Saturday, August 27, 2005

Boom and bust

Economics is divided into two main branches: macroeconomics, and microeconomics. When you talk about the economy on a sector-specific level, then you are talking micro. For example, explaining the rising trend in oil prices is micro. If you are talking about the economy as an aggregate, then you are talking macro.

Used to be economics was entirely micro. After all if you are talking about the "allocation of scarce resources to alternative uses to satisfy human wants", then your approach is going to be highly sector-specific.

However what if all those sectors seem to move in the same direction? For example, suppose all the prices moved up, rather than just the price of oil? Or, suppose not just one industry contracts, but all industries put together experience a contraction? Something funny is going on that may not be amenable to micro-analysis.

So when you are talking about the business cycle, which is simply the trend in the GDP growth rate, then you are talking macro. Why would all industries put together experience growth or contraction?

Just as in micro, one may divide the causes into supply-side and demand-side. On the supply side, growth in resources (accummulation of capital, growth in the labor force, technological progress) all contribute to aggregate growth. Or some negative "shock" may strike at costs of production, of such magnitude as would appear in the aggregate figures. For example, if an economy is agriculture-dependent, then a prolonged dry spell could very well force an economic contraction.

The demand side is much trickier, and here the economic consensus is far from established. The mainstream view (which has numerous detractors, some of them Nobel prize winners) is that total demand for goods and services may also go up or down, accounting (in part) for swings in the business cycle.

The distinction is very important. In the long run, the growth of GDP depends on supply fundamentals - more resources, and more productive use of available resources (technology). So investments must flow in; the labor force must grow and become more skilled; and production technology should be constantly upgraded.

In the short run however we may experience fluctuations - episodes of boom and bust - which may have to do with short run shocks, whether on the supply side or on the demand side. None of us like instability. It's not nice to think we are soaring high this year, only to crash and burn the next. If government policy can do something about it at all, we would like economic growth to be smooth.

The challenge of economic development is twofold: first is to raise growth rate of GDP to high and sustained levels. This is the main engine for poverty reduction. Second is to avoid excessive oscillations of the business cycle. We need to get the priority straight: Growth must first have a fundamental basis in productivity. If growth is merely a figment of the business cycle, then an episode of boom will turn into a bust eventually.

Unfortunately the track record of the Philippines since the 1980s points to more of a boom-bust rather than sustained growth mode. A recent paper by Sandra Leitner (Discussion Paper 2005-10, Philippine Institute for Development Studies) classifies the cycle as follows: 1983-1989; 1989-1997; and 1997-2000. Each cycle lasts about 7 years. It seems we are still in the middle of the third one (fortunately, on the upside. But then when it's over...)

Does government policy have something to do with this cycle? After all, the "shocks" may be the underlying drivers of the economy, with government policy largely helpless in the face of these shocks. In that case, it is impossible for any administration to get the blame for a downturn; by the same token, it should not claim credit for an upturn.

This should make for leisurely reading tomorrow. See ya.

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