Pakistan Economy in the light of Business Cycles- 2009-14 Muhammad Arif Editor At Large The Financial Daily Former Head of fscd state Bank

Proceedings of 1st International Conference on Global Sustainable Development (1st ICGSD-2013), held on 27-28, February, 2013

Pakistan Economy in the light of Business Cycles- 2009-14

Muhammad Arif

Editor At Large The Financial Daily

Former Head of FSCD State Bank, Head of Research in Arif Habib Investments and professor on Finance in different Universities including KASBIT

Abstract

The paper in hand has two parts. First one is on defining Business cycles. The term business cycle (or economic cycle) refers to economy-wide fluctuations in production, trade and economic activity in general over several months or years in an economy organized on free-enterprise principles These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession).

The second part is the actual crux of the paper and by applying concept of Business cycles case of Pakistan has been analyzed with implications on significant macro indicators in the current and oncoming years i.e. 2013 and 2014

Than with concluding remarks some solutions and projections on FY 2013-2014 have been provided

Key Words: Business Cycles, Pakistan economy, Macro indicators

BACKGROUND

With globalization the economic activities are interconnected and booms and dips effect every part of the worlds with less or higher magnitude. Since 1930’s recession the world has faced five recessions. Four short terms and one that started in 2008 have extended up to 2013. To understand the problem one has to understand the basics of the Kitchen inventory cycle of 3–5 years (after Joseph Kitchen),the Jugular fixed investment cycle of 7–11 years (often identified as 'the' business cycle),the Kuznets infrastructural investment cycle of 15–25 years (after Simon Kuznets also called building cycle]),The Kondratiev wave or long technological cycle of 45–60 years (after Nikolai Kondratiev).

With their understanding one can evaluate the present situation and can plan for the future

Rationale for the Research

It deals with understanding Business cycles dynamics i.e. better to understand the coming possible implications on macro indicators like countries as Pakistan

Statement

To gauge economic indicators on the basis of Business cycles concepts

SIGNIFICANCE OF THE STUDY

It is very important as it focuses on finding reasons for surge and dips in the economy like Pakistan

HYPOTHESIS

Either Jugular fixed investment cycle is better for the projection of Pakistan Economy (based on 5 business cycles)?

METHODS AND PROCEDURES

Basically going through qualitative analysis and not using quantitative methods that provide only benchmarks. In this paper historical data has been used to predict about FY 2013-14

Primary source

Primary source of data has been World Bank and SBP data on Pakistan and on world

Secondary Source

Secondary source has been used for defining Business cycles for which references have been given at the end

THE DELIMITATION

This study has certain limitations as it can not be 100% true in case of longer term projections but nothing has been developed as yet that can provide 100% long term projections. Only it can provides direction.

Introduction

The term business cycle (or economic cycle) refers to economy-wide fluctuations in production, trade and economic activity in general over several months or years in an economy organized on free-enterprise principles These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession).

Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite being termed cycles, these fluctuations in economic activity do not follow a mechanical or predictable periodic pattern.

The first systematic exposition of periodic economic crises, in opposition to the existing theory of economic equilibrium, was the 1819 Nouveaux Principes d'économie politique by Jean Charles Léonard de Sismondi. Prior to that point classical economics had either denied the existence of business cycles, blamed them on external factors, notably war,or only studied the long term. Sismondi found vindication in the Panic of 1825, which was the first unarguably international economic crisis, occurring in peacetime. Sismondi and his contemporary Robert Owen, who expressed similar but less systematic thoughts in 1817 Report to the Committee of the Association for the Relief of the Manufacturing Poor, both identified the cause of economic cycles as overproduction and under consumption, caused in particular by wealth inequality. They advocated government intervention and socialism, respectively, as the solution. This work did not generate interest among classical economists, though under consumption theory developed as a heterodox branch in economics until being systematized in Keynesian economics in the 1930s.

Sismondi's theory of periodic crises was developed into a theory of alternating cycles by Charles Dunoyer, and similar theories, showing signs of influence by Sismondi, were developed by Johann Karl Rodbertus. Periodic crises in capitalism formed the basis of the theory of Karl Marx, who further claimed that these crises were increasing in severity and, on the basis of which, he predicted a communist revolution. He devoted hundreds of pages of Das Kapital (1867) to crises. In Progress and Poverty (1879), Henry George focused on land's role in crises – particularly land speculation – and proposed a single tax on land as a solution.

