I. War and the Business Cycle
II. New Paradigms, Old Cycles
By: Dr. Sam Vaknin
Also published by United Press International (UPI)
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The Disruptive Engine - Innovation and the Capitalist Dream
The Friendly Trend - Technical vs. Fundamental Analysis
The Roller Coaster Market - On Volatility and Risk
The Myth of the Earnings Yield
The Bursting Asset Bubbles
The Misconception of Scarcity
The Merits of Inflation
The Washington Consensus - I. The IMF
The Distributive Justice of the Market
Governments and Growth
I. War and the Business Cycle
Peace activists throughout the world accuse the American administration of profit-motivated warmongering. More sophisticated types remind us that it was the second world war - rather than President Franklin Delano Roosevelt's New Deal - that ended the Great Depression. "Wag the Dog" is a battle cry in Europe implying that the United States is provoking yet another conflict in Iraq to restart its stalled economy and take the collective mind off an endless stream of corporate sleaze.
In the wake of the previous Gulf war, in the Spring 1991 issue of the Brookings Review, a venerable American economist, George Perry, wrote:
"Wars have usually been good for the U.S. economy. Traditionally they bring with them rising output, low unemployment and full use of industrial capacity as military demands add to normal economic activity." According to Perry, writing long before the dotcom euphoria and slump, war is counter-cyclical.
The National Bureau of Economic Research (NBER) Business Cycle Dating Committee tends to support this view. The strongest expansions were registered during and after major crises - the Civil War, the first and second world wars, the Korea War, throughout most of the conflict in Vietnam and immediately following Operation Desert Storm, the previous skirmish in Iraq.
In the wake of September 11, US military spending is already up one tenth and poised to continue its uptrend. Defense contractors and service industries, concentrated across the southern USA stand to undoubtedly benefit after a lean decade following the unwinding of the Cold War. GDP may grow by 0.6 percent this year based on $50 billion in war-related expenditures, project DRI-WEFA for MSN's Money Central.
This is an unrealistic price tag. According to the Cato Institute, Operation Desert Storm cost $80 billion (in 2002 dollars), the bulk of which was covered by grateful allies. This war may be more protracted, less decisive and its costs are likely to be borne exclusively by the United States. Postwar reconstruction in Iraq will dwarf these outlays, even allowing for extra revenues from enhanced oil production.
DRI-WEFA present a worst case scenario in which GDP falls by 2.2% over two quarters, the Fed Funds rate ratchets up to 6% to staunch inflation, and unemployment peaks at 7.8%. Recovery is unlikely in the first 18 months of this nightmarish script.
On the minus side, the budget deficit has already ballooned, crowding out lending to the private sector, stoking inflation and threatening to reverse the downtrend in interest rates. Edward Yardeni of Prudential has demonstrated how inflation has followed every single military conflict since 1800. Ultimately, taxes are likely to rise as well.
Yet, that war impacts the timing and intensity of the business cycle is by no means universally accepted.
In an International Finance Discussion Paper titled "Money, Politics and the Post-war Business Cycle" and published by the Board of Governors of the Federal Reserve system in November 1996, the authors, Jon Faust and John Irons, sweepingly dismiss "political effects on the economy". "If they exist" - they add - "they are small and difficult to measure with confidence."
David Andolfatto, from the Department of Economics of Simon Fraser University in British Columbia, Canada, in his "U.S. Military Spending and the Business Cycle" dated October 2001, quotes an email sent to him by one of his students:
"I heard someone say that the US government tends to ‘find themselves in war’ every time they are in a recession. This person also claimed that the increased government expenditures on war pulled the US out of each of the last few recession they’ve been in. Furthermore, this person said that the ‘military industry’ is one of the biggest industries in the US, which is why greater government expenditures on war always pull the US out of recessions ... the boom the US had in the last decade was in large part attributed to all their considerable military effort ..."
Andolfatto then proceeds to demolish this conspiratorial edifice. Military spending per adult in the USA has remained constant at $2000 between 1947-2000. It actually declined precipitously from 15 percent of gross domestic product during the Korea War to 4-5 percent today. Military buildups - with the exception of the Gulf War - mostly happen during peacetime.
