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!


  1. Jesse- if you think I missed anything out in this short synopsis - feel free to chime in.

  2. Fish I hope you and your readers don't take this comment the wrong way, but there is something that all of us in the business are well aware of, and that is how many of the big players in this saga have similar backgrounds. Either educational, or experience or even religion!

    Eg Summers, Rubin, Greenspan, Bernanke, the head of Goldman (Blankfien) and JPMorgan (Dimon) and most of the other investment banks, and the NY Fed Chief which allowed Goldman to become a bank and access government money and of course Madoff- they are all Jewish.

    Now of course I dont mean to scapegoat any group. But when so much of the financial power is in one group- whatever they are Sikhs, Jehovahs Witnesses or anything- it could lead to looking after each others interests to the detriment of others.

    Just a comment which you won't find mentioned anywhere else, wven though it is well known.

  3. Sounds good. Business cycles aren't limited to capitalism, though!

    IIRC Keynes suggested not necessarily that business cycles can be "smoothed" but that unused labour capital should be employed via government spending when there is a demand depression.

    It makes little sense to build more houses and cars when houses and cars were already oversubscribed during the previous boom, but other areas of an economy were likely starved during excesses and these areas could be reconstituted. In the US, much of its infrastructure is in need of repair so why not repair it. Its energy infrastructure is dependent on foreign sources so why not develop less geographically-dependent sources. Its education quality is poor so why not improve it. Et cetera.

    The key for Keynes's ideas, then, is jobs, but best to supply jobs that do something that is productive. On that front, as of today, government austerity is a bad thing according to Keynes but IMO that should not prevent governments from "re-assigning" people to more productive endeavors. That might mean, dare I say it, more people getting some fresh air and finding their true calling wielding a shovel!

  4. A good "failure" of Keynesian principles was the building of the new Oakland Bay Bridge. The idea by the government was to invest in infrastructure and the Bay Bridge was in need of significant repairs. So the government got billions to spend but instead of employing locally unemployed workers, they outsourced most of the build to China because it was cheaper! LOL so much for infrastructure spending to reduce unemployment!

    But what was the local authority to do? US labour was far too expensive. They could either spend the money getting a bridge that would last 50 years with local workers, or spend the money getting a better quality bridge (just by getting more workers and materials for the same money, not on the workmanship necessarily) that would last 70 years by using Chinese workers. Tough call.

  5. Hi Jesse

    Indeed- the business cycle is not just for capitalism, but it gets much more murky when we look at feudal, communist or other systems where the cycles are so several distorted. Of course it could be said that Emperor Greenspan (and that is the amount of power he had) also distorted things by constantly interfering to save speculators.

    Poor Keynes- his name is taken in vain to justify all sorts of actions he would have found abhorent- like saving banks and hedge funds.

    Skeptic- the reason their are so many Jewish people in high positions in finance, is that they were instrumental in getting the whole industry going in the US!

    Also most of Madoff's victims were Jewish too.

    However I do agree that more diversity in these positions would be a good thing. Even if there is no nepotism, there may be a perception of this.

  6. They're ccoming round the mountain,
    here they come ... tra la la ... pump pump pump

  7. Anon (2)!

    Thanks very much for your excellent analysis and comments on the business cycle F & J.

    To reiterate, if we were (are) in early stage recovery -- the seeming reversal is due to improper fiscal intervention. Or possibly we never were in recovery, it was just a bandage -- and it won't hold. Because they are a lot of recovery signs. It's interesting!

  8. Hi Anon 2

    I would say the latter. The need to pervert the business cycle is so strong that Central bankers and Politicians think they have more power than they do. They can only delay the inevitable deleveraging. Of course they have wealthy and well-connected specualtors screaming for them to do something.

    Witness the games being played in Europe. Each new 'fix' is followed by another crisis.


  9. Based on last months sales the Sunshine Coast has 28 months of inventory.

    One palatial waterfront home - 6500 foot, just sold for $1.4 Million. That is $1 MILLION below the original asking price.

    It has been on the market for a few weeks less than a year.

  10. 1.07 Million below to be exact :)

  11. Some commenter somewhere (I think CalculatedRisk) commented that many "modern" cities will have their house prices more tightly tied to the stock market's performance than others. He surmised that to truly elicit a crash, the stock market needs to underperform, due to where residents tend to draw their incomes.

  12. Repeat after me. "There'll be no Canadian recession." ;)