In 1860, French economist Clement Jugular identified the presence of economic cycles 8 to 11 years long, although he was cautious not to claim any rigid regularity. Later, Austrian economist Joseph Schumpeter argued that a Jugular cycle has four stages: (i) expansion (increase in production and prices, low interests rates); (ii) crisis (stock exchanges crash and multiple bankruptcies of firms occur); (iii) recession (drops in prices and in output, high interests rates); (iv) recovery (stocks recover because of the fall in prices and incomes). In this model, recovery and prosperity are associated with increases in productivity, consumer confidence, aggregate demand, and prices.

In the mid-20th century, Schumpeter and others proposed a typology of business cycles according to their periodicity, so that a number of particular cycles were named after their discoverers or proposers:

• 
  the Kitchin inventory cycle of 3–5 years (after Joseph Kitchin);
  
• 
  the Jugular fixed investment cycle of 7–11 years (often identified as 'the' business cycle);
  
• 
  the Kuznets infrastructural investment cycle of 15–25 years (after Simon Kuznets also called building cycle]);
  
• 
  The Kondratiev wave or long technological cycle of 45–60 years (after Nikolai Kondratiev).
  

There were frequent crises in Europe and America in the 19th and first half of the 20th century, specifically the period 1815–1939. This period started from the end of the Napoleonic wars in 1815, which was immediately followed by the Post-Napoleonic depression in the United Kingdom (1815–30), and culminated in the Great Depression of 1929–39, which led into World War II.. The first of these crises not associated with a war was the Panic of 1825

Business cycles in OECD countries after World War II were generally more restrained than the earlier business cycles. This was particularly true during the Golden Age of Capitalism (1945/50–1970s), and the period 1945–2008 did not experience a global downturn until the Late-2000s recession. Economic stabilization policy using fiscal policy and monetary policy appeared to have dampened the worst excesses of business cycles, and automatic stabilization due to the aspects of the government's budget also helped mitigate the cycle even without conscious action by policy-makers

In this period the economic cycle – at least the problem of depressions – was twice declared dead. The first declaration was in the late 1960s, when the Phillips curve was seen as being able to steer the economy. However, this was followed by stagflation in the 1970s, which discredited the theory. The second declaration was in the early 2000s, following the stability and growth in the 1980s and 1990s in what came to be known as The Great Moderation. Notably, in 2003, Robert Lucas, in his presidential address to the American Economic Association, declared that the "central problem of depression-prevention [has] been solved, for all practical purposes."^[11] Unfortunately, this was followed by the 2008–2012 global recession.

Various regions have experienced prolonged depressions, most dramatically the economic crisis in former Eastern Bloc countries following the end of the Soviet Union in 1991. For several of these countries the period 1989–2010 has been an ongoing depression, with real income still lower than in 1989. This has been attributed not to a cyclical pattern, but to a mismanaged transition from command economies to market economies.

High business profits do not necessarily lead to increased economic growth. When businesses and banks have disincentive to spend accumulated capital, such as cash repatriation taxes from profits in overseas tax havens and interest on excess reserves paid to banks, increased profits can lead to decreasing growth.

In 1946, economists Arthur F. Burns and Wesley C. Mitchell provided the now standard definition of business cycles in their book Measuring Business Cycles

Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of the next cycle; in duration, business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar characteristics with amplitudes approximating their own.

Within mainstream economics, the debate over external (exogenous) versus internal (endogenous) being the causes of the economic cycles, with the classical school (now neo-classical) arguing for exogenous causes and the under consumptionist (now Keynesian) school arguing for endogenous causes. These may also broadly be classed as "supply-side" and "demand-side" explanations: supply-side explanations may be styled, following Say's law, as arguing that "supply creates its own demand", while demand-side explanations argue that effective demand may fall short of supply, yielding a recession or depression.

This debate has important policy consequences: proponents of exogenous causes of crises such as neoclassical largely argue for minimal government policy or regulation (laissez faire), as absent these external shocks, the market functions, while proponents of endogenous causes of crises such as Keynesians largely argue for larger government policy and regulation, as absent regulation, the market will move from crisis to crisis. This division is not absolute – some classical (including Say) argued for government policy to mitigate the damage of economic cycles, despite believing in external causes, while Austrian School economists argue against government involvement as only worsening crises, despite believing in internal causes.

The view of the economic cycle as caused exogenously dates to Say's law, and much debate on endogeneity or exogeneity of causes of the economic cycle is framed in terms of refuting or supporting Say's law; this is also referred to as the "general glut" debate.

