Domino theory to explain economic cycles

From World War II until the 1980s, Western economies kept going through a process that can be compared with falling dominos. What we mean is this:

As explained in Authorities seeking control over Visible Hand, fiscal policy – invented by Keynes - and monetary policy - invented by Friedman were initially devised to smooth out waves in the economic cycle. Their idea was to build up reserves in boom times that could be used in leaner times. On balance, measured over the entire cycle this policy should be neutral. In practice, however, more reserves have always been used in leaner times than have been built up in more buoyant times. Reserves have also often been used to further crank up already reasonably good growth. Actually, all this was continued until inflation rose excessively. This resulted in cycles that can be compared with falling dominos.

Let us start with a recession. To emerge from the recession, budget deficits were always reduced – in other words taxes were reduced and government expenditure increased – so consumers could spend more money. At the same time, interest rates were substantially lowered. The idea was that private individuals and companies would borrow more and save less. Higher growth therefore first became apparent in the car and construction industries. Moreover, the advantage of lower interest rates was that they boosted asset prices. This generated a positive wealth effect and provided further collateral for loans.

As the recovery progressed, however, the problem arose of credit in the private sector increasing while the demand for credit from the government remained more or less constant. This was also at a time when savings were lower and there was therefore less capital available in the economy for investment. Interest rates therefore began to rise. This would immediately nip the economic recovery in the bud and the next domino would fall. To keep interest rates low, the money supply was therefore substantially increased. In time, that led to rising inflation, but that became impossible to bear at some point. This caused all kinds of imbalances in the economy which therefore started growing more slowly rather than more rapidly.

There went the last domino. The economy had to be seriously braked – generally this meant recession- to curb inflation. To achieve this, monetary policy was considerably tightened and interest rates were substantially raised. And then the cycle repeated itself. There was always more stimulation to get out of a recession, however, than braking to curb inflation. The final result was therefore than budget deficits and debts (expressed as a percentage of the total economy) continually rose, as did inflation.