Despite their strengths, capitalist economies have two outstanding weaknesses: they perpetuate the gap between rich and poor and they move in cycles of boom and bust.
As the governor of the Reserve Bank, Glenn Stevens, said this week, "there will always be a business cycle" and "the cycle of greed and fear cannot be regulated away".
But why is the business cycle an inevitable, inescapable feature of market economies? What are the factors that cause the cycle?
We can attempt to explain the existence of the cycle in purely mechanical terms. Looking at it from the perspective of a particular economy, we can say that the cycle in the countries with which it trades will help to cause a cycle in its own economy. Their downturn will cause a fall in its exports and - in Australia's case - often precipitate a worsening in our terms of trade.
But there are also domestic factors, the biggest of which - historically, anyway - is the "inventory cycle".
A manufacturer's or a retailer's sales are growing by, say, 3 per cent a year and its inventory of unsold goods is growing at the same rate. Then, for some reason, there's a fall in the rate at which sales are growing, or maybe an outright fall in sales.
It takes a while for the business to realise this and, by the time it has, the level of its unsold goods has leapt. To get its inventory level back to where it should be, the firm will have to slash its orders, thereby causing a sharp fall in production. Production will stay lower until the firm's inventory level is back in its original relationship with sales.
It works the opposite way, of course, when there's an unexpected and initially unnoticed jump in sales. Calculations by the UBS bank show that in the US the inventory cycle has accounted for about 80 per cent of the peak-to-trough decline in real gross domestic product in the past seven recessions.
Most of the rest of the decline is explained by volatility in business investment and the rate of construction of new homes. This works in a roughly similar fashion.
The home-building industry sees that demand for new homes has outstripped supply, so it sets to work building a whole bunch of homes. But it takes many months from the time you get finance and building approval to the time when a home is finished.
So, typically, the industry's in the process of building a lot more homes when it discovers that demand has fallen off. It ends up with an oversupply of new homes, which prompts it to slash its building activity until such time as demand has caught up with and overtaken supply.
Many building workers lose their jobs and some contractors go bankrupt. Eventually, however, when demand has overtaken supply, the industry starts off on another boom.
Similarly, businesses tend to turn their investment in new buildings and equipment on and off depending on whether demand for their products is outstripping their supply or vice versa.
So, that's the purely mechanical explanation for the ups and downs in production and employment. It rests on the delays before businesses realise that conditions in their markets have changed. By the time they twig, the adjustments they have to make to bring things back into equilibrium are large and disruptive, with the adjustments likely to disrupt other parts of the economy.
The weakness in the mechanical explanation, however, is that it doesn't tell us what caused the change in demand that set off the mechanical adjustment process.
In any case, the importance of the inventory cycle has been greatly diminished by two developments. The first is the advent of computerised inventory control, which means inventory levels are watched continuously and adjusted frequently by small (and thus less disruptive) amounts. Continued…
