Tuesday, January 18, 2011

China Goes to Nixon

I love reading this series. It reminds me of the thesis I would have written if I hadn’t run out of money (Oh the irony). This is why the current slump we’re I isn’t a normal business cycle:

A “normal” business cycle is relatively simple; it’s a swing between short term inventory and employment. When the supply of goods is low (relative to demand) then the demand for workers to create those goods goes up and with that wages and prices and demand. This pushes both inflation and inventory until inventory is appropriate for demand at which point excess labor is shed and the house of cards tumbles only to be regenerated as inventories shrink to below a minimal demand. This is the “normal” five to seven year business cycle. On a Swan diagram it looks like a circle over time.

He key to the business cycle is short term (consumable) inventory. One can go on forever (and some do) about what consumable inventory means from a business cycle perspective but the average Joe knows, it’s what he finds at the average store in the mall, stuff you buy that has a short lifespan.

That’s not the end of the story. Simon Kuznetz discovered that the economy also had a periodic cycle of about 20 years superimposed on the business cycle. Kuznetz suggested that his cycle revolved around the construction industry. Jay Forrester suggested that by substituting durable goods (washing machines, refrigerators, industrial stoves, etc., items with a lifetime over 10 years) for consumable inventory in a business cycle model a Kuznetz cycle would be the natural outcome. This might suggest that the housing bubble is the high inventory, low employment segment of a Kuznetz business cycle and it might be true but the story still doesn’t end there.

In the 1920’s Nikolai Kondratiev published a paper arguing for longer, fifty year, business cycles, the so called Kondratiev wave. When Forrester substituted Capital Goods (Hoover dams, houses) for durable goods in the same models he used for the business cycle a forty to seventy year cycle emerged. Kondratiev himself was able to show cycles going back into the late eighteenth century and Vilfredo Pareto showed (a bit before Kondratiev) that there were long wave cycles going well into the middle ages (known then as Goldsmith Crisises) and hints of the same in Roman times.

The Goldsmith Crisises were characterized by enormous unpayable debts and equally enormous paper wealth. Few people realize that in an age that accepted only species currency (gold) that a goldsmith could create fiat money by issuing promissory notes. Imagine an era when a peasant wants to borrow money to hire laborers to dig a well so he can irrigate his fields. He promises to pay the loan back from the increased production from his fields. Soon everyone of his neighbors do the same but the increased production drives prices down so no one can repay the debt. Substitute your favorite Capital Good here and you see what is happening today.

There are hints this may phenomenon may have been well understood by the ancients who had data running over multiple millennia rather than just a few centuries. The Bible tells of the Jubilee cycle, a roughly 50 year cycle at the end of which all debts are forgiven. One suspects forgiving debts was the obvious solution to what amounted to mass bankruptcy. There is also the dictate to let slaves go after 7 years and to let the ground lie fallow for a year. That would institutionally get rid of excess inventory and avert the typical business cycle.

However that’s a digression. Economics ultimately is a psychological endeavor, how people respond to economic conditions and perceived trends is what drives the real world economy. At the depth of a business cycle businessmen are loath to hire new workers until the business picks up and demand increases. Typically, inventories are high relative to demand, income is low and since no one wants to spend money the velocity of money is also low, people save if they can. Credit evaporates and the money supply (in the largest sense) declines.

We are in the trough of the first Kondratieff wave after the Great Depression. Our Capital stock has never been larger. Here in Boston the Big Dig is over as is the building boom. While some of our older infrastructure is in dire need of repair we don’t need any new roads, bridges, dams or other massive Capital projects. Industrial capacity is at an all time high even if demand is low. Our collective debt is greater than it’s ever been and with a soured economy repaying of that debt looks doubtful. Our instinct is to cut back even further to weather this storm. We tighten out collective belts and watch the economy shrivel still further.

We are, presented with several solutions. We can continue to tighten out belts and hope that free enterprise jump starts the economy or we could declare the equivalent of a Jubilee and simply wipe out all debts corporate, personal and national. Based on historical precedents, we will surreptitiously cancel our debts through monetary inflation. We’ve done it before. We monetized the Vietnam War and Cold Wars and look what it gave us the: the 1990’s.