The Business Cycle, Why It’s Important

The Business Cycle. It has four stages. They Include:

  1. Recession
  2. Trough
  3. Expansion
  4. Peak

The four stages of the business cycle helps companies, organizations, government and investors determine how to allocate capital. This is because the stage of the Business Cycle helps determine which Industries, companies and investments may outperform others. This is useful not only from an individual perspective but also from an organizational management perspective. The stage the Business Cycle is in helps Investors determine what types of investments to make.

Recession: This is when imbalances that build up in the economy over a period of time during an expansion cause economic activity to fall. For Example: the bubble in housing dramatically inflated the value of residential real estate. When the value or prices of homes could no longer be justified the prices of those homes fell. This created an imbalance between the price the buyer paid for the home, the amount the buyer borrowed to buy the home and the market value of the home. Homes became worth less than the value of the loans homeowners had borrowed to buy them. The imbalance created a situation where homeowners owed more on their mortgages than their homes were worth. When the price of the home dropped this caused the value of homes in the surrounding neighborhood to fall. The financial system froze when homeowners could not make their mortgage payments and the financial institutions that had made the mortgage loans could not absorb the losses. The problem was magnified by the fact that the mortgage loans were turned into securities that could be bought and sold backed by the promise homeowners would make their payments. So those companies and organizations that had bought the securitized mortgages loans also lost money.  Because this happened on such a large scale the normal means of making money available for use stopped functioning.

A recession can occur from less dramatic imbalances. The less dramatic the imbalance the less severe the recession. More severe recessions can become a depression.

Trough: This is the stage where the fall in economic activity that occurs during a recession bottoms or is at it’s most severe.  In the case of the Financial Crises the financial markets seized like a motor without oil when credit became unavailable to both companies and consumers. The value of the stock market fell dramatically and jobs were lost.

Expansion: After the economy bottoms economic activity usually picks up. This happens because those with money to invest see an opportunity to achieve a good return since the assets they want to invest in are low in price. So as the investment occurs economic activity increases.  Inflation and Gross Domestic Product start to rise during this period as the demand for goods and services rise.

In 2009 when real estate, the markets and job losses had gone into a free fall the government stepped in to make the investment required to break the recession. The government made loans to banks, financial institutions and other important companies such GM and Chrysler through the Troubled Asset Relief Program known as TARP.

Usually companies and private investors make this type of capital available. The Federal Reserve lowers Interest Rates to incent Private Investment. In the most recent case the Government stepped in as a Last Resort because Private Capital was not available. Banks usually provide this capital in the form of credit. But since the Banks had lost so much of their value they were both unable and unwilling to loan money to fuel investment.

We are currently in the Expansion Phase. However, Because of the Severity of the Damage done to the Economy created by Falling Asset Prices such Real Estate and Securities the degree to which the Economy has been recovering has been Much Slower than in Previous Expansions.

Peak: During the Top or Apex of an Expansion Economic Activity is at its most robust.  Unemployment is usually low and the Federal Reserve may have to raise Interest Rates to prevent to much activity from creating to much Inflation. Gross Domestic Product the sum of all Goods and Services Bought and Sold is also at its highest. Ultimately, the excesses which occur during the Peak create New Imbalances. This leads to a new Recession and the Business Cycle begins again.

The Investment Advisor – Helping Individuals, Families, Companies and Non-Profit Organizations in Pennsylvania