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by Valentino Piana (2015)



1. Summary features of this phase in the business cycle
2. Typical pathways in key economic areas
3. Key events

4. Winners and losers

5. Influence on election outcomes
  6. Possible countervailing developments  
  7. Transition to the next phase  

8. Empirical examples


Summary features of this phase in the business cycle

An abrupt and deep fall in one key fragile variable quickly puts an end to the boom. Skyrocketing expectations meet reality-checks and ceilings, with widespread disappointment and negative surprises. People in the opposition having warned about the risks feel vindicated. In this case, peak is just before a recession.

A second possibility is a peak resulting from a mild GDP slowdown, which many at the time might have considered as transitory and unimportant, followed instead by a much steeper fall, which ex-post attributes the quality of peak to that period. In this case, peak is the highest GDP growth segment, after which one (or more) period(s) of deceleration come(s), before finally a true recession.

Typical pathways in key economic areas

Domestic business dynamics

Excessive and mutually inconsistent expectations about total market dynamics and their own market shares push competing firms to a wave of production capacity accumulation by investment (possibly backed by loans) which prolong and boost the booming phase. However, sales cannot live up to such expectations for long, with the resulting negative suprises - at least for some of the market agents. The cancelation of their further investment plans, together with the accumulation of unwanted inventories, possibly later sold at a discounted price, reduce domestic demand and increase supply in a market which has already a disequilibrium. If not counterbalanced, a snowballing effect follows, with rising outstanding credits towards banks and restriction to new credits.

Aggregate profits, which were very high just few months before, might become negative.

Aside this spontaneous, market-led, decentralised mechanism in the domestic real economy, a peak can also be due (independently or not) to a crash in the financial markets, on the stock exchange, in the housing market, in foreign trade, as well as be a result of policies.

More in general, a peak can alternatively or cumulatively be the result of the exhaustion of the drivers propelling growth, the decoupling of positive and negative dynamics of different macro-markets (which in the boom were aligned), the self-defeating trajectories of uneven and unsustainable development, the overcoming of critical ceilings and thresholds, the erratic insertion of an extraneous negative shock upon which development stubles.

Foreign trade

At peak, high interest rates can foster exchange rate appreciation, with foreign goods becoming cheaper and more competitive. This can well be followed by losses in market share of domestic companies, setting in motion a mechanism of falling sales, workforce and consumption.

If other countries are raising their interest rates, the transmission to domestic ones provokes a hike (the more so if the central bank is already trying to tame inflation, the trade deficit, and wage raises by high rates), stressing the agents with debt (mainly business and the state, but possibly also households), which can prompt the change in their attitudes (repayment instead of increased debt), which depress aggregate demand.

In highly open economies, crisis in major foreign partners (either in terms of GDP or in terms of currency depreciation or both) can lead to peak and recession. If meanwhile the domestic market is still expanding or booming, the contemporary fall in exports and rise in imports strongly deteriorates the trade balance, to which the policymaker can respond with a further contractionary policy.

Financial markets

Stock exhange crash, a physiologial event in such markets, is a primary reason for the peak. Banks, companies, and people having invested in shares, possibly by making loans, encounter losses and difficulties in meeting their commitments. Together with bankruptcy in key financial intermediaries, this leads to a liquidity crisis and insolvency crisis. The most exposed firms, with unsustainable investment plans, are the first to get into troubles. Backwards along the supply chains, firms are facing falling demand, longer timing of payments and liquidity constraints, with hardship impacting also soundly managed firms who carried out works and sold items to those who went down.

The crash itself is an expression of the dynamics linking profits, distributed profits, shares price-to-earning ratio, and financial investment waves. During expansion, total profits rise but profitability falls because of new investments (which require time to become profitable) and rising costs (e.g. wages during the booming phase, but also raw materials' prices). The price of shares rises and overshoots reasonable price-to-earning ratios because most purchases are disconnected from dividends but are justified by capital gains (i.e. by the expectation of the rise in price). Foreign capital can massively enter the market, in the form of portfolio investment ("hot capital"). They can quickly flow away in the opposite direction, if other financial place offer more attractive condisions, multiplying otherwise irrelevant erratic movements into a crash.

The more implausible high the price-to-earning ratios are, the more the investors will feel the fear of a downturn. What ever negative piece of news (or even without any new piece of information, as convincingly demonstrated by R. J. Shiller for the 1987 "black Monday" fall) might put in motion a contractionary dynamics (possibly helped by decision-making routines, such as stop-losses thresholds).

