There’s been a lot of talk lately about how the US economy is crawling out of recession. You may have heard terms like “bottom” and “trough”, seen graphs of GDP growth, and read articles referencing NBER.

You may be highly skeptical and unwilling to believe that the latest recession is a thing of the past; after all, you likely know someone still looking for a job and you likely know someone else who recently lost a home. Or, you may be very optimistic, and knowing how the business cycle revolves, you are beginning to invest and think about growth. Understanding the business cycle will help you make better decisions — individually and in business.

Off the bat, I should state that economics is not an exact science (but you likely knew that already). And while there are a few axioms (supply/demand, money supply) and indicators (GDP, unemployment) that can help paint a realistic picture, most of what you see and read is based on analyst insight and experience, backed up with historical data and predictive models. There are faults all along the way. When you consider the complexity of the global economy, it should be clear that economics is more of an art than a science. The Business Cycle, though, seems to be something you can count on.

What is the Business Cycle?

Plainly put, the Business Cycle represents 4 phases of aggregate economic movement, ranging from periods of high growth to recession and back again. John Maynard Keynes (d. 1946) referred to these cycles as “waves of optimism and pessimism”, or to put it another way, waves of expansion and contraction. These phases were first written about more than 50 years ago by Arthur Burns in his book “Measuring Business Cycles”.

The four phases

  1. Peak - The highest point of economic output just before a downturn
  2. Recession - When the economy actually shrinks, or contracts
  3. Trough - The “bottom”
  4. Recovery - The economy has stopped shrinking is growing once more

Last 5 US Business Cycles

Peak YYYY-MM Recession Period Trough YYYY-MM Recovery Period
1980-01 6 1980-07 12
1981-07 16 1982-11 93
1990-07 8 1991-03 120
2001-03 8 2001-11 73
2007-12 ? ? ?

Data Source: NBER

Notice that peaks and troughs are represented by month and year, while the other two phases are measured over a number of months. You’ll also notice that recession and recovery periods can vary greatly.

Who determines when each phase begins and ends?

In the US, the task is managed by the National Bureau of Economic Research (NBER). NBER is a private, nonprofit, and nonpartisan research organization (stocked with Nobel Prize winning economists). They work on many economics projects and work closely with businesses and universities. They self-proclaim their dedication to promote “a greater understanding of how the economy works”.

For example, NBER most recently concluded that “the last [US economic] expansion ended in December 2007″. We know that after such expansion, according to the Business Cycle, will come a period of recession, followed by a bottom, leading to a new period of expansion.

Does everyone agree?

In short, nope. Milton Friedman, to name one prominent example, believed that the economy fluctuates rather than cycles. The new classical framework states that the economy is much more flexible than that which is implied by the business cycle framework.

There’s also an issue of market equilibrium. Having a somewhat predictable business cycle implies that the markets will be out of sync quite a lot — allowing some speculators and investors to take advantage of price differences at different phases of the cycle (this is called arbitrage, take a look into Rational Expectations Theory as well). Other differing methodologies include the credit/debt cycle, political cycles, and Marxian cycles.

Final thoughts

Even against dissenter argument and alternate viewpoints, the Business Cycle framework still works and is easily observable. Economists at NBER continue to assign dates to peaks and troughs. Individuals, businesses and organizations still base many of their purchasing and hiring decisions on what phase we’re currently in. This likely won’t change any time soon.

The only problem with relying on NBER is that they lag reality. For example, we have very likely reached the bottom of the current cycle and are now in a phase of recovery. NBER might make it official at some point this year, maybe next year. Investors waiting for official announcements will find that they’re missing the boat.