Boom and Bust Cycle, What Causes It, and Its History

The boom and bust cycle is the alternating phases of economic growth and decline. It's how most people describe the business cycle or economic cycle.

In the boom cycle, growth is positive. If the gross domestic product growth remains in the healthy 2-3 percent range, it can stay in this phase for years. It accompanies a bull market, rising housing prices, wage growth, and low unemployment.

The boom phase doesn't end unless the economy is allowed to overheat. That's when there's too much liquidity in the money supply, leading to inflation. As prices rise, irrational exuberance takes hold of investors. The GDP growth rate grows above 4 percent for two or more quarters in a row. You know you're at the end of a boom phase when the media says the expansion will never end and when even the grocery clerk is making money from the latest asset bubble.

The bust phase is like life in the Middle Ages. It was brutish, nasty, and mercifully short. It usually lasts only 18 months or less. GDP turns negative, the unemployment rate is 7 percent or higher, and the value of investments falls. If it lasts more than three months, it's a recession. It can be triggered by a stock market crash, followed by a bear market.

A stock market crash can cause a recession. As stock prices fall, everyone loses confidence in the state of the economy. When investors don’t feel confident about the future outlook, they pull out their investments. They cut back business activities such as purchasing, hiring, and investing.

Three forces combine to cause the boom and bust cycle. They are the law of supply and demand, the availability of capital, and future expectations.

Strong consumer demand drives the boom phase. Families are confident about the future, so they buy more now, knowing they'll get better jobs, higher home values, and rising stock prices later on. This demand means companies have to boost supply, which they do by hiring new workers. Capital is easily available, so consumers and businesses alike can borrow at low rates. That stimulates more demand, creating a virtuous circle of prosperity.

If demand outstrips supply, the economy can overheat. Also, if there's too much money chasing too few goods, it causes inflation. When this happens, investors and businesses try to outperform the market. They ignore the risk to achieve gain. 

Plummeting confidence causes the bust cycle. Investors and consumers get nervous when the stock market corrects or crashes. Investors sell stocks, and buy safe-haven investments that traditionally don't lose value, such as bonds, gold, and the U.S. dollar. As companies lay off workers, consumers lose their jobs and stop buying anything but necessities. That causes a downward spiral.

Know the causes of recession so you can hedge your finances before it happens. Look out for signs such as high interest rates, falling home prices, and a decline in durable goods orders.

The bust cycle eventually stops on its own. That happens when prices are so low that those investors that still have cash start buying again. This can take a long time, and even lead to a depression. Confidence can be restored more quickly with central bank monetary policy and government fiscal policy. 

The National Bureau of Economic Research provides the history of boom and bust cycles. It uses economic indicators to measure the boom and bust cycles. These include GDP statistics, employment, real personal income, industrial production, and retail sales. 

Since 1929, there have been 28 cycles. On average, the booms last 38.7 months and the busts last 17.5 months. Data on the NBER cycles date as far back as 1857.