Monday, November 08, 2004
Riding the long wave
Posted by David Smith at 09:13 AM
Category: David Smith' s magazine articles

Economy-watchers have always been fascinated by cycles, the idea that the ups and downs for businesses and consumers follow regular patterns. Economic cycles, like stars, are named after their discoverers. The standard business cycle, the Kitchin cycle, goes from peak to trough to peak again within the space of five years.

A longer cycle, the Juglar cycle, has major peaks separated by around 8-10 years. Think of the top of the global economic cycle at the end of the 1980s and then at the end of the 1990s.

These are bread and butter cycles. There is nothing pre-ordained about them but they have a habit of coming back. They are driven by economic behaviour – businessmen and consumers becoming over-optimistic and gearing up too much for the upturn, then cutting back when they discover they have over-committed. Governments and central banks also have a clear influence on the cycle, applying the accelerator when the economy has cooled too much and the brakes when it is overheating.

Importantly, the fact that there are cycles does not mean that booms have to be followed by recessions. A “growth recession”, a period of slower growth within a period of overall expansion, is more usual. Britain has had a couple of these since emerging from the last proper recession in 1992.

More interesting than these economic cycles, however, are the extended cycles or “long waves” most associated with the Russian economist Nikolai Kondratiev. Kondratiev was an official in the Soviet finance ministry under Stalin and had politically incorrect economic views. He thought, for example, that the Soviet regime should see what it could learn from market economies and, for his troubles, ended his life in the Gulag just before the Second World War.

Before that, however, he had put forward the idea of long cycles in economic activity, their peaks separated by 50 or 60 years, dating back to the 18th century and the dawn of the industrial age. Kondratiev’s long waves – 25 to 30 year upswings followed by downswings – offered a pretty good explanation of the depression of the inter-war years and, while he was not around to see it, the global economy’s “golden age” from the 1950 to 1973. His work was popularised by the great economist Joseph Schumpeter.

Does Kondratiev have any relevance for the modern age? Some think so. A couple of years ago, explaining what was then Japan’s long period of stagnation, an official from the country’s central bank told journalists that: “We have the bad luck to be in the downward phase of the fourth Kondratiev cycle.”

Now Brian Reading of Lombard Street Research, in a paper entitled “Synchronised Sinking”, has examined the relevance of cycles to the global economic outlook. He notes that to the extent that Kondratiev long waves have been identified, they are – as Schumpeter also argued – largely a product of technological innovation. Thus, the upswing from 1790 to 1814 was largely the product of developments in the cotton industry, that of 1845 to 1870 by steam and the railways, the upwave of 1896 to 1929 as a result of cars and electricity, and the post-World war Two upswing happened as a result of innovation across a range of fronts, including plastics, chemicals and the jet plane. The 1990s appeared to see the beginning of another such upswing, on the back of the IT revolution.

But will it end in tears? Reading, without being a paid-up member of the Kondratiev club, which he thinks is largely a technological phenomenon, argues that there are reasons to expect the two motors of the global economy – America and Asia – to have a prolonged correction.

The 1990s, apart from the IT revolution, saw the emergence of a “new dollar area”, in which half the world returned to something like the post-war Bretton Woods system of fixed exchange rates. This was driven, of course, by the desire of the Asian economies, and in particular China and Japan, not to allow their currencies to rise against the dollar.

As he argues: “The new dollar area comprises the US, an inner circle of countries whose currencies are pegged to the dollar and an outer circle of currencies managed against it.” The circles take in China, Hong Kong, Malaysia, Japan, India, South Korea, Taiwan, Thailand, Indonesia, Singapore and Russia – half of global gross domestic product.

The consequences of this are well known. The dollar has not been allowed to depreciate in a way that would begin to correct America’s widening trade deficit. The quid pro quo for the stable dollar policies of Asia has been that they have been prepared to finance the twin deficits – current account and budget - of the United States.

The outcome, according to Reading, is not in doubt. “The new dollar area, like Bretton Woods, must end in tears,” he writes. “The synchronised boom it has created cannot continue. There can be no soft landing for either the US or China. Quite simply, Americans save too little and must save more, meaning demand and incomes will contract. The Chinese invest too much and must invest less, meaning demand and incomes will contract. This is the recipe for synchronised sinking.”

Is he right? Stripping away the elegant gloss of economic cycles – short and long – the argument is a familiar one; US imbalances can’t last and unwind nastily. Against that is the view that American and Asian economic dynamism (perhaps itself a Kondratiev upswing) will always trump Europe and that, as a result, the scope for working through these imbalances is far greater than the pessimists would allow. The outcome of that debate will profoundly affect prospects for the global economy for years to come.

From Professional Investor, November 2004

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Posted by: Sheila at May 18, 2005 09:29 AM