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What is pro-cyclicality?

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July 29, 2011 – Comments (4)

Excellent post at Credit Writedowns. Absolutely dovetails with my last post: The danger is from the spending cuts, not the potential downgrade - http://caps.fool.com/Blogs/the-danger-is-from-the/620224

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What is pro-cyclicality?
Economics | Edward Harrison | 29 July 2011 11:24

http://www.creditwritedowns.com/2011/07/what-is-pro-cyclicality.html

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 eurozone, 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 we see 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 they exacerbate the swings in the business cycle, creating deadweight losses. The federal government can always counter this pro-cyclicality and smooth out the cycle. This is one of the structural flaws of the euro zone; there is no federal agent to do this, and, thus, the business cycle will invariably be volatile.

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.

4 Comments – Post Your Own

#1) On July 29, 2011 at 2:08 PM, whereaminow (< 20) wrote:

binve,

I'd like to carry on our other conversation over email if that's cool with you. 

David in Qatar

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#2) On July 29, 2011 at 2:43 PM, binve (< 20) wrote:

David, no problem I will email you.

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#3) On July 29, 2011 at 5:25 PM, Frankydontfailme (27.80) wrote:

Will you guys post the best hits?

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#4) On July 29, 2011 at 6:02 PM, Mega (99.97) wrote:

Austerity attempts to meet the hurdle we see have created larger deficits in the periphery (Spain, Greece, Portugal and Ireland).

Larger deficits compared to what?  I assume you don't mean compared to 2007, but compared to some possibility of what the PIIGS might have done?

Abandoning the Euro and mounting a huge stimulus might have supported Spanish GDP (depending on how much the markets hated it), but would have substantially increased Spain's deficit compared to 2007.

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