Boom And Bust Cycle In A Nutshell

The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.

Understanding the boom and bust cycle

Boom and bust cycles affect most areas of an economy, including sales, profits, employment rates, the housing market, government spending, and financial market performance. Since the Wall Street Crash of 1929, there have been 28 boom and bust cycles of varying intensity, frequency, and duration.

What causes boom and bust cycles?

Why do boom and bust cycles occur? In other words, why does economic growth not follow a long, steady, upwards trajectory?

The answer can be found in the monetary policy of central banks. During periods of prosperity, banks lend money to individuals and businesses at low-interest rates. This money is then invested into technology, stocks, and real estate, among many other things, with investors earning higher returns as the economy grows. 

When capital is easily available, individuals tend to overinvest. This practice is called malinvestment, where money is invested in a wasteful way. The abundance of capital also stimulates more demand, which creates a virtuous cycle of prosperity.

If demand outpaces supply, the economy can overheat. Too much capital chasing too few goods causes inflation, which then causes investors and businesses alike to try and outperform the market. Bad investments then pour into the market as investors ignore the obvious risks.

During the bust phase of the cycle, investor confidence plummets. Apprehensive of a stock market correction, they pour capital into assets such as gold, bonds, and the U.S. dollar. In a recession, discretionary spending decreases as consumers lose their jobs. The bust phase ends when prices are low enough to once again stimulate investor demand.

Phases of the boom and bust cycle

The boom and bust cycle has four phases, with each affording a more concise look at the machinations of alternating periods of growth and decline.

The four phases are:

Boom (expansion) – during the boom phase, economic growth accompanies a bull market with rising house prices, wage growth, and low unemployment. This phase can last for years if growth remains in a healthy range of 2-3%. However, if growth is above 4% for two or more consecutive quarters, the boom phase may be coming to an end.

End of boom (peak) – the point where expansion reaches a maximum value. The National Bureau of Economic Research defines this phase as the inflection point where an economy ceases to expand.

Bust (contraction) – as most can appreciate, the bust phase is brutal, short, and devastating. Bust phases last an average of 11 months and are characterized by an unemployment rate of 7% or higher and a devaluing of investments. If the contraction of the economy lasts more than 3 months, it is considered a recession. Any resultant stock market crash also causes a bear market which may last for years.

End of bust (trough) – the end of the bust phase is the point where the economy stops contracting and begins to expand.

Key takeaways:

  • The boom and bust cycle describes the alternating periods of economic growth and decline common to many capitalist economies. Since the Wall Street Crash of 1929, there have been 28 boom and bust cycles.
  • The boom and bust cycle is caused by the monetary policy of central banks, who lower interest rates and freely lend capital during periods of prosperity. Irrational and unsustainable investment behavior then causes the economy to overheat. 
  • The boom and bust cycle has four phases: boom, end of boom, bust, and end of bust. The cycle is ultimately set in motion if economic growth exceeds 4% in two or more consecutive quarters. 

Read Next: Tulip mania, Mississippi Bubble, South Sea Bubble, Stock Market Crash of 1929, Japanese Lost Decade, Dot-com Bubble, 2007-8 Global Financial Crisis.

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