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Wednesday, January 17 2018

Pete's Lecture Series: The Long Wave Cycle vol. 2

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Suspended in time and space for a moment, you feel a crisp winter wind blowing across the tundra. Echoes vibrate from a dreary Siberian prison camp. Twilight paints the pre-dawn skies over the sullen, arctic permafrost. The year is 1938. A worn out, emaciated figure with torn clothing trudges in shackles and chains, nearing the time when he will draw his last breath. He once lived a very different life of moderate prosperity in the 1920s Soviet Union. But this man is now a slave, sentenced by dictator Joseph Stalin in an insult-ridden, fixed trial to “count the birch trees” in his gulag. Such was the punishment the man received in return for his diligent, insightful work, the work of a true genius. The man’s name: Nikolai Dimetrievich Kondratieff. Occupation: economist. Crime: thinking for himself. Twelve years earlier, in 1926, Kondratieff turned in his analytical observations of Western capitalism to Stalin, a task that Stalin had assigned the economist to work on. Undoubtedly, Stalin had hoped that Kondratieff would be able to find a weakness in capitalism that the Soviets would be able to exploit, thus demonstrating their theories that communism was the superior system. But Kondratieff did not find weaknesses. Instead, the economist concluded that capitalism underwent long cycles, invariably ending in depressions, but that capitalism also had the ability to rejuvenate itself, and spring back to life no matter how harsh any given depression turned out. Not only that, but each succeeding cycle would build upon the last, thus continually boosting capitalist economies to higher levels in spite of the periodic severity of intermittent depressions. Needless to say, Stalin did not appreciate this objective and unbiased analysis from the Soviet economist, and therefore ridiculed and then punished him. In the late 1980s, the Russians posthumously exonerated Kondratieff for his “crimes,” and declared him one of the world’s greatest economists. We in the West would be wise to do the same.

Kondratieff determined that there were longer cycles in capitalism, much longer than the normal 7 to 11-year business cycle that runs from recession to recession, which everyone is familiar with. By collecting and analyzing endless reams of data from 1789 until 1925 covering price inflation, interest rates, wages, foreign trade, use of physical goods, and savings rates, Kondratieff created time series plots of each of these variables. He procured his raw data from France, Germany, England, and the United States of North America (that’s what we were called back then). One of his observations was that the rise and fall of the above variables had almost the same exact timing in all interrelated capitalist economies that traded with one another. Given that there were intermittent recessions that occurred every 7 to 11 years, Kondratieff smoothed the raw data by employing a 9-year moving average, which really brought out the long waves. I wish I could show you the plots, as they are amazing! Ultimately, Kondratieff observed that there were cycles that ran 45 to 80 years in capitalism, the duration depending upon wars, monetary inflation of currencies, and extensions of consumer credit. These cycles were characterized by an upward wave and a downward wave. The peak, right in the middle of the cycles, was always characterized by a peak in almost all of the aforementioned economic variables, except savings rates. The most important observation is that inflation and interest rates move up in the first half of the cycle, and move back down in the second half of the cycle. Kondratieff observed three peaks in his data: 1817, 1865, and 1920. These three years are pivotal, and demonstrate the most remarkable similarities! Each of the three peak years exhibits the following traits:

All three peak years are preceded by two years of stagflation, a very rare economic condition during which the economy slows down while prices continue to surge upward.
Prices reach their absolute peak in all three of the peak years, having increased before the peak years, and decreasing after the peak years.
Interest rates reach their absolute peak in all three of the peak years, having increased before the peak years, and decreasing after the peak years.
All three peak years are immediately followed by a major, deep recession, also known as a primary recession. This recession is accompanied by the end of a bear market in stocks.

Later, some economists built upon the work of Kondratieff. Most notably, P.Q. Wall came up with seasons to describe the phases that each individual cycle goes through:

Spring—the capital goods sector starts out depressed, exhausted, or obsolete. Interest rates, wages, and the costs of raw materials are low. The upswing starts from a low level of confidence, but a slow, methodical uptrend emerges, with the building of new industries that bolster employment and stimulate consumer demand. There is renewed enthusiasm as living standards rise and unemployment wanes. People are generally nervous, apprehensive, and apathetic. Inflation is very low. Kondratieff observed three springs in his data: 1789-1802, 1845-1858, and 1896-1907.

