Saturday, August 13, 2011

The business cycle in a nutshell





Capitalism has many flaws, however one of it's biggest virtues is the business cycle. Firstly, as most will agree, the graph for any socio-economic parameter has been trending up for the history of humanity. Whether that be GDP, protein consumption per capita, or survival, we are moving upwards. The reason is our increasing numbers coupled with our ingenuity.



Even catastrophes like HIV or WW2 only put a temporary dent in this progress.



However it is not a smooth line up, but a jagged saw tooth.The cycle (and there are multiple different cycles running at the same time- eg commodities/industrial production etc) in it's most simplified situation is thus:



Along comes a need or an innovation- eg railroads in the US to bring wood and gold back to the burgeoning eastern seaboard or the Internet. This draws in money which causes a boom in the sector or even the whole economy. Eventually it becomes too speculative as investors are mesmerized by the huge gains made by the early money. More and more money flows into the sector, so much so , that bubbles often form in these assets or companies and they leave their most optimistic fundamental valuations. Eventually the boom turns to bust as not all the 'blue-sky' projections can be met.



Companies go bust. Most railway companies in the US went belly-up as did the Dot-com companies. Debt is defaulted on. A recession in that industry or even the whole economy ensues and we wait for the next driver.



The graph above is the picture of human greed and fear. It is stupidity too, however, it is necessary to move us along the graph upwards. Without speculation, we would not have had dozens of railway companies fighting to cross the US. The process would have taken decades longer.



So are we always stuck with this business cycle, where a mis-allocation of resources ends in tears- which can often be so severe that it leads to social upheaval eg WW2?



Some economist like Keynes suggested acting to smooth out the cycles. Intervene to reign in speculation as the cycle went up and add money (borrowed if need be) on the way down.



Then we had fools like Greenspan and Bernanke (and the Treasury secretaries like Robert Rubin, Lawrence Summers and Paulson who worked with them) who thought they could halt the business cycle- they unfortunately influenced all the other Central Bankers from Europe to Canada.



They allowed the cycles to go as high as possible and even advocated removing the few legal restrictions which kept the worst of human greed and speculation under check. This is from the free-market theories of Milton Freidman.



It led to HUGE up-cycles and misallocation of resources- eg the Dot-com boom. When these bubbles burst, they then became Keynesian - lowering interest rates and trying to bail out the stranded speculators.



They did this prior to the Dot-com with a number of mini-booms/busts like the LTCM (derivatives explosion) and the Russian and emerging market debt boom/crisis.



What this did was make the up swings huge but cut off the down swings. It seems like a good idea and in fact many wise economists in Central banks thought that Greenspan had found the Holy Grail. Lots of up, but very little down. There were no major recessions from 1987 when Greenspan took over.



Of course all that does is delay the inevitable. You don't get a good purge of speculation, the big money gets the message fast- we will be bailed out of our mistakes. So each bubble gets bigger as it has to swallow the losses of the previous one too.



Thus we had the huge housing bubble in the US. When that burst they tried again. Zero interest rates and even took the debt of speculators onto Government books. However it was too big and all the pent up excess had to come out of the system.



They could not stop the downward movement with their usual bag of tricks. The business cycle took it's full revenge.


There in fact several different cycles with different time frames that play out at the same time. There are short cycles and then longer more dramatic ones. Nicolai Kondratiev a Soviet economist and wrote about it. His theory was that this was how capitalism moved from animal exuberance to purging the excess speculation. A form of self-cleansing if you will. For suggesting this he earned Stalin's anger and was sent to a gulag and later executed there.


As I mentioned we have come though a period where we had the worst of both worlds. Regulators who did not regulate. Central bankers who were too close to the speculators and politicians who did not want the good times to be curtailed. The result was a delaying of the cleansing until we now have the mother-of-all down waves.


It is human nature to want to delay pain. We did it in Canada. When the crisis hit in 2008- we were in excellent shape. Low consumer debt, near balanced budget, and still buoyant commodity prices.


However our own Central bankers and politicians panicked. You know the script. Zero interest rates, CMHC doubling, Tax incentives, RRSP down-payments, Long mortgages etc.


All leading to our own speculative bubble which as Ben has shown is right where the US was when they burst. Had they done nothing we would have gone though pain. However it is very likely that as a result there will be even more pain.. I guess everyone just hopes it bursts on someone else's watch.


It is like a party where everyone is get rat-faced drunk and a few people nag that this is not going to end well. "This will end with fights, and vomiting, and maybe even more serious events". - They are told they are Spoil-sports! Drink. Enjoy the fun.


Of course the bears in the US were fully vindicated, not that it gives them much comfort, since they have to share the pain with everyone else!