Until the Keynesian revolution in mainstream economics in the wake of the Great Depression, classical and neoclassical explanations (exogenous causes) were the mainstream explanation of economic cycles; following the Keynesian revolution, neoclassical macroeconomics was largely rejected. There has been some resurgence of neoclassical approaches in the form of real business cycle (RBC) theory. The debate between Keynesians and neo-classical advocates was reawakened following the recession of 2007.

Mainstream economists working in the neoclassical tradition, as opposed to the Keynesian tradition, have usually viewed the departures of the harmonic working of the market economy as due to exogenous influences, such as the State or its regulations, labor unions, business monopolies, or shocks due to technology or natural causes.

Contrarily, in the heterodox tradition of Jean Charles Léonard de Sismondi, Clement Juglar, and Marx the recurrent upturns and downturns of the market system are an endogenous characteristic of it.

The 19th century school of Under consumptionism also posited endogenous causes for the business cycle, notably the paradox of thrift, and today this previously heterodox school has entered the mainstream in the form of Keynesian economics via the Keynesian revolution.

One alternative theory is that the primary cause of economic cycles is due to the credit cycle: the net expansion of credit (increase in private credit, equivalently debt, as a percentage of GDP) yields economic expansions, while the net contraction causes recessions, and if it persists, depressions. In particular, the bursting of speculative bubbles is seen as the proximate cause of depressions, and this theory places finance and banks at the center of the business cycle.

A primary theory in this vein is the debt deflation theory of Irving Fisher, which he proposed to explain the Great Depression. A more recent complementary theory is the Financial Instability Hypothesis of Hyman Minsky, and the credit theory of economic cycles is often associated with Post-Keynesian economics such as Steve Keen.

Post-Keynesian economist Hyman Minsky has proposed an explanation of cycles founded on fluctuations in credit, interest rates and financial frailty, called the Financial Instability Hypothesis. In an expansion period, interest rates are low and companies easily borrow money from banks to invest. Banks are not reluctant to grant them loans, because expanding economic activity allows business increasing cash flows and therefore they will be able to easily pay back the loans. This process leads to firms becoming excessively indebted, so that they stop investing, and the economy goes into recession.

While credit causes have not been a primary theory of the economic cycle within the mainstream, they have gained occasional mention, such as (Eckstein & Sinai 1986), cited approvingly by (Summers 1986).

Within mainstream economics, Keynesian views have been challenged by real business cycle models in which fluctuations are due to technology shocks. This theory is most associated with Finn E. Kydland and Edward C. Prescott, and more generally the Chicago school of economics (freshwater economics). They consider that economic crisis and fluctuations cannot stem from a monetary shock, only from an external shock, such as an innovation.

There were great increases in productivity, industrial production and real per capita product throughout period from 1870 to 1890 that included the Long Depression and two other recessions. There were also significant increases in productivity in the years leading up to the Great Depression. Both the Long and Great Depressions were characterized by overcapacity and market saturation.

Over the period since the Industrial Revolution, technological progress has had a much larger effect on the economy than any fluctuations in credit or debt, the primary exception being the Great Depression, which caused a multi-year steep economic decline. The effect of technological progress can be seen by the purchasing power of an average hour's work, which has grown from $3 in 1900 to $22 in 1990, measured in 2010 dollars. There were similar increases in real wages during the 19th century. See: Productivity improving technologies (historical) A table of innovations and long cycles can be seen at: Kondratiev wave# Modern modifications of Kondratiev theory

Carlota Perez blames "financial capital" for excess speculation, which she claims is likely to occur in the "frenzy" stage of a new technology, such as the 1998–2000 computer, internet, dot.com mania and bust. Perez also says excess speculation is likely to occur in the mature phase of a technological age.

RBC theory has been categorically rejected by a number of mainstream economists in the Keynesian tradition, such as (Summers 1986) and Paul Krugman.

Another set of models tries to derive the business cycle from political decisions. The partisan business cycle suggests that cycles result from the successive elections of administrations with different policy regimes. Regime A adopts expansionary policies, resulting in growth and inflation, but is voted out of office when inflation becomes unacceptably high. The replacement, Regime B, adopts contractionary policies reducing inflation and growth, and the downwards swing of the cycle. It is voted out of office when unemployment is too high, being replaced by Party A.

The political business cycle is an alternative theory stating that when an administration of any hue is elected, it initially adopts a contractionary policy to reduce inflation and gain a reputation for economic competence. It then adopts an expansionary policy in the lead up to the next election, hoping to achieve simultaneously low inflation and unemployment on Election Day.

