The Business Cycle

Note: To find out more about the differences between the consumption business cycle and the production business cycle read my newer post The Business Cycle Revisited.

All causes, effects and basic workings behind the Business Cycle have already been outlined by the theory of Credit Expansion.

This article shall elaborate on the detailed workings during the business cycle, from start to finish, divide it into phases, and establish a checklist for each phase during the cycle.

Phase 1: The Unhampered Market

The initial phase is a market system unhampered by central bank intervention. Consumers demand consumer goods. Entrepreneurs obtain savings money from capitalists in credit transactions and buy and combine factors of production and pay workers in order to produce those consumer goods. If the factors were withdrawn from less important uses and employed in more important ones, and on top of that there is still money left after paying interest to the capitalists, the entrepreneur earns a profit. Everyone who has earned money in this transaction, workers, capitalists, and entrepreneurs will then use part of the money earned and act as consumers which brings us back to the beginning. But with part of what they earned they act as capitalists and save it up for future consumption. Thus, as a whole,  part of their labor is available to  contribute to a stock of goods that are not consumed but rather aid in the production process, factors of production, via savings and investment. The more the immediate wants are satisfied over time, the lower the people’s time preference for present goods, and thus the more will people save, and the more capital will be available which increases the future output of goods per unit of labor. The unhampered market system, as a tendency, continuously provides for a rising standard of living for everyone who is involved. The government limits its scope to protecting the individuals on the market against aggression. It funds this activity via a minimal tax. Interest rates fully reflect the market participants’ voluntary time preferences, prices reflect voluntary value preferences.


  • True GDP expands significantly
  • A continuous and slow decline of interest rates
  • A continuous and slow increase of the savings rate
  • A money supply growth of 3% or less
  • A continuous decline in the money prices of consumer goods

Phase 2: The Bank Credit Expansion

Now the central bank appears and prints additional fiat money. It goes out on the market and asks capitalists, or banks who act on the capitalists’ behalf, to sell the debt they hold at a price based on the interest payments and riskiness of the security. Capitalists won’t be interested in the exchange since they genuinely desire to hold the debt as a means of obtaining interest income. Hence the central bank needs to offer a higher price for the debt. As a result, the debt is sold at a higher price. It is sold to an institution that has not generated genuine savings but rather printed fiat money out of nothing.


  • Interest rates for the debt instrument types bought by the central bank begin falling a bit faster
  • Overall interest rates remain untouched
  • Banks accumulate excess reserves
  • True GDP keeps rising
  • The savings rate is still increasing

Phase 3: The Business Credit Expansion

The capitalists and banks whose debt has been bought by the central bank now hold cash again. They will thus loan out money again since their time preferences haven’t changed. But the entrepreneurs they previously loaned money to don’t need additional capital. Thus they will try to loan out money to others. They will try to find a borrower from whom they can expect the same interest rate as they were earning previously, or at least an interest rate that is only slightly lower. Since they realized a premium upon their previous sales of debt, they will still be able to earn more interest income per month if the interest rate for the total loan only drops marginally. Slowly the rate for loans on the broad market begins to drop. Bank profit from interest earnings begins to rise consistently. The central bank, again, buys up newly created debt from the capitalists which the capitalists, again, loan out. The activity is repeated.


  • Interest rates begin dropping faster across the board
  • Banks loan out excess reserves
  • Banks begin to report higher profits
  • The money supply growth rate accelerates beyond 3%
  • True GDP keeps rising
  • The savings rate keeps rising

Phase 4: Entrepreneurial Activity Expands

Would-be entrepreneurs, who up to now were unable to obtain loans from the capitalists, because interest rates indicated that not enough voluntary savings were available to bridge the temporary shortfall in consumption goods that comes with investment, are now under the impression that the market provides enough factors of production to complete the projects they had been planning. With the borrowed money, they will begin obtaining factors of production on the market.

Since no additional savings and thus factors of production have been added to the market, the prices for factors of production will rise slowly. The factors are withdrawn from other occupations where they were obtained for less money, but were fulfilling demands based on true market data. Salaries for employees in these new production lines will go up.

