sitting in a vault or as a deposit at the central bank to meet depositors' withdrawal. In this case, we set the required reserve ratio to 10%. Thus, the bank grants $18,000 home improvement loan and retains $2,000 in the vault.
A homeowner takes the credit and buys $18,000 in materials at a construction store. The store deposits this money into its bank. The bank lends out $16,200 for a car loan to a taxi company and retains $1,800 in the vault. The taxi company uses the car loan to buy a new car at a car dealership. The dealership takes the funds and deposits it in its bank, and the deposit-loan cycle continues.
Similar to the multiplier effect, this deposit and loan cycle becomes an infinite process. Economists focus on the money supply, and the banking system as a whole creates extra money in the economy. However, we can define the home improvement loan and new car as investment. Of course, not all bank loans result in investment. Banks grant credit cards that allow people artificially to prop up their spending.
The banking system could amplify and enhance savings, so one dollar in savings can support more than a dollar in investment, which becomes Characteristic 2. It depends on whether businesses and households use the bank loans to invest in capital or artificially prop up spending. A country such as the United States where most people spend their incomes, the banking system can amplify the meager savings that let banks lend out as loans.
Characteristic 2: The banking system could multiply the investment through the deposit-loan process, causing investments to exceed savings during economic expansions.
The banking system creates a side effect as it amplifies savings. Many businesses and families use bank loans to buy real estate. As the economy continues growing, the banks continue granting loans. Businesses and families create a strong demand for real estate that pushes up property values, which leads to Characteristic 3. As people and businesses continually buy real estate, the bank loans inflate asset bubbles. As people and businesses witness the bubbles, they become exuberant and invest more into the appreciating assets. Even banks join the exuberance and could relax their lending standards. Even if the bank forecloses on a property, they know they can sell the property at a greater price, knowing the bank could come out ahead.
Characteristic 3: A growing economy with a strong banking system automatically creates asset bubbles.
Most companies do well during the expansion cycle while poorly performing companies can hide losses from the investors, banks, and stockholders. These companies can hold on and can convince banks to continue lending to them and convince investors to buy their stocks and bonds. Nevertheless, an event triggers an awareness that leads to shock, and eventually to extreme paranoia. The event could be a plunge in the stock market, currency devaluation, or a wave of massive businesses bankruptcies. Bankers and investors start scrutinizing every company's financial statements more closely. They discover the problems at the poorly performing companies and become horrified at the companies' losses. Then banks and investors stop lending, which becomes Characteristic 4.
Characteristic 4: Banks and investors become fearful to lend and invest during a crisis. Companies and people cannot borrow from the banks while investors stop investing in companies.
The badly performing companies begin contracting and laying off workers. The workers become fearful of the crisis, and they serve a dual role as consumers in the economy because they reduce their spending and boost their savings. Companies experience a decline in sales, and lay off more workers. Thus, we enter a vicious cycle where we have Keynes's Paradox of Thrift. Consumers continually reduce their spending and raise their savings while businesses witness drops in sales. Then businesses lower their production and stop investing into structures, machines, and equipment, which becomes Characteristic 5.
Characteristic 5: Investment falls during recessions and crises as companies become pessimistic of the future.
Consumers and families remain afraid and continue saving. Even if they deposit their savings into banks, the banks are afraid to lend. On the other side, firms and households may not want to borrow especially if they accumulated large amounts of debt during the economic expansion. Thus, savings no longer enter the economy and fuel investment. Furthermore, Keynes's Liquidity Trap strikes the economy. Even if the central bank reduces the interest rate to zero, banks refuse to lend. Then expansionary monetary policy stops working, which becomes Characteristic 6.
Characteristic 6 – Keynes's Liquidity Trap: As a central bank reduces interest rates, banks refuse to lend while businesses and households may not want to borrow. Thus, low interest rates have no effect on the economy, causing expansionary monetary policy to become ineffective.
Many economists believe the investment and government-spending multipliers are constant and equal about two. Thus, for every one dollar in additional investment or government spending boosts incomes in the economy by $2. However, the multipliers vary with people's and businesses' perceptions of the economy. For example, people see friends, relatives, and acquaintances being laid off, and they become nervous and start saving. Thus, people save more and consume less, causing the marginal propensity to save to increase while the marginal propensity to consume to decrease.
During a recession or crisis, people and businesses raise their savings, so the marginal propensity to save becomes high while the marginal propensity to consume becomes low. Economists calculate the simple multiplier by using 1/MPS. Thus, as the marginal propensity to save rises, then the multiplier becomes smaller, leading to Characteristic 7. Consequently, as the government injects more spending into the economy, people earn wages and siphon this spending out of the economy through saving. Even if people deposit their savings into banks, the banks are afraid to lend. Finally, if the government reduces income taxes to spur consuming spending, the taxpayers save this, so decreasing taxes during a recession also becomes ineffective.
Characteristic 7: The Keynes's investment, government spending, and tax multipliers change because they depend on people's and businesses' perceptions of the economy. Thus, the government-spending and investment multipliers vary with the state of the economy.
If the government tries to boost government spending or reduce taxes to expand the economy during a recession, the multiplier stops operating. Thus, government spending or taxes have little influence on the economy during recessions or crisis. Even if the government greatly expands spending and accumulates a massive debt, the economy would respond weakly.
We need three conditions for fiscal and monetary policies to work on the economy. First, people must start spending again to create sales for businesses. Second, companies must become optimistic as they experience increasing sales. Thus, they hire more workers and invest in machines, equipment, and structures. Finally, banks begin lending to families and businesses again that fuels investment into the economy. Thus, these three conditions become necessary to get the economy functioning again.
Most recessions last briefly because the three conditions return to normal quickly. Subsequently, government could restore confidence and faith in the economy by using fiscal policy. If people believe the government's policy to expand spending or reduce taxes, people begin spending again while businesses start investing again, and the banks begin lending.
However, we know fiscal policy had failed in Japan during the 1990s and in the United States after the 2007 Great Recession. I cannot answer for Japan, but the U.S. government created massive insecurity in the economy after the 2007 Great Recession. Many companies do not know how their costs will change with the new federal health care plan. Furthermore, the U.S. government passed the American Recovery and Reinvestment Act of 2009 to inject $831 billion into the economy. However, many experts and economists complained this amount was too small. Thus, the U.S. government has failed to restore the people's, businesses', and banks' confidence in the economy.
People continue to save and reduce consumption. Meanwhile, companies continue to shun investment and refuse to hire workers while the banks refuse to lend. Thus, we have the last characteristic - Characteristic 8.
Characteristic 8: Both monetary and fiscal policies can become ineffective during recessions and crises. Government must use its policies to restore people's, businesses, and bankers' optimism, faith, and confidence. Otherwise, the economy begins stagnating, and the country enters an extended recession.
For fiscal and monetary policies to be effective, they must restore faith and trust. Therefore, people will raise consumption and reduce savings raising the marginal propensity to consume and decreasing the marginal propensity to save. The faith restores the businesses wanting to invest in structures, machines, equipment, and technology, and to hire workers. The faith also restores bankers' confidence to start lending to lend to businesses and households. Then businesses begin borrowing from the banks and financial institutions while the financial markets start lending to businesses and households. As government uses the fiscal policy, the increase in government spending or fall in taxes has the appropriate effect on the economy because everyone in society has restored the Keynesian multipliers.