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Understanding Economic & Business cycles

An economic cycle is the general state of the economy as it goes through normal 4 stages in a cyclical pattern. The four stages of the cycle are (1) expansion, (2) peak, (3) contraction, and (4) trough. Factors such as GDP, interest rates, total employment, and consumer spending, can help determine the current stage of the economic cycle.

Insight into economic cycles can be very useful for businesses and investors.

An economic cycle, which is also known as a business cycle, is the circular movement of an economy as it moves from expansion to contraction and back again. Economic expansion is characterized by growth. A contraction, on the other hand, sees it go through a recession, which involves a decline in economic activity that spreads out over at least a few months.

In today’s world, virtually every economy is a market-based economy in which the laws of supply and demand determine prices.

Supply and demand pressures influence the economy through different variables, such as global economic conditions, trade balances, productivity, inflation rates, interest rates, and exchange rates. The variables, in aggregate, shape the economy and the state of the economic cycle.

The economic cycle is a trend of upward and downward movements of GDP that ultimately determines the overall long-term growth of an economy.

GDP measures the aggregate value of goods and services and is used to depict the overall wealth of an economy. Higher GDP usually correlates with more well-off citizens.

1. Expansion: During expansion, the economy experiences relatively rapid growth, interest rates tend to be low, production increases, and inflationary pressures build.

2. Peak: The peak of a cycle is reached when growth hits its maximum rate. Peak growth typically creates some imbalances in the economy that need to be corrected.

3. Contraction: A correction occurs through a period of contraction when growth slows, employment falls, and prices stagnate.

4. Trough: The trough of the cycle is reached when the economy hits a low point and growth begins to recover.

The recovery phase may sometimes be referred to by some as a 5th stage.

Importance & relevance of the Economic Cycles

Every person is a participant in the market-based economy. The defining factor of the success of a market-based economy is that it essentially makes everyone better off by producing and consuming more goods & services over the time frame. The GDP of any country’s economy captures the increased production and consumption levels, and a growing GDP is an important aspect of a successful economy.

Given that everyone is a participant in their county’s overall economy, it makes sense that everyone is impacted by the state of the economic cycle. It is usually in everyone’s best interest for the economy to be in an expansion phase to accumulate more wealth.

Impact of Economic Phases

When the economy is in expansion, businesses normally generate more profits, which lead to hiring more employees and more disposable income and spending. It, in turn, leads to more profits for businesses, and it continues in a virtuous cycle.

When the economy is in contraction, businesses lose profits, which leads to downsizing and laying off the employees. When employees lose their jobs, there is less disposable income and less consumer spending, which leads to even lower business profits. It continues in a vicious cycle.

An economy should be in continuous expansion; however, contractions are needed to keep inflation in check and to make sure the economy does not overheat.

An overheated economy is an economy that has experienced a long period of strong economic growth but also has begun to reach high levels of inflation. Inflation that is too high leads to inefficiency and complacency within a market-based economy.

End of Cycles or period of prolonged uncertainties’?

The world's economic graph over the next few decades may resemble jagged shards of broken glass, with many tips pointing downwards.

Even though the economic world is accustomed to periodic ups and downs, most seasoned observers place their faith on a certain rhythm to this ebb & flow—namely, that corrective policy action and market forces will inevitably address the causes behind any downturn, paving the way for the next upswing. And life will go on. This cyclicality, almost akin to the seasons of nature, lies at the core of most long-term forecasting and preparation. But what if repeated assaults on the edifice of this cyclicality have brought things to a point where familiar patterns begin to disappear, making the future far more difficult to envisage with any degree of accuracy? A sense of helplessness, albeit self-induced, may begin to take root, shaking the world out of its smug complacency.

We are, in fact, at that crossroads today.

Current situation

World is also facing geopolitical tensions in Russian invasion of Ukraine and tensions in South China Sea resulting in very high energy prices & food shortages resulting in elevated level of inflation.

Currency market is also witnessing reset with Dollar strengthening with investors preferring safe heaven in the form of US Treasuring resulting in depreciating in major currencies.