However, the overall market is not yet fully permeated by this new activity. Lots of the previous operations remain active. The overall mood is positive. The new entrepreneurs are convinced their projects will be successful. The employees withdrawn from other occupations are happy about the raise in salary. They have not begun spending this new money yet. Prices for consumer goods have not begun to rise yet so it appears as though their real income rises. Their example catches others people’s attention. They, too, begin looking for new occupations. The ensuing reduction of the supply of consumer goods will not immediately be reflected in market data. The prospect of new and better goods in the future entices the majority. The central bank keeps on buying up additional debt.


  • The ratio of entrepreneurs to workers on the market increases
  • The money supply grows more sharply
  • Interest rates bottom
  • Prices for factors of production slowly start to rise more noticeably
  • Stock prices begin to rise more sharply
  • Talk about new industries and businesses in the media increases
  • Business sentiment turns more optimistic than before

Phase 5: The Credit Acceleration

The perpetuation of the central bank’s purchases now impels capitalists to make riskier loans than before. The ability to load loans off at the central bank at a premium reduces the relevance of risk assessment. A broad market for risky loans emerges, the junk bond market. The rise in the price of factors of production is starting to become more obvious on their main market, the stock market. Especially the markets for risky loans and stocks and for loans and stocks for projects that yield output in the farther future will suddenly appear much more lucrative to capitalists.

Entrepreneurs believe that the goods to be produced in these projects will meet a demand and that enough basic consumption goods are available at a low enough price to justify expenditures for the new future products. Profit expectations of the new enterprises appear reasonable.  As a result stock prices continue to rise. More capitalists will enter this market and realize gains. Established businesses will also begin changing their strategy and embark upon riskier and longer term projects.

It is not possible to determine from the outset which projects will be boosted more than others. If the government, for example, encourages home ownership via corresponding legislation and pushes home loans by itself, and if the central bank buys mortgage backed securities, it is rather likely that lending for the purpose of home ownership will increase and a housing bubble will ensue. But it is important to understand that such a housing bubble would only be one part of an overall reallocation of resources.

New would-be capitalists appearing on the market, who would usually have saved money and thus generated capital by abstaining from consumption no longer see their time preference reflected in the lower interest rates. Instead they will be compelled to buy stocks or houses as a means of wealth generation which at this point appears far more lucrative than loaning out money for less risky and shorter term projects. In addition they will be impelled to consume part of what they would have usually saved. Capital consumption as outlined in Savings and Investment ensues.

The number of resources withdrawn from the production of current basic consumer goods increases. Their employment in long term and risky projects increases. Meanwhile the true availability of savings has decreased. Production of basic consumer goods is neglected more and more as a result.

The additional money loaned and spent in salaries now visibly hits the market for consumer goods. The recipients of the money don’t save as much as the low interest rates indicated. And of the money they do save, part is diverted to risky or long term stocks. Due to higher consumption and less production, prices for basic consumer goods begin to rise slowly. The central bank begins to slow down its purchases of debt.

The entrepreneurs have gotten used to the easy access to credit. The overall sentiment will still be positive toward debt. Entrepreneurs will demand new credit once some of the initial loans are paid off. The lack of additional debt purchases from the central bank, coupled with the ever more prevalent shortage of savings will now cause interest rates to rise. Entrepreneurs will borrow money for more risky and longer term projects.


  • The junk bond market becomes more popular
  • Loans are being repackaged and sold at premiums
  • Profit expectations are revised higher
  • The savings rate peaks
  • The stock market soars
  • The money supply growth rate peaks
  • Interest rates rise
  • Prices of factors of production increase sharply
  • Prices for consumer goods begin rising slowly
  • True GDP peaks

Phase 6: The Credit Boom

Overall sentiment is very positive toward the projects that have been embarked upon. Factors of production are still priced based on the initial earnings expectations, meaning the expectation that their output would meet an expected demand. But the rise in consumer prices is no longer negligible. The raise in salaries is more and more put into relation with prices for consumer goods. Credit transactions will now take into consideration a significantly lower level of purchasing power, adding a premium to the interest. Interest rates begin rising more sharply. The rise of the prices of factors of production impels people to obtain them solely for the purpose of realizing a price gain and as a hedge against rising prices. Stock prices soar at an unusually high pace. Consumer prices rise more sharply. The central bank halts the credit expansion.