During the Unites States' recent spate of unprecedented prosperity in the 1990s, military layouts actually shrank. When they did expand in 1978-1987, the economy endured at least one serious recession (1979-1983). In reality, changes in military expenditures lag changes in GDP. Surprisingly, mathematical analysis reveals that GDP growth does not respond measurably to unexpected surges in military spending. Rather, military budgets swell when GDP suddenly increases.
But this is a minority view. Even economists who dispute the economic schools of shock-driven cycles admit that war does affect the economy. Theoretically, at least, government spending, investment decisions and consumer confidence should be affected.
Jonas Fischer at the Chicago Federal Reserve Bank claims that real business cycle models cannot account for the response to fiscal shocks of real wages and hours worked, unless they unrealistically assume that marginal income tax rates are constant and that increased government purchases are financed in a specific manner.
In any case, war, or a commensurate military buildup, do cause expansionary deficit-financed government purchases, employment, output and nonresidential investment to rise while real wages, residential investment and consumption fall. This is compatible with the predictions of neo-classical business cycle models.
There are longer-term effects. According to Martin Eichenbaum from Northwestern University, productivity in the manufacturing sector declines - though it rises in the private sector as a whole. Ultimately, the production of durable goods contracts and interest rates, having initially dropped, end up rising. Marginal income tax rates tend to mount post conflict.
Consumers and investors are inclined to postpone big-ticket decisions in times of uncertainty. Hence the adverse reaction of the capital markets to the recent crisis over Iraqi disarmament. With the exception of the Gulf War and the Cuban Missile Crisis, the Dow Jones Industrial Average has always crumbled in the face of hostilities, only to skyrocket when the situation stabilized and certainty was restored.
The DJIA went down 12 percent when the Korean War broke in 1953 - only to reverse the entire loss and climb yet another 18 percent in the following 3 months. After September 11, 2001 it plunged 14 percent and then clawed back the shortfall and soared an extra 21 percent by the yearend.
After the first victorious day in Operation Desert Storm, stocks surged by 4.6 percent on Jan. 17, 1991, by another 7 percent in the following 30 days and by a total of 25 percent in the next 2 years. According to Ned Davis Research, quoted by USA Today, the Dow has risen on average by c. 15 percent in the year after every triumphant excursion by America's military. Messier conflict, though - like the Vietnam War - induce no exuberance, it seems.
The Gulf War was preceded by a brief recession in the United States. The Dow lost one fifth of its value. Unemployment soared. House prices fell and so did retail sales. When the war erupted, business in shopping malls, car dealerships and airlines ground to a halt. The spike in oil prices added to their woes.
But the recession lasted merely nine months and ended officially a month before the actual invasion of Kuwait by Iraq. It was followed by the longest expansion on record. It affected both sides of the Atlantic. This, despite the fact that the economy was in bad shape long before Saddam's antics. Interest rates stood at about 8 percent, inflation was running at double the current rate and President George Bush Sr. raised taxes rather than lower them, as his son has done.
Was the quiver in 1991-2 induced by the war in Iraq - or by the contraction of defense and aviation industries following the end of the Cold War? Probably the latter.
But talking about a uniform trend in a country as vast as the United States is misleading. As Knight Kiplinger, editor-in-chief of the Kiplinger Letter notes, regions and industries in the USA have endured recessions even as the entire economy boomed.
II. New Paradigms, Old Cycles
The looming war in Iraq is a timely reminder of the fleeting nature of economic fads.
Until recently, the very existence of business (trade) cycles was called into question by the devotees of the New Economy. It took a looming global recession to convince wild-eyed optimists that old cycles are more reliable guides than any new paradigm. Even now, three years later and still in the throes of a meltdown of capital and real markets on both sides of the Atlantic, the voguish belief in the demise of pre-1990s economics is alive and well.
Even conservative voices, such as The Economist reassure us that consumer price inflation is dead and that policymakers should concentrate on the risk of deflation brought on by asset disinflation. Central bankers - particularly Alan Greenspan the mythical Chairman of the Federal Reserve - are castigated for adhering to outmoded schools of thought and for fighting the last war (against inflation), or the wrong one (artificially perking up the stock markets).
The Economist was among the most consistent and persistent critics of the New Economy. Yet, by preaching that certain economic phenomena - notably inflation - are "over" it has joined, unwittingly, a growing camp of "revisionist" economists who spot the demise of the business cycle.
