Vol 0, No 7
9 November 1998
B A L K A N   E N C O U N T E R:
New Paradigms, Old Cycles
Dr Sam Vaknin
New paradigms die hard. It took a looming global recession to convince wild-eyed optimists that old cycles are more reliable guides than new paradigms.
Business cycles - from the smallest to the biggest - go through seven phases. Centuries of cumulative economic experience allow us to identify these stages more accurately than ever before.
An economic cycle invariably starts with inflation. The previous cycle having ended - and the new one just began - the economic environment is as uncertain as can be. The fundamental component is the scarcity of goods and services (following recession or deflation) and the maladapted money supply. Too much money chases fewer commodities. The general price level rises. But this constant, ubiquitous, all pervasive rise (known as 'inflation') is also the result of mass psychology. Households and firms compensate for the growing uncertainty (=growing risk) by raising prices. They have no idea what should the appropriate or optimal equilibrium price level be. Market signals are garbled by psychological noise.
Everyone is trying to stay ahead of perceived economic threats and instabilities by raising the risk premiums that they demand from their clients. Consumers, on the other hand, are willing to pay more today because they are convinced that the price trend is unidirectional and irreversible: up. The psychological underpinnings and bearings of inflation have been studied deeply in the last few decades. It is the source of the uncertainty that remained obscure. My hypothesis is that the end of every economic cycle fosters this panicky uncertainty which is monetarily reflected as inflation. In more technical terms, inflation is a market pathology, a market failure.
Inflation disguises bad economic performance of firms and of the economy as a whole. 'Paper' profits make up for operational losses. The incentives to innovate, modernize, and enhance productivity suffer.
Economic yardsticks and benchmarks get distorted and do not allow for meaningful analysis of the performance of the economy. Inflation leads to technological and economic stagnation. Plants do not modernize, the financial aspects of the firm's operations are emphasized, the industrial and operational aspects de-emphasized and neglected. Economies are seized by the pathological economic condition known as 'stagflation' - zero or negative growth, coupled with inflation. A sense of urgency and crisis sets in and clears the path towards the next, second phase.
In an effort to overcome the pernicious effects of inflation, governments liberalize, deregulate and open their economies to competition. Firms innovate and streamline. Efficiency, productivity and competitiveness are the buzzwords of this phase. As trade barriers fall, cross border capital flows (=investment) increase, productivity gains and new products are introduced - the upward price spiral is halted and contained. The same money buys better products (more reliable, more functions, more powerful). The same wages generate more products. This is technological deflation. It is beneficial to the economy in that it frees economic resources and encourages their efficient allocation. Real incomes rise and generate increased demand and production.
Inevitably, technical deflation leads to a restraint in the general price level. Increased consumption (both public and private) coupled with a moderate asset price inflation prevent an outright monetary deflation (=a downward spiral in the general price level). Inflation is kept to sustainable levels. This phase is known as 'disinflation'. It is a transitory phase. The transition from hyperinflation or high inflation to a supportable level of inflation is a matter of one or two decades. This period is bound to be shortened by the revolutions in information, communications and transportation technologies. In fact, the whole cycle is hastened due to the more rapid dissemination of information. It is the availability and accessibility of information, which determines the values of important parameters such as the equilibrium general price level and other parameters of expectations (such as equity prices). The more information is available more readily - the more efficient the markets and the shorter the cycles. This enhances the false perception of instability inherent in modern markets. But speed does not necessarily a imply lack of stability. On the contrary, the faster and more violent the adjustments in the market mechanism - the more efficient it is.
The psychological wellbeing and assurance brought on by disinflation generate demand for assets, especially yielding assets (such as real estate or financial assets). The more certain the future value of streams of income, the more open the economic environment, the shorter the economic cycle, the more frequent and rapid the economic interactions - the more valuable assets become. Assets are mainly stores of expectations regarding future values. An assets bubble is created when the current value (=price) of money is low and the future value of money is certain and likely to grow through stable or decreasing prices. Stock exchanges, real estate, financial transactions - all balloon out of proportion in a kind of irrational exuberance.