  • A euphoria emerges on the stock market, stock prices skyrocket
  • The money supply growth continues declining
  • Consumer prices rise more sharply
  • Interest rates rise further
  • The savings rate declines sharply
  • Stock prices peak
  • True GDP falls

Phase 7: The Credit Peak

Interest rates for loans keep rising sharply. The prices for factors of production increase which drives up cost for the new operations. The products they might at this point be launching are not the highest priority for the consumers. Due to a lack of immediate consumption products vis a vis  consumer demand, the prices for other consumer products begin rising sharply. Thus consumers need to cut back on extra consumption and confine their expenditures to basic consumer goods which are now more expensive. Thus revenue for the new operations falls. Rising prices and falling revenue will affect the profit of these operations. They will start to have problems paying interest to the capitalists and banks.

One by one, new businesses that produce less basic and more extra goods will begin defaulting on their loans and revise their earnings expectations down. First the riskiest ones, then the less risky ones. The capitalists will no longer extend additional credit. The market data now shows the capitalists and entrepreneurs what the true value and time preferences of the consumers are. Stock prices begin to fall, consumers refuse to change their consumption behavior while prices for basic consumer goods and commodities soar.

Resources need to be released from their current occupations. Since people will not immediately find new occupations, a rise in unemployment ensues.


  • Stock prices decline
  • Interest rates peak
  • Consumers complain about high prices for basic goods, such as gasoline or food
  • Business defaults increase
  • Commodity prices soar
  • Business sentiment turns less positive
  • The money supply growth keeps slowing down
  • Unemployment increases
  • True GDP continues to fall

Phase 8: The Credit Crunch

A general realization that the consumption demands were not in line with the actual amount of basic consumer goods available ensues. People will first of all begin consuming less, especially those who have been temporarily released from their occupation. Now the prices of consumer goods will reverse their gains begin falling sharply as well. The same realization reaches those people who are still occupied in more useful lines of production.

They will consume less and save more. More savings will be available. At the same time, as entrepreneurs still one by one liquidate their current failed operations, no additional credit is demanded. Existing loans are paid off or foreclosed upon. Businesses and consumers now rather want to consolidate their finances and save money so as to make available more productive factors for the production of basic consumption goods to get back to the level before the credit expansion began. A lot of money will initially be parked in very low risk debt securities, such as Treasuries. Their interest rates will begin falling first. Other debt securities will follow. The recipients of the money prefer to hold the cash until they are able to identify entrepreneurs who plan to produce more basic goods. Cash gains in preference to other goods.

The overall sentiment turns negative. Profit expectations are again revised down by the capitalists. They begin selling more of their stocks, factors of production are released from their current occupation and return to prices that truly reflect their usefulness to the consumers.


  • Stock prices crash
  • Commodity and consumer prices fall
  • The savings rate increases
  • Loan foreclosures increase significantly
  • Interest rates fall
  • Business sentiment turns negative
  • The number of bankruptcies increases
  • Unemployment increases
  • True GDP continues to fall

Phase 9: The Correction

Unless the government tries to counteract the processes that lead to a correction, in particular the liquidation of unprofitable operations, or attempts to perpetuate the process of credit expansion, prices will quickly return to levels where they represent voluntary value preferences. Otherwise the correction will also occur, but it will take much longer. Individuals have cut back on their consumption in order to save up money. The increase in savings lowers the rate of interest and thus indicates to entrepreneurs that a sufficient level of productive factors is available. Entrepreneurs identify operations that are profitable and obtain funds from the capitalists. They begin employing factors of production in these operations. The market returns to the unhampered state, albeit at a level of output and a standard of living that is lower than where it was before the credit expansion was started.


  • Stock prices bottom out
  • Interest rates bottom out
  • Consumer and commodity prices rise back to a certain level and then continue their slow long term decline
  • Unemployment declines
  • True GDP begins to rise again
  • Interest rates rise back to a certain level and then continue their slow long term decline

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