Similarly, currency crisis are the result of compound effects of real and financial issues, e.g. with speculators playing against a state where foreign reserves at the central bank considered not high enough. The fall in currencies of countries (conidered similars by the investors' eyes and routines) can provoke a domino effect, by spreading the fall across economic areas ("contagion"), often neglecting substantial differences among the involved countries. The policymaker response to foreing pressure to devaluate is at first to resist (e.g. by raising the interest rates and approving reforms considered positively by the foreign investors), then if a large scale devaluation still takes place, the fears of inflation often lead towards choosing a restrictive package of wage freeze, public expenditure cuts and other measures. The only good news then is a much lower interest rate than during resistance. The economy usually does not escape recession.

Price level and real interest rates

A spike in interest rates, be it the autonomous result of the attempt of banks to absorb a rising share of the high profits enjoyed by firms during the boom or be it a central bank policy, justified as "taming" an "overheated" economy, inflation, trade deficit, is conducive to put an end to the boom.

At peak, inflation is usually a worry for the central bank, not necessariliy because of actual figures: it's enough a hyper-sensitivity to the issue at her board. In other cases, inflation is indeed very dangerous and many social groups hurt by it are loudly asking for anti-inflationary action.

Labour market

Employment may continue to rise even during the peak, as lagging behind investment and GDP dynamics. However, in recession it will stop rising.

Public finance

The public sector is usually not at the forefront of the crisis, so its dynamics continue to enjoy the positive development of the boom until firms and banks in danger do not ask for an injection of cash from the state to remain afloat. Even governments that had sweared there was no money to help (the poor, the unemployed, the environment, etc.) are quickly compelled to push billions to save their friends in the boards, generaring huge deficits that taxpayers, the social groups without the benefit of fiscal heavens, will have to painfully repay.

Key events

The bubble burst for its internal logics, with the timing possibly but not necessarily influenced by unrelated events that shake the confidence in the country. Terrorist attacks, war menaces, assassination of presidents, scandals surronding ministrers and other key policital figures, could make the case.

Winners and losers

Labour was getting higher wages and power during the boom, raising fears in the business community and its political allies. They may act to stop the boom and rein in the balance of power. So they calculate to invert it, thanks to a temporary recession that woud push labour back in line.

Their bet, however, can well turn against many in the business communities, since a crash hits hard the less experienced financial operators and in a chain reaction many more investors.

Influence on election outcomes

A difference of few weeks can provide the ground for largely different outcome in elections where the economy were at the centre of voters' information and decisionmaking (which is not always the case!).

Elections in the peak tend to favour the government if the need for stable leadership is in the forefront and the crisis can be attributed to external pressure. A nationalistic tone can play well in this case. By contrast, later elections in which the government seemed incapable of tackling the crisis would most likely see the prevalence of the opposition.

Possible countervailing developments

A stock exchange crash does not always lead to economic recession: if extremely expansionary monetary and fiscal policy are timely adopted and the chain of bankruptcies is interrupted early enough, the shock can be absorbed and a golden autumn is given to the previous expansion or boom.

Transition to the next phase

A peak is followed by recession or, in the second case we mentioned in the introduction, by a GDP slowdown that later on morphs into recession.

Empirical examples

USA 2007: the high expansion of the previous years, coupled with extremely high growth in China, pushed up the international price of oil and other commodities (including food). This hurts especially the social groups for which food, gasoline and other such commodities constitute large shares in expenditure. This includes US minorities and lower-middle class to which subsidised loans had convinced to buy a new house (possibly for the first time). In difficulty to pay back such sub-prime loans, whose interest rates were rising as well, they began to lose ownership and put an end to the extraordinary boom in housing prices.

Packed in sophisticated financial products, overly-optimistically rated AAA by rating agencies, such credits became outstanding, leading to losses and bankruptcy in major financial institutions (Bear Stearns, Freddie Mac, Fannie Mae, AIG, Merril Lynch and Lehman Brothers), whose bad fortunes catalysed the stock exhange crash in 2008. In addition to such line of development linking expansion to crash, a lot of other self-propelling autonoumous dynamics are present on each macro-market involved. Together taken, 2004 was the year of the highest GDP growth of the following decade (the peak in the second meaning of the word), whereas 2007 was the last year before the recession. The stock exchange index which hit its all-time high on October 9, 2007, has fallen more than 50% in less than 18 months.

Barbados 2001: after growing by 2.2 in 2000, the economy contracts by 2.5% in 2001. The main reason is the collapse of tourism, which accounts for about the 15% of GDP, following the September terrorist attacks in New York. At the same time, sugar production declines by 14% because of a draught. A slightly higher inflation is due to oil prices dynamics and to a relatively expansionary fiscal policy, whereas unemployment is increasing above 10%. The government wins the elections, with people attributing the crisis to external forces and appreciating the fiscal expansion (including subsidies to hotels, confirmation of employment levels in the public sector) and the sacrifice example of the prime minister (who freezes his own wage).

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