Many countries are also experiencing debt crisis,

The dominance of the US (world’s largest economic machine) in global economic affairs, and its obsession with the world of finance, has led us to view all matters through the prism of money. A firm belief that there is practically nothing in the world that cannot be addressed through monetary or fiscal maneuvers, tweaking interest rates or printing money. So, for many Americans, the best example of a Black Swan event would be the Lehman Brothers collapse, almost as much as the 9/11 attack. But, as the events of the last 2 years have shown, and the severe heatwaves of this summer portend, far bigger calamities probably lie in store in the years ahead, to which there is no quick fix known to man.

This is particularly germane to the economic world, as the damage would not only show up in loss of life or livelihood in some remote part of the globe, which the western world can dismiss with some polite, insincere acknowledgment. This time it is showing up in hard, quantifiable losses running into trillions, and threatening to become even worse. Taiwan, the world’s chip factory, is a good example. Since last year, it has been witnessing the worst drought in five decades, as typhoons have all but disappeared and monsoons rare. Chip factories are water guzzlers and production has had to be curtailed severely, leading to shortages across industries. Whereas a drought in a small Asian island wouldn’t even have made for a footnote in the western media, now everyone, from California to Bengaluru, seems to be praying for rains in Taiwan.

Or take the case of China, where the government has chosen such a strict tolerance policy against Covid-19 that shutdowns have brought economic growth to a standstill. In the second quarter, GDP growth slowed to 0.4 %, and most analysts believe that too was an overstated number. More than 2 years after its onset, this is how heavy a price the pandemic continues to exact on global economic growth.

The most recent instance of alarm has been the series of continuing heatwaves sweeping across the western world. 40 degrees Celsius, mostly unheard of on the Continent, is par for the course this summer. And there is more at stake than a sweaty brow. Wheat prices are going through the roof as production plummets in Europe; olive oil prices soar as Italy grapples with its worst drought in 70 years. The Food and Agriculture Organization or FAO’s Food Prices Index has been on a tear this year, even as food inflation crossed 10 % in June in the US, and nothing that the European Central Bank or the US Federal Reserve can do will reverse it easily. The gods of the financial world seem powerless in front of the forces of nature.

Now, what if these events were not one-off aberrations, but the tip of the iceberg? Everyone in the economic universe is always in a tearing rush to proclaim the end of a crisis and ‘move on to the next phase of growth and profits, even as wiser men warn us against it. WHO is on record saying that there will be more pandemics soon, perhaps even deadlier than the present one? If this prediction, of a Covid-19-like pandemic every few years, was to come true, where would it leave prospects for global growth?

The World Meteorological Organization or WMO warns that heatwaves and forest fires will become recurring features, heavily impacting crops in years to come.

Will food inflation be tamed then, through interest rate hikes?

These days, it is not uncommon to hear people talk about the possibility of another Black Swan event in the financial markets, triggered by the recent inflation and recession concerns. But, in this milieu of climate change, how far are we from a colossal natural disaster like the 2004 Asian tsunami or the 2011 earthquake in Japan? The prospect is too painful to even contemplate, though the threat so very real.

It may suit politicians to underplay these perils, but the general public is not fooled. As populations recognize this inability of their elected governments to undo the damage and address their woes, unrest is creeping in. With inflation and cost of living issues spiraling out of control, the political instability of the likes seen in Sri Lanka or Brazil may become more widespread, further imperiling an already fraught world.

The truth is that we have pushed our planet beyond a tipping point. The future is now full of unknown unknowns, though it would be fairer to call them known unknowns as this is all our doing, and we should have seen it coming. None of this should surprise us, really.

Slowly, it is beginning to dawn upon CEOs of giant corporations, and leaders of the western world, that the planet is in a scary place. For too long, they have focused only on the benefits of growth, ignoring all the costs. Now, the chickens are coming home to roost and there is no place for them to hide.

We are used to a world where periods of expansion dwarf intermittent bouts of contraction, but could soon be simply lurching from one crisis to another, with the very notion of a regular cycle fundamentally altered. The world’s economic graph over the next few decades may not resemble the gentle undulating humps of a camel’s back inexorably sloping higher, but jagged shards of broken glass.

Many of those tips will be pointing southwards.

CA Harshad Shah, Mumbai, India

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