Welcome to Finance and Fury, The Furious Friday Edition

With the current state of the markets – and the focus only on today’s news and short-term cycles – In this episode – we will be looking at economies and markets in relation to Waves and cycles in a complex system –

  1. Like seasons in weather – markets have cycles – like weather though, predicting it is not the most accurate –
  2. To do this though we will have a look at what is known as a Kondratieff Wave – And do they still have applications to modern financial markets almost 100 years later

 Understanding Kondratieff Waves

  1. A Kondratieff Wave is a long-term economic cycle believed to be born out of technological innovation – results in a long period of prosperity, then a lull, then a decline
    1. Theory was founded by Nikolai D. Kondratieff – a communist Russia-era economist who noticed agricultural commodity and copper prices experienced long-term cycles – focused on other economic cycles involved which have periods of evolution and self-correction.
    2. With every rise comes a fall – due to the creative destruction element before the take-off of technology
    3. In 1926 – Kondratieff published a study called Long Waves in Economic Life which first looked at these periods
  2. Kondratieff noted that capitalist economies have long waves of boom and bust, that he described similar to the seasons in a year.
    1. Kondratieff’s analysis described how international capitalism had gone through many “great depressions” and as such were a normal part of the international mercantile credit system – The long term business cycles that he identified through his research are also called “K” waves.
    2. Long term means long term – not a few years like a business cycle – but 60 years – around 70% of the average life span – so most of us may see one and a half of these cycles play out
  3. Today – Kondratieff Waves are relegated to a branch of economics called “heterodox economics,” in that it does not conform to the widely accepted, orthodox theories espoused by economists.
    1. Provides an alternative approach to mainstream economics that can help explain economic phenomenon that is ignored by equilibrium models – or traditional economics – does do by embedding social and historical factors into analysis – incorporates behavioural economics of both individuals and societies into market equilibriums over long timeframes.
      1. Mainstream economists who are currently implementing policy – essentially ruling the economic world should be presumably achieving full employment, constant GDP growth with near-perfect utilisation of resources – but also stay there – perhaps buffeted by mild external shocks – but in all their efforts they fail in the real world
    2. K waves faced a lot of hostility on the academic side – criticise equilibrium models of economics which is what academics are built on –
  4. Similar to the academic side – This theory was also not welcomed in Kondratieff’s Russia – His views were not popular to communist officials, especially Josef Stalin, because they suggested that capitalist nations were not on an inevitable path to destruction but, rather, that they experienced ups and downs
    1. At the time – USA was going through the 1929 crash and the great depression of the 1930s – USSR was no better off but the propaganda machine (similar to NK today) couldn’t have the theory of that it was a temporary decline
    2. As a result, he ended up in a concentration camp in Siberia and was shot by a firing squad in 1938

So does this wave theory hold up today almost 100 year later?

  1. Start by looking at the identified patters – following Kondratieff Waves since the 18th century.
    1. The first resulted from the invention of the steam engine and ran from 1780 to 1830.
    2. The second cycle arose because of the steel industry and the spread of railroads and ran from 1830 to 1880.
    3. The third cycle resulted from electrification and innovation in the chemical industry and ran from 1880 to 1930.
    4. The fourth cycle was fuelled by autos and petrochemicals and lasted from 1930 to 1970.
    5. The fifth cycle was based on information technology and began in 1970 and ran through the present, though some economists believe we are at the start of a sixth wave that will be driven by biotechnology and healthcare.
  2. Modern day economic academics have started to pay attention to this – subject of “cyclical” phenomenon – essay from Professor W. Thompson of Indiana University – took a step back and looked at K waves – concluded that they have influenced world technological development since the 900’s – that these developments commenced in 930AD in the Sung province of China – he propounds that since this date there have been 18 K waves lasting on average 60 years
    1. Most people are quite familiar with business cycles that tend to be denominated in terms of months to years – For example – typical business cycle goes – Sales are good, people are confident about the future, and unemployment is reduced. Then sales fall off, the immediate future seems gloomier, and unemployment increases.
    2. The Kondratieff wave is a longer version of economic fluctuation – built off the theory of technological innovation and subsequent diffusion at the world level – can also have some rather major implications for war, peace, and order in the world system through political instability
    3. What drives k-waves has been the subject of considerable analytical dispute. Arguments have been advanced that bestow main driver status on investment, profits, population growth, war, agricultural-industrial trade-offs, prices, and technological innovations
      1. Truth be told – who knows what really is the cause – however, the effects of these cycles are what is notable and what we will focus on

Each cycle has it sub-cycles

– which are dubbed as seasons as broken down into four sub-cycles – The K wave is a 60 year cycle (+/- a few years here or there) with internal phases that are sometimes characterised as seasons: spring, summer, autumn and winter:

  1. Spring: Increase in productivity, along with inflation, signifying an economic boom – 1949-1966
    1. Spring (25 years) – Inflationary phase with rising stock prices and increased employment and wages.
    2. Phase: new factors of production emerge, creates good economic times, where consumption goes up – people spend more and there is rising inflation – it is the starting period of inflation
    3. Best assets are typically real estate and shares – but as this is the start of the new cycle – typically it means that these assets have just gone through a crash
    4. This stage is all about confidence turning around and picking up – and when confidence is high – everything booms
      1. Except bonds – due to inflation
  2. Summer: Increase in the general affluence level leads to changing attitudes toward work that results in a deceleration of economic growth – 1967-1981
    1. Summer (5-10 years) – Stagflation phase with rising interest rates, rising debt and stock corrections. Imbalances lead to war – either economic or physical
      1. Interest rates normally rise which combats inflation – and the risking debts also get slowed down –
      2. The share markets normally go through a bit of a correction as well or just make no progress and stagnate –
      3. There can be a build up of capital goods as consumption starts to lower
    2. Hubristic ‘peak’ war followed by societal doubts and double-digit inflation – but commodities do well in the stage
  3. Autumn: Stagnating economic conditions give rise to a deflationary growth spiral that gives rise to isolationist policies, further curtailing growth prospects – 1982 – 2000
    1. Autumn (7-10 years) – Deflation phase where falling interest rates lead to a plateau and stock prices increase sharply
      1. Inflation starts to drop to due consumption decreasing
    2. The financial fix of inflation leads to a credit boom which creates a false plateau of prosperity that ends in a speculative bubble
    3. In this phase due to falling interest rates – debts rise massively – this causes real estate to boom and for bond prices to rise – shares also do well before they have their peak and crash
  4. Winter: Economy in the throes of a debilitating depression that tears the social fabric of society, as the gulf between the dwindling number of “haves” and the expanding number of “have-nots” increases dramatically – 2000 – meant to be 2020
    1. Winter (3 year collapse and 15 year readjustment) – Depression phase with stock and debt markets collapsing
      1. But commodity prices are increasing.