Saturday, March 28, 2015

Keynes On The Trade Cycle

Brad DeLong provides us with a description of the trade cycle (or business cycle) that is provided in Chapter 22 of the General Theory.  He then condenses it into a small number of bullet points.  Its pretty clear that the level of business investment, which is dependent upon the expected return on investment, is the critical factor in his theory.  Interest rates, and the relative scarcity of capital, play a role in the business cycle but they are less important than the expected return on new capital.  Downturns in the business cycle are steeper than recoveries because business pessimism and business optimism have different cycles.  Keynes, of course, was concerned with problem of overcoming pessimism and restoring optimism about the return on new capital.   The Great Depression was a case in point.  Business pessimism became self reinforcing during the Depression and Keynes looked to government investment as a means to reverse the business cycle.

When I look at the US economy today it seems different to me than it might have been in the 1930's.  We have deindustrialized and have become a services economy.  Healthcare services represent 17% of GDP and educational services are also major component of GDP.  Most of our households include two wage earners.  That has stimulated demand for daycare services and other services that satisfy the needs of two wage earner families. Financial services are also a larger part of the economy.  I could go on but my point is that the services industries are not as capital intensive as the industries that they have replaced.  Business investment, and the US business cycle, used to be heavily dependent upon the automobile sales cycle.  When Detroit had a good year the economy had a good year.  That is less true today.  A good share of the parts and finished products are produced elsewhere.  Buick sells more cars in China than it does in the US but the capital investment required to service that market does not occur in the US.  It makes sense for Buick to invest in China because the automobile market in China is now larger than the US market.  Capital investment will usually flow in the direction of the market.  The market for tradable products has become global and so has capital investment.

The real estate market is a capital intensive market and the investment required to satisfy the demand for real estate is local.  It is also an interest rate sensitive market since most of the development is financed with mortgages.  If we look at the business cycle in the US it is highly correlated with the availability and cost of mortgage finance.  The Fed has been able to use interest rates to expand and contract the huge real estate market and the US economy which is heavily dependent upon real estate investment.  It also eased regulations so that mortgage securitization enabled more credit to flow into the real estate market and expand access to mortgage finance by less credit worthy consumers.  To a large extent, capital investment in the US and the business cycle has been influenced by real estate investment and by monetary policy.  It is not surprising that the collapse of the real estate market, along with the debt hangover, has played such a huge role in the US business cycle. 

Given the changes in the US economy, and the globalization of capital investment, the US business cycle is more complex than it might have been when the economy was more capital intensive and most on the capital investment was domestic.  It may have become more dependent upon the flow of business activity that is triggered by new business ventures.

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