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Business Cycle Theory

Business Cycle from Kalecki, 1935, Econometrica

The existence of "economic crises" marked by industrial depressions is alluded to already in the works of Mercantilists, Physiocrats and even Adam Smith.  However, it is common to identify the 1825 British crisis as the first general economic crisis of importance to draw the attention of economists.  (Some also use this 1825 date to mark the beginning of modern industrial capitalism).  While the idea of crisis has been debated for some time, the idea that crises are periodic - that is, something that comes and goes and returns again with some regularity, that is, a cycle, rather than a singular incident - took longer to set in.

Among the earliest writers to try to provide an economic theory of industrial depressions are the Earl of Lauderdale, Thomas Spence and Heinrich Storch.  They depicted economic crises as a situation of general overproduction brought about by the excessive build-up of production capacity, and the failure of consumption to rise up to meet it.  .The Classical economists - notably James Mill, Jean-Baptiste Say, David Ricardo and Nassau William Senior - rejected overproduction as a theoretical impossibility, and characterized economic crises as misdirected, rather than excess, production.  The topic became somewhat urgent in the post-Napoleonic wars slump, and culminated in the "General Glut" controversy of 1819-21.  Against the classical argument, Robert Malthus, Simonde de Sismondi and Thomas Chalmers revived the overproduction theory, but a little more elaborately, explaining underconsumption via dynamic mismatches in income distribution and expenditure among social classes.  

The 1825 and 1836 crises brought money and finance into the picture for the first time.  The role of the banking system in provoking the slumps was discussed during banking controversy of the late 1830s and early 1840s, between Samuel Jones Loyd (Lord Overstone) and Thomas Tooke and their followers in Britain, and was carried over by Hans von Mangoldt in Germany, Courcelle-Seneuil in France and Amasa Walker in the United States.  These new theories explained economic crises in terms of a sudden collapse in investment spending, as a result of financial losses due to speculative bubbles and/or in facilitating excessively optimistic build up of productive capacity during periods of overlending. 

German Historicists such as K.H. Rau, W.G.F. Roscher and Lujo Brentano, backed away from monetary theories, and came up with eclectic theories, focused on specific real ratios of production proportions and distribution of consumption.  This may be called antecedent to the "German tradition" of cycle theory, focusing on inter-sectoral maladjustments (in contrast to the "English tradition" of dynamic maladjustment).

Socialist literature produced many theories of economic crises.  It is possible to distinguish between those which saw crisis as a necessary consequence arising from income distribution under capitalism (e.g. William Godwin, William Thompson, P.-J. Proudhon, Karl Rodbertus, Eugen Dühring),  and those which saw crisis as an inevitable outcome of the capitalist organization of industrial production (Sismondi, Louis Blanc, Henry George, Karl Marx, Friedrich Engels, Karl Kautsky, Brentano,  Albert Schäffle, Adolph Wagner, Wilhelm Lexis).

The idea of a periodic cycle can be found already in the 17th C. work of William Petty, who identified a seven-year cycle ("and the medium of seven years, or rather of so many years as makes up the Cycle, within which dearths and plenties make their revolution", Petty's 1662 Treaties on Taxes and Contributions p.23-24), although it was not followed up.  The identification of periodicity (initially a decennial cycle) was proposed by William Langton (1857) and John Mills (1867), who tied it to personal feelings and credit, while William Stanley Jevons.(1862, 1867) famously tied it to the real phenomena of sunspots and harvests.  But it is really to the fundamental study of Clément Juglar (1862) that business cycles and their periodicity became established as a topic of research.

The relationship between economic theory and business cycles has been a complicated one, and not always intimate. With equilibrium serving as an organizing concept of economic theory, particularly after the Marginalist Revolution of 1871, and focused on individual markets rather than the macro-economy, it offered little or no room for regular fluctuations.  For a long time the research programs proceeded along parallel tracts, with little contact with each other. Business cycle theory became the province of the French and German historical schools, and was taken up with special verve by the American Institutionalist School.  In the inter-war period, Wesley Clair Mitchell and the NBER became the pre-eminent experts on business cycle, focusing on establishing their empirical stylized facts of the cycle.

The post-WWI slump and especially the 1920 recession, however, was a watershed.  It is really only then that pure economic theorists began to try explaining business cycles.  Some (e.g. H.L. Moore) tried to account for them via existing general equilibrium theory, and a few (e.g. Frisch) relied on random shocks to drive longer fluctuations. Others transformed equilibrium theory into a new aggregative "macro-economic" theory.  In many ways, the debates after 1920 resurrected the arguments of a century earlier. The (Marshallian) Cambridge School and the Stockholm School turned to explaining crises in terms dynamic maladjustments between expectations and outcomes, facilitated by means of bank credit - echoing the earlier banking-currency school debates.  The "German tradition" of inter-sectoral maladjustment was taken up by the Kiel School (in real terms) and the Austrian School (with the contrivance of money).  Underconsumption theories were resumed by Foster and Catchings, and, most famously, John Maynard Keynes.

The Great Depression after 1929 changed things once again.  The prolonged, apparently never-ending slump discredited the assumed periodicity of the cycle.  The Keynesian Revolution fundamentally changed the research program, setting cyclical aspects aside, and focusing on the possibility of equilibrium settling permanently at underemployment.  Interest in the cyclical aspects resumed in the post-WWII period, now armed with the toolkit of Keynesian macroeconomics, to explain cyclical macro-fluctuations.

[See our accompanying surveys of Old Business Cycle Theory and Keynesian Business Cycle Theory.]



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Resources on Business Cycle Theory


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All rights reserved, Gonçalo L. Fonseca