All bubbles burst in the end - and so do these assets bubbles. This is the fifth phase. It is crucial because it signifies the termination of the bull part of the cycle. The prices of assets collapse precipitously. There are no buyers - only sellers. Firms find it impossible to raise money because their obligations (commercial paper and bonds) are rendered valueless. A credit crunch ensues. Investment halts.
The collapse of assets bubbles generates asset price deflation. The psychological counterpart of this deflation is the disappearance of the 'wealth effect' and its replacement by a 'thrift effect'. This influences consumption, inventories, sales, employment and other important angles of the real economy.
If not countered by monetary and fiscal means - a lowering of interest rates, a fiscal Keynesian stimulus, an increase in money supply targets - a monetary deflation might set in.
Admittedly, a full-fledged deflation is rare. More frequent are a recession, a slump, a credit crunch, a slowdown, a growth recession and other less exotic variants. It is also possible to have differentiated or discriminatory deflation. This is a deflation in certain sectors of the economy or in certain territories of the globe - but not in others. In any case, a monetary deflation is a monstrous, venomous economic beast. Due to reversed expectations (that prices will continue to go down), people postpone their consumption and spending. Real interest rates skyrocket because in an environment of negative inflation, even a zero interest rate is high in real terms.
Investment and production slump - inventories shoot up, further depressing prices. The decline in output is accompanied by widespread bankruptcies and by a steep increase in unemployment. The real value of debt increases. Coupled with declining prices of assets, it leads to bank failures as a result of debts gone sour. It is a self- perpetuating state of affairs and it calls for the implementation of the seventh and last phase of the cycle.
This is the phase of reflation. The market failure, at this stage, is so pervasive that all the self-balancing and allocation mechanisms are rendered dysfunctional. State intervention is needed in order to restart the economy. An injection of money through a fiscal stimulus, a monetary expansion, a lowering of interest rates, firm support of the financial system, tax and other incentives to consume and to import.
Unfortunately, all these goals are best achieved by engaging in warfare. It is often the case : a convenient war reflates the economy, re-ignites the economic engine, generates employment, increases consumption, innovation and modernization. But with or without war - people sense the demise of an old cycle and the imminent birth of a new one, fraught with uncertainty and ignorance. They rush to buy things. Because the economy is just recovering from deflation - there aren't usually many things to buy. A lot of money chasing few goods - this is a recipe for inflation. Back to phase one.
But the various phases of the cycle are not only affected by psychology - they affect it. During periods of inflation people are willing to take on risk. The risk of inflation is clear to them and the only compensation is through higher yields (returns, profits) on financial instruments. Yet, higher returns inevitably and invariably imply higher risks. Thus, people are forced to offset or mitigate one type of risk (inflation) with another (credit or investment risk). Paradoxically, an inflationary period is a period of certainty. Inflation is certain. People tend to develop an ideological type of economics. Based on the underlying and undeniable certainty of ever-worsening conditions, the intellectual elite and decision-makers resort to peremptory, radical, rigid and sometimes coercive solutions backed by an ideology disguised as 'scientific knowledge'. Communism is a prime example, of course - but so is the 'Free Marketry' variant of capitalism, as practiced by the IMF and by central bankers.
Deflation, on the other hand, is usually a much shorter period. People do not expect it to last. They fully expect it to be followed by inflation - they just do not know when. Thus, its nature is more transitory. Assured of low prices and preoccupied with economic survival - people become strongly risk averse. While in times of inflation people are seeking to protect the value of their money - in times of deflation people are in pursuit of sheer livelihood. A dangerous 'stability' sets in. People invest in land, cash and, the more daring, in bonds. Banks do the same. In such times, ideologies are the first victims. They are replaced by philosophies and worldviews. People become much more pragmatic. They look to the possible rather than to the ideal. Communism is replaced by Socialism, Capitalism replaces Free Marketry. Perhaps this is the only good outcome of deflation.
Dr Sam Vaknin, 9 November 1998
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