The political business cycle theory is strongly linked to the name of Michał Kalecki who discussed "the reluctance of the 'captains of industry' to accept government intervention in the matter of employment." Persistent full employment would mean increasing workers' bargaining power to raise wages and to avoid doing unpaid labor, potentially hurting profitability. (He did not see this theory as applying under fascism, which would use direct force to destroy labor's power.) In recent years, proponents of the "electoral business cycle" theory have argued that incumbent politicians encourage prosperity before elections in order to ensure re-election—and make the citizens pay for it with recessions afterwards.

For Marx the economy based on production of commodities to be sold in the market is intrinsically prone to crisis. In the heterodox Marxian view profit is the major engine of the market economy, but business (capital) profitability has a tendency to fall that recurrently creates crises, in which mass unemployment occurs, businesses fail, remaining capital is centralized and concentrated and profitability is recovered. In the long run these crises tend to be more severe and the system will eventually fail. Some Marxist authors such as Rosa Luxemburg viewed the lack of purchasing power of workers as a cause of a tendency of supply to be larger than demand, creating crisis, in a model that has similarities with the Keynesian one. Indeed a number of modern authors have tried to combine Marx's and Keynes's views. Henryk Grossman reviewed the debates and the counteracting tendencies and Paul Mattick subsequently emphasized the basic differences between the Marxian and the Keynesian perspective: while Keynes saw capitalism as a system worth maintaining and susceptible to efficient regulation, Marx viewed capitalism as a historically doomed system that cannot be put under societal control.^[32]

The American mathematician and economist, Richard M. Goodwin formalized a Marxist model of business cycles, known as the Goodwin Model in which recession was caused by increased bargaining power of workers (a result of high employment in boom periods) pushing up the wage share of national income, suppressing profits and leading to a breakdown in capital accumulation. Later theorists applying variants of the Goodwin model have identified both short and long period profit-led growth and distribution cycles in the United States, and elsewhere.^[33] David Gordon provided a Marxist model of long period institutional growth cycles, in an attempt to explain the Kondratiev wave. This cycle is due to the periodic breakdown of the 'social structure of accumulation' – a set of institutions which secure and stabilize capital accumulation.

Economists of the heterodox Austrian School argue that business cycles are primarily caused by excessive creation of bank credit – or fiduciary media – which is encouraged by central banks when they set interest rates too low, especially when combined with the practice of fractional reserve banking. The expansion of the money supply causes a "boom" in which resources are misallocated due to falsified interest rate signals, which then leads to the "bust" as the market self-corrects, the malinvestments are liquidated, and the money supply contracts.

One of the primary criticisms of Austrian business cycle theory is the observation that the United States suffered recurrent economic crises in the 19th century, most notably the Panic of 1873, prior to the establishment of a U.S. central bank in 1913. Adherents, such as the historian Thomas Woods argue that these earlier financial crises were prompted by government and bankers' efforts to expand credit despite restraints imposed by the prevailing gold standard, and are thus consistent with Austrian Business Cycle Theory.

Henry George identifies land price fluctuations as the primary cause of most business cycles. The theory is generally ignored in most of today's discussions of the subject^[35] despite the fact that the two great economic contractions of the last 100 years (1929–1933 and 2008–2009) both involved speculative real estate bubbles.

George observed that one of the factors that is absolutely necessary for all production — land — has an inherent tendency to rise in price on an exponential basis as the economy grows. The reason for this is that the quantity of land (the stock of locations and natural resources) is fixed, while its quality is improved due to improvements such as transportation infrastructures and economic development of the surroundings. Investors see this tendency as the economy grows and they buy land ahead of the boom areas, withholding it from use in order to take advantage of its increased value in the future. Because housing and commercial real estate provide collateral for a large portion of lending, there is a tendency for real estate prices to rise faster than the rate of inflation in business cycle upswings.

Speculation in land concentrates profits in landholders and diverts economic resources to speculation in land, squeezing profits away from production that has to occur on this land.

In effect, land speculation creates a built-in supply shock that squeezes the economy just as economic output increases. This is a systemic retardation of the economy, placing a sharp brake on further economic expansion. This shock to the economy occurs as long as there is land speculation, creating an underlying tendency toward inflation and recession late in the growth phase of the business cycle. Land speculation, according to George, is always the cause of economic downturns. There are any number of contributing causes; things like oil price shocks, consumer confidence crises, international trade fluctuations, natural disasters — but none of these things creates the underlying weakness.

Land speculation slows the economy in two ways. It increases production costs by making land in general more expensive (shifting the AS curve upward) as well as decreasing productivity by denying access to the best locations, shifting the AS curve to the left and lowering "potential output".^[

The Wisconsin Business School publishes an on line database with building cost and land values for 46 U.S. metro areas.