As recapped by Victor Zarnowitz, the research director of the Foundation for International Business and Economic Research in New-York, the optimists believed that downsizing, new technologies, inventory control, the predominance of the services sector, deregulation, better government and globalization have rendered boom and bust a thing of the past.
They tended to tone down the roles of earnings, inventories, investment and credit, the drivers of the "now defunct" classical business cycle. They also largely ignored the interplay between different sectors of the economy and between entwined national economies - continuous interactions which determines inventory planning, the level of wages and pricing. The purported connection between the money supply and output was largely discounted as unproven.
The consensus now, though, is that the cycle is alive and well, though it is less volatile and more subdued. Economies spend less time in recession than they used to until 1980. The cycle is still susceptible, though, to exogenous shocks, such as war, or an abrupt increase in the price of oil. Bursting asset bubbles, if they become more frequent in the future due to financial liberalization, globalization and unbridled credit growth, may restore past volatility, though.
Another ominous phenomenon is the synchronization of recessions and expansions across continents. According to the International Monetary Fund, gross capital flows has exceeded $7.5 trillion globally in 2000 - four times the amount of money sloshing around in 1990. Foreign portfolio assets doubled as a percentage of household assets.
The ratio of merchandise exports to world output has long exceeded its 1913 level, the previous record year. Such unhindered exchange exerts similar influences on countries as far apart as Germany, the United states, Argentina and Singapore - all in the throes of a concurrent recession.
Still, expansions continue to be restricted by the increase in population, net investment and, importantly, technological innovation. The downside is also limited by population increase, government policy on income support and investment. The economy fluctuates to adjust itself to these constraints. The business cycle is a symptom of this process of adaptation.
The waxing and waning of credit made available by alternately over-optimistic and over-cautious financial intermediaries plays a crucial part. Fiscal policy - which affects investment and employment - also matters as do foreign trade, monetary policies and the reaction of the financial markets.
The business cycle typically passes through seven phases correlated with the fluctuations in the output gap - the difference between an economy's actual and potential gross domestic product. Cycles are self-perpetuating, though they can be hastened by exogenous shocks, such as a precipitous rise in oil prices or a protracted military campaign. They can also be smoothed or ameliorated by the operation of automatic fiscal stabilizers and appropriate counter-cyclical government policies.
Centuries of cumulative experience allow us to identify these stages better than ever before, though timing them with any accuracy is still impossible. They are based on the shifting balance between the emotions of greed and fear - as immutable as human nature itself.
Every economic cycle invariably starts with inflation. The previous sequence having ended and the new one just begun the environment is mired in uncertainty. In the wake of a recession, often coupled with deflation, goods and services are (absolutely) scarce and money is (relatively) abundant.
When too much money chases few products, the general price level rises. But this constant and ubiquitous increase (known as "inflation") is also the outcome of mass psychology. Households and firms compensate for the aforementioned high degree of uncertainty (that is, of risk) by raising the prices they charge. Market signals are thus garbled by psychological noise and uncertainty increases. It is a vicious cycle: inflation brought on by uncertainty only serves to enhance it.
Ignorant of the appropriate or optimal equilibrium price level, everyone is trying to stay ahead of perceived economic threats and instabilities by increasing the risk premiums that they demand from their customers. On their part, consumers are willing to pay more today to avoid even higher prices tomorrow.
Inflation appears to be a kind of market pathology, or a market failure. But the psychological underpinnings of inflation have been thoroughly dissected in the last few decades. It is the source and dynamics of economic uncertainty that remain obscure.
Inflation disguises the suboptimal and inefficient 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 are distorted and prevent meaningful analyses and well-founded decision making.
Inflation leads to technological and economic stagnation. Pecuniary aspects are emphasized while industrial and operational ones are neglected. Financial assets are preferred to investments in machinery, infrastructure, research and development, or marketing. This often yields stagflation – zero or negative growth, coupled with inflation.
In an effort to overcome the pernicious effects of inflation, governments liberalize, deregulate and open their economies to competition. This forces firms to innovate and streamline. Efficiency, innovation, entrepreneurship, productivity and competitiveness are the buzzwords of this phase.
