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What is pro-cyclicality?

Looking up the term procyclical on the Internet, I see the Wikipedia entry defines it as:

Procyclical is a term used in economics to describe how an economic quantity is related to economic fluctuations. It is the opposite of countercyclical

In business cycle theory and finance, any economic quantity that is positively correlated with the overall state of the economy is said to be procyclical. That is, any quantity that tends to increase when the overall economy is growing is classified as procyclical. Quantities that tend to increase when the overall economy is slowing down are classified as ‘countercyclical’…

Procyclical has a different meaning in the context of economic policy. In this context, it refers to any aspect of economic policy that could magnify economic or financial fluctuations. An economic policy that is believed to decrease fluctuations is called countercyclical.

I talked about this in the first context in 2008. What got me thinking about procyclicality again was the chatter about cut, cap and balance which the Republicans in the US Congress are proposing. The goal is to reduce deficits. The plan is to cut spending, cap spending increases and pass a balanced budget amendment to the US Constitution.

Balanced budget amendments are another one of these artificial constraints that look better on paper than they do in reality because they are procyclical.

In the euro zone, the stability and growth pact provides a 3% deficit hurdle which almost all of the euro zone breached during the recession. Austerity attempts to meet the hurdle have created larger deficits in the periphery (Spain, Greece, Portugal and Ireland).

The same problems were apparent in the US states where balanced budget amendments are the order of the day. Before Barack Obama entered the White House, I asked in January 2009 “Will federal largesse be countered by state and local cutbacks?” By June 2010, it was obvious the answer was yes. That’s what procyclicality means.

Procyclicality is fine for states as a constraint despite how it exacerbates the swings in the business cycle, and creates deadweight losses. That is because the federal government can always counter this pro-cyclicality and smooth out the cycle. Procyclicality is one of the structural flaws of the euro zone; there is no federal agent to do counter procyclical budgeting during a recession. Thus, the euro zone business cycle will invariably be volatile, making current account imbalances a lightening rod for intra-European recrimination.

Now, America is looking to impose the same sort of procyclicality on the US federal government. When downturns hit, revenues drop because tax receipts drop due to income shortfalls and spending increases because of automatic stabilisers. So, a balanced budget amendment would require even more cuts. But since those cuts reduce income and tax receipts, you need enough cuts to overcome the negative revenue effects on the budget. That means a balanced budget amendment would require deep, deep cuts in federal spending at precisely the worst moment in the business cycle. That’s procyclicality.

This is a recipe for disaster. And it will lead to huge volatility in the business cycle, deadweight economic losses and growth underperformance. If you hear anyone telling you this is a good mechanism for reining in deficit spending, you will know they haven’t thought through the effects of procyclicality.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

5 Comments

  1. David Lazarus says:

    It sounds great in theory but disastrous in practice. What is really needed is counter cyclical policy. Though like any policy it actually requires people to do their job. Considering that the US regulators would not regulate then why should we expect any counter cyclical regulator to do that responsibly?

      • David Lazarus says:

        Not just that but it would be open to adjustment. The former UK Chancellor Gordon Brown had a similar policy to have a balance budget over the business cycle. Though the definition of the cycle changed, so it meant that during the boom the UK had a fiscal deficit just before the global financial crisis.

        Another impact of such a law would shrink government over time as the economy stagnates. It would make banks far too big to save as they would have expanded overseas where the opportunities were. So when they crash again they would be so big that the government would be unable to protect depositors.

  2. Tom Hickey says:

    Actually, the push is on to pass a balanced budget amendment AND can the automatic stabilizers. That is a recipe for social and political disaster, and it would regress the US to the 19th century.

    • David Lazarus says:

      Ending the automatic stabilisers will cut the expenditure but will also cut the income as those who lose their jobs will no longer spend anything. It will also increase crime as people resort to crime to survive.