Sunday, March 11, 2007

Why the Economy is Less Cyclical

While I believe there is a high probability of another U.S. recession soon, and while this one is likely to be more severe than the ones of 1990-91 and 2000-01, it nevertheless remains a fact that business cycle fluctuations have become less intense. In some other countries, the pattern is even more clear, with countries like Britain, Australia and Sweden not experiencing a full blown recession since the early 1990s.

The interpretation statists would make is that monetary policy has become more skillfull in managing the economy and that monetary policy now finally "works" in stabilizing the economy. I, on the other hand, have argued that the fact that the recession in America 2000-01 was very mild and in Britain, Australia and Sweden completely non-existent reflects that problems have been postponed, not avoided.

I still believe that. However, there is also a strong case that structural changes in the economy have made the economy less cyclical, and that monetary policy mistakes that in the past would have created a recession will now only produce a slowdown because of these changes.

Carl Steidtmann of Deloitte has written an interesting article where he argues that three structural changes in the U.S. economy (changes which is even more pronounced in Britain, Sweden and Australia) have made it less cyclical.

First, non-cyclical sectors constitute a much higher proportion of the economy than in the past. Second, more effective inventory management have reduced inventory levels and thus made swings in inventory levels much smaller than in the past. Third, increased level of foreign trade ensures that foreigners take a much higher proportion of the fall-out in case of slowing demand. And when governments inflates, the influx of cheap goods from China and elsewhere ensures that consumer prices don't increase as much as in the past, thus enabling government to inflate the money supply without having to revers it quickly as consumer price inflation gets out of hand.

This doesn't imply that government monetary policy has become more successfull. Just that the economy is now less vulnerable to its distortions.


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