As trade barriers fall, cross border capital flows and investments increase, productivity gains and new products are introduced. The upward price spiral is halted and contained. The same amount of money buys better, more reliable products, with added functionality.
The rise in real incomes results in increased demand. The same dose of working capital generates more production. This is technological deflation. It is beneficial to the economy in that it frees economic resources and encourages their efficient allocation.
Increased consumption (both public and private) coupled with a moderate asset price inflation prevent an outright downward spiral in the general price level (monetary deflation). Moreover, as Jeffrey Miron demonstrated in his book, "The Economics of Seasonal Cycles", output growth causes a surge in money supply.
These conflicting influences allow inflation to remain within a sustainable "band". This transitory phase - from hyperinflation or high inflation to a more supportable plateau - is known as "disinflation". It usually lasts one or two decades.
Various studies have shown that the revolutions in knowledge, communications and transportation technologies have shortened both the cycle and every stage in it. This is attributed to the more rapid dissemination and all-pervasive character of contemporary information.
The values of important parameters such as the equilibrium general price level and other gauges of expectations (such as equity prices) are all determined by data. The more information is available more readily – the more efficient the markets and the shorter and the speedier the business cycles. This enhances the false perception that modern markets are inherently unstable. Yet, rapid cycling does not necessarily imply instability. On the contrary, the faster the adjustments in the marketplace – the more efficient the mechanism is.
The psychological wellbeing and reassurance brought on by disinflation generate demand for assets, especially yielding ones (such as real estate or equities). The more certain the future value of streams of income, the more frequently people transact and the more valuable assets become.
Assets store expectations regarding future values. An assets bubble is created when the current value (i.e. price) of money is low compared to its certain future value. This is the case when prices are stable or decreasing. Stock exchanges and real estate then balloon in irrational exuberance out of proportion to their intrinsic (or book) value.
All asset bubbles burst in the end. This is the fifth phase. It signifies the termination of the bull part of the cycle. Asset prices collapse precipitously. There are no buyers only sellers. Firms find it impossible to raise money because their obligations (commercial paper and bonds) are not in demand. A credit crunch ensues. Investment halts.
The bursting of an assets bubble generates asset price deflation. The "wealth effect" is replaced with a "thrift effect". This adversely affects consumption, inventories, sales, employment and other important angles of the real economy.
The deflationary phase, on the other hand, is usually much shorter. People do not expect it to last. They fully anticipate inflation. But though not assured of low prices, they are so preoccupied with economic survival that they become strongly risk averse. While in times of inflation people are looking for ways to protect the value of their money in times of deflation people are in pursuit of mere livelihood. A dangerous "stability" sets in. People invest in land, cash and, the more daring, in bonds. Banks do the same. Growth grinds to a halt and then reverses.
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.
Full-fledged deflations are rare. Outright or growth recessions, business slumps, credit crunches, slowdowns - are more common. But a differentiated or discriminatory deflation is more common. It strikes only certain sectors of the economy or certain territories.
A monetary deflation - whether systemic or specific to certain industries - is pernicious. 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. This is known as a "liquidity trap".
Investment and production slump and 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 ("debt deflation"). Coupled with declining asset prices, deflation leads to bank failures as a result of multiple 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: reflation.
The market's failure, at this stage, is so rampant that all the mechanisms of self-balancing and allocation are rendered dysfunctional. State intervention is needed in order to restart the economy. The authorities need to inject money through a fiscal stimulus, to embark on a monetary expansion, to lower interest rates, to firmly support the financial system and to provide tax and other incentives to consume and to import.
Unfortunately, these goals are best achieved militarily. War reflates the economy, re-ignites the economic engine, generates employment, increases consumption, innovation and modernization.
Still, with or without war, people sense the demise of an old cycle and the imminent commencement of a new one, fraught with uncertainty. They rush to buy things. Because the recessionary economy is just recovering from deflation – there aren't usually many things to buy. A lot of money chasing few goods – this is the 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 hazard. They demand to be compensated for the risk of inflation 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, the inflationary segment of the business cycle is an interval of certainty. That inflation will persist is a safe bet. People tend to adhere to doctrinaire schools 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 ideologies disguised as "scientific knowledge". Communism is a prime example, of course but so is the "Free Market" variant of capitalism, known as the "Washington Consensus", practiced by the IMF and by central bankers in the West.
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