Many social indicators (mental health, crimes, suicides) worsen during economic recessions (though general mortality tends to fall, and it is in expansions when it tends to increase^[38]). As periods of economic stagnation are painful for the many who lose their jobs, there is often political pressure for governments to mitigate recessions. Since the 1940s, following the Keynesian revolution, most governments of developed nations have seen the mitigation of the business cycle as part of the responsibility of government, under the rubric of stabilization policy.

Since in the Keynesian view, recessions are caused by inadequate aggregate demand, when a recession occurs the government should increase the amount of aggregate demand and bring the economy back into equilibrium. This the government can do in two ways, firstly by increasing the money supply (expansionary monetary policy) and secondly by increasing government spending or cutting taxes (expansionary fiscal policy).

By contrast, some economists, notably New classical economist Robert Lucas, argue that the welfare cost of business cycles are very small to negligible, and that governments should focus on long-term growth instead of stabilization.

However, even according to Keynesian theory, managing economic policy to smooth out the cycle is a difficult task in a society with a complex economy. Some theorists, notably those who believe in Marxian economics, believe that this difficulty is insurmountable. Karl Marx claimed that recurrent business cycle crises were an inevitable result of the operations of the capitalistic system. In this view, all that the government can do is to change the timing of economic crises. The crisis could also show up in a different form, for example as severe inflation or a steadily increasing government deficit. Worse, by delaying a crisis, government policy is seen as making it more dramatic and thus more painful.

Additionally, since the 1960s neoclassical economists have played down the ability of Keynesian policies to manage an economy. Since the 1960s, economists like Nobel Laureates Milton Friedman and Edmund Phelps have made ground in their arguments that inflationary expectations negate the Phillips curve in the long run. The stagflation of the 1970s provided striking support for their theories, defying the simple Keynesian prediction that recessions and inflation cannot occur together. Friedman has gone so far as to argue that all the central bank of a country should do is to avoid making large mistakes, as he believes they did by contracting the money supply very rapidly in the face of the Wall Street Crash of 1929, in which they made what would have been a recession into the Great Depression.

The case of Pakistan

As regards the implication of five business cycles that economists mostly agree upon are:-

Recovery:- Stimulatory economic policies, confidence pickup, inflation still falling, in markets:- short rates low or falling bonds yield bottoming, stocks rising, commodities rising, property prices bottoming.

Early upswing: - increasing confidence, healthy economic growth, inflation remains low, Mrakets:-Short rates at neutral, bonds stable, stocks and commodities strong, property picking up.

Late upswing: - Boom mentality, inflation gradually picks up, policy becomes restrictive, Markets:-Short rates rising, bonds yields rise, stocks topping out, property and commodities prices rising strongly.

Economy slow or enters recession:-Short term interest rates peak, confidence drops suddenly, inventory correction begins, inflation continues to accelerate, Markets:-short rates peaks, Bond yields peak, Bond yields tops out and starts to fall, stock and commodity prices fall, property prices top out.

Recession:-Production falling, inflation peaks, confidence weak, Markets:-Short rates drop; Bond yields drop, stocks bottoming, property and commodity weak.

Since its inception, Pakistan has undergone three complete business cycles and just entered the growth recessionary phase of the fourth business cycles (Fig.1). Historical trend indicates that the duration of the recovery period on average lasts six to eight years and growth average about 6.5% during this interval. On the other hand the duration of growth recessionary period has varied, however growth averaged around 4.5% during this time frame. The last economic downturn, one which took place in 1988-2001 is particularly long as a result of combination of unfavorable domestic and international situation with respect to the country.

Over the last five years i.e. FY2003-08, Pakistan has performed above its potential GDP (5.2 %) averaging 6.5% over this interval. Through 90s, growth averaged 4.5% i.e. below potential. At present position in terms of business cycles was expected to range around 5.6% from 2009-13 but in FY09, however the estimates of GDP growth for the year are looking abysmally low i.e. around 2.5-3.5%. The main reasons for this are the late receipt of foreign aid and project loans and worsening law and order situation. After significant deceleration in growth in FY08 due to accelerating twin deficits, high inflation, exchange rate depreciation and their drag on FY09 has slowed down GDP growth to 1.6 % in FY08 and 2.8% from their targets of 7.2% set for FY08 and 3.0 % for FY09. The growth would pick up marginally in FY13 as a result of adjusting from a significantly large shock experienced in FY08-12. In this respect, in FY 13 one can see a gradual rebound in growth to 3.5%,