Summer—the economy overheats, exhibiting high inflation as a result of many available value-driven business opportunities. Interest rates and wages skyrocket, and there are increasing demands for capital. Summer ends with a primary recession, and is always accompanied by a major war (The War of 1812, The American Civil War, and World War I), likely the result of heightened energy levels. The mass mood starts out somewhat cautious but ends with growing confidence. There is very high and increasing inflation. Kondratieff observed three Summers in his data: 1803-1816, 1859-1864, and 1908-1920.

Autumn—business is fundamentally tired, credit is overextended, and economic activity is sluggish. The underlying slowdown reduces the forces of economic inflation and makes it possible for people to have their cake and eat it, too, that is, to create purchasing power artificially without causing inflationary overheating. Liquidity does not flow to productive investments because these became overvalued at the end of Summer, and there is a lack of value-driven business opportunities. Therefore, money flows into a succession of undeserving investment vehicles, thereby precipitating bubbles. Consumers, corporations, and governments borrow heavily because real savings were almost eradicated by the inflation of late Summer. People are generally very confident, and there is a feeling of euphoria associated with growth devoid of inflation and all asset classes rising in tandem. People don’t care about debt anymore because no one can even remember the hard times of the past that once made debt something worth caring about. Bankruptcies increase, unemployment remains low, but inflation-adjusted wages stagnate or decline. Autumn ends with a stock market crash, followed by a real estate crash, the results of bubbles bursting. There is disinflation, meaning that prices still rise every year, but they rise by a smaller and smaller percentage as the years go by. Kondratieff observed two and a half Autumns in his data, having published his findings in the middle of the third Autumn. The three complete Autumns were 1817-1829, 1865-1873, 1921-1929.

Winter—the depression period cleanses debt from the economy, primarily through bankruptcy. Winters are economically characterized by bank failures, enormous unemployment rates, and falling home and stock prices. Emotionally, Winter is characterized by despair, panic, fear, and concern. There is deflation, the broad based decline in all prices for goods and services. Kondratieff observed only two Winters in his data: 1830-1844 and 1873-1896.

Thus, in summary, Kondratieff observed the following two and a half Long Wave Cycles: 1789-1844, 1845-1896, and 1897-1925 (this one is a half cycle).

There is one more very important observation Kondratieff made. He noticed that recessions occurring during the downward part of the Long Wave Cycle had a different character than the recessions occurring during the upward part of the Long Wave Cycle. Those recessions occurring during the upward half of each cycle tended to be short, shallow, and had quick recoveries in employment. Recessions occurring during the downward half of each cycle tended to be longer, deeper, and exhibited more drawn out recoveries in employment. Thus, one can surmise that inflation is the lifeblood of the economy. When inflation is rising, recessions are not so traumatic, but when inflation is falling, then recessions become more of a big deal. Thus, the intermediate business cycles are strung, as it were, on the waves of the long cycles.

As you may have suspected, the Long Wave Cycle did not end upon the death of Kondratieff. No, it continued to exert itself after his death and is most certainly alive and well even today. Although he was imprisoned at the time, Kondratieff must have found some solace in that there was a worldwide depression in the 1930s, just as his work would make you suspect there would be. Ultimately, the third Long Wave Cycle ended in 1949, eleven years after the great Russian economist died. Few people today realize that the Great Depression of the 1930s was hardly the only depression the world has ever known. In fact, in the 1920s, most people called the 1890s the Great Depression! Depressions, defined as negative GDP growth lasting for more than 18 months, occurred in two prior Kondratieff Winters before the 1930s episode that we are most familiar with.

And you should not think that the post-Industrial Revolution cycles since 1789 are the only ones there ever were. The Long Wave Cycle can be found in the history of agricultural prices going as far back as the year 1260. The Mayans in Central America held festivals to ward off a calamity that appeared every 50 to 60 years. The Bible tells of 50-year jubilees in which old debts were forgiven. The long wave is deeply rooted in capitalism. It is old, very old.

In the upcoming Part 3 of this series of Economic Updates, we will discuss some of the reasons for the Long Wave Cycle’s existence, recalling the lessons of systems engineering that we learned in Part 1. We will integrate our knowledge of systems engineering and history in order to interpret the modern-day continuation of the Long Wave Cycle.

Pete's Lecture Series: The Long Wave Cycle vol. 2 | 5 comments | Create New Account
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