Phases of the Cycle and Irish Data

What is the business cycle?

Real GDP does not grow at a steady pace. It speeds up, slows down, sometimes falls, then picks up again. This repeating pattern of fluctuations in output around its long-run trend is the business cycle.

We use real GDP because it removes the effect of price changes. Otherwise a rise in prices could look like a rise in output.

The four phases

A common rule of thumb: a recession is two or more consecutive quarters of falling real GDP. With annual data, as in the examples below, we look for a fall in real GDP from one year to the next. The slump is the bottom, where output is very low and unemployment is highest.

Reading the data: growth, unemployment and inflation

To place an economy in the cycle, calculate the growth rate and look at the other indicators.

Why does each indicator behave as it does?

• Unemployment lags. Firms do not hire again until they are sure demand is back, and they first get more output from existing workers. So unemployment often peaks after GDP has started to recover.

• Inflation falls in a downturn. Weak demand means firms cannot raise prices, wage demands fall, and fewer people compete for goods. In a deep slump prices can even fall (deflation).

• Inflation rises in a boom. Demand outruns capacity, so firms raise prices and wages are bid up.

The cycle and the government's finances

The cycle changes the government's budget even if no policy changes.

A positive balance is a budget surplus; a negative one is a budget deficit. The national debt is the stock built up by past deficits.

In a boom, incomes, profits and spending are high, so income tax, VAT and corporation tax all rise, while fewer people claim Jobseeker's Benefit. In a recession the reverse happens: tax revenue falls and spending on social welfare rises. The deficit widens automatically. These are the automatic stabilisers: they cushion the downturn by putting money into households' hands without any new decision by the government.

The national debt in euro keeps rising for as long as there is a deficit, even in the first year of recovery. The debt-to-GDP ratio is also affected by interest on old debt. The ratio only falls once nominal GDP grows faster than the debt (net of interest).

Fiscal policy is pro-cyclical if it amplifies the cycle (cutting spending or raising taxes in a slump, spending freely in a boom) and counter-cyclical if it leans against it (saving in a boom, supporting demand in a slump).

Booms, busts and Ireland's experience

Why booms turn into busts

Booms feed themselves. Rising prices make people expect more rises, so they borrow more to buy, which pushes prices up further. Banks lend freely against rising property values. This is a credit-fuelled asset bubble. A bubble bursts when borrowers cannot repay, prices fall and banks stop lending. Falling property prices leave households owing more than their homes are worth, so they cut spending and construction collapses.

To moderate a boom, the government can run a budget surplus, raise taxes or cut spending (fiscal policy), and regulators can limit lending, for example with mortgage lending rules (macroprudential policy). Interest rates are set by the ECB for the whole Eurozone, so Ireland had little control of its own rate.

The Irish cycle

The figures below are approximate and illustrative, based on CSO data.

Irish data patterns (approximate). Unemployment rose from about 4% in 2006 to a peak of about 15% in 2012 and fell below 6% by the late 2010s. The budget moved from a small surplus in 2006 to a deficit of about 32% of GDP in 2010 (a one-off figure inflated by bank rescue costs). National debt rose from under 25% of GDP in 2007 to over 100% in 2012, because of the cost of the bank rescue, large deficits and the fall in GDP.

Prices, spending and income. Inflation, which was above 4% in the mid-2000s, fell below zero in 2009 and 2010 (deflation), as the CSO's CPI showed. Government spending rose sharply in the late 2000s, and then was cut back in the austerity years of 2009 to 2013. GNI and GDP can move quite differently: GDP is distorted by multinational activity (for example, the 2015 revision raised 2015 GDP growth to over 25%), so GNI shows a smoother and more realistic cycle in Irish residents' income.

How to read a data series. Check the units and whether figures are real or nominal. Look at the direction and size of changes, not just the level. Compare several indicators (growth, unemployment, prices, budget balance, debt) and remember that unemployment lags. Then name the phase and justify it with at least two indicators.

Causes of the downturn. Domestic: the property and credit bubble, overreliance on construction and on tax revenue from property transactions, and weak regulation of banks. International: the global financial crisis and the Great Recession from 2007, which cut demand for Irish exports and made foreign funding for Irish banks dry up.

Why GDP can mislead. Large multinational companies book profits and intellectual property in Ireland, which inflates GDP. Much of that income belongs to foreign owners and leaves the country. GNI\* removes these distortions (such as the profits of redomiciled companies and depreciation on foreign-owned intellectual property and leased aircraft), so it gives a better picture of income that actually belongs to Irish residents.

Was fiscal policy pro-cyclical in the boom? Many economists argue yes. Tax revenue was unusually high because of the property boom, and the government cut taxes and raised spending as if this were permanent. When the bubble burst, revenue collapsed, and the government had to cut spending and raise taxes in the slump, which deepened it. The lesson is to save windfall revenue in a boom, and to build a fiscal buffer, which is part of the reason for the Irish Fiscal Advisory Council and the European fiscal rules.

A small open economy

Ireland exports a very large share of what it produces and relies on foreign direct investment (FDI). That makes its cycle more exposed to what happens abroad.

• Transmission of a foreign downturn. If the UK, the US or the Eurozone go into recession, demand for Irish exports falls (injections fall). Firms cut output and jobs, incomes fall, and consumer spending falls too. Multinationals may also reduce investment.

• A smaller multiplier. The multiplier is $k = \frac{1}{\text{MPS} + \text{MPT} + \text{MPM}}$. In an open economy a large share of each extra euro goes on imports (high MPM), so less is re-spent at home and the multiplier is small. For example, with MPS 0.1, MPT 0.2 and MPM 0.3, $k = \frac{1}{0.6} = 1.67$, compared with $\frac{1}{\text{MPS} + \text{MPT}} = \frac{1}{0.3} = 3.33$ in a closed economy with no imports (if there were no taxes either, $k = \frac{1}{\text{MPS}} = 10$).

• Policy options in a slump. Expansionary fiscal policy (more spending or tax cuts) boosts demand, but a high MPM leaks the stimulus abroad, and debt and EU fiscal rules limit how much can be borrowed. Monetary policy is set by the ECB for the whole Eurozone, so it may not suit Ireland's situation. Supply-side policies (training, infrastructure, attracting investment) help over the longer run but do not lift demand quickly.

• Different timing and severity. Ireland's cycle can differ from larger economies because of its dependence on a few sectors (construction, multinationals), its exposure to trading partners, the fact that it cannot set its own interest rate, and distortions in GDP data from multinational activity.

Summary

• The business cycle is the repeating fluctuation of real GDP around its long-run trend. Its phases are boom, recession, slump and recovery.

• Growth rate = (change in real GDP ÷ earlier GDP) × 100. A recession means two or more consecutive quarters of falling real GDP.

• Unemployment lags output; inflation is highest in a boom and falls (or turns negative) in a downturn.

• Budget balance = tax revenue − government spending. In a recession, automatic stabilisers widen the deficit; debt is the accumulated stock of deficits.

• Fiscal policy is pro-cyclical if it amplifies the cycle and counter-cyclical if it offsets it. Ireland's boom, bust (2008 to 2012) and recovery (from about 2013) show the risks of credit-fuelled bubbles and a reliance on property taxes.

• In a small open economy, a foreign downturn spreads quickly, the multiplier is smaller because of a high MPM, and GNI\* is a better measure than GDP.

Key terms: business cycle, boom, recession, slump, recovery, trend, real GDP, budget deficit, budget surplus, national debt, automatic stabilisers, pro-cyclical, counter-cyclical, asset bubble, GNI\*, multiplier, marginal propensity to import.