Boom and Bust Cycle: Definition, How It Works, and History

What Is the Boom and Bust Cycle?

The boom and bust cycle is a process of economic expansion and contraction that occurs repeatedly. It's a key characteristic of capitalist economies and is sometimes synonymous with the business cycle.

The economy grows, jobs are plentiful, and the market brings high returns to investors during the boom. The economy shrinks, people lose their jobs, and investors lose money in the subsequent bust. Boom-bust cycles last for varying lengths of time. They also vary in severity.

How the Boom and Bust Cycle Works

The United States has experienced several boom and bust cycles since the mid-1940s. Why do we have a boom and bust cycle instead of a long, steady economic growth period? The answer can be found in the way central banks handle the money supply.

A central bank makes it easier to obtain credit by lending money at low interest rates during a boom. Individuals and businesses can then borrow money easily and cheaply and perhaps invest it in technology stocks or houses. Many people earn high returns on their investments and the economy grows.

The problem is that people will overinvest when credit is too easy to obtain and interest rates are too low. This excess investment is called “malinvestment.” 

There won’t be enough demand for all the homes that have been built and the bust cycle will set in. Assets that have been overinvested will decline in value. Investors lose money, consumers cut spending, and companies cut jobs. Credit becomes more difficult to obtain as boom-time borrowers become unable to make their loan payments. These bust periods are referred to as recessions. It's called a depression if the recession is particularly severe.

Additional Factors in Boom and Bust Cycles

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

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

Government subsidies that make it less expensive to invest may also contribute to the boom-bust cycle by encouraging companies and individuals to overinvest in the subsidized item. The mortgage interest tax deduction subsidizes a home purchase by making the mortgage interest less expensive. The subsidy encourages more people to buy homes.

The Bottom Line

The boom and bust cycle is an informal term for the economic fluctuations between periods of prosperity and depression. Businesses are likely to see high profits when the economic climate is favorable, resulting in higher spending and employment. The wider economy is likely to see higher prices and lower employment when businesses are less profitable.

The effective prediction and moderation of boom and bust cycles has been a major focus of economists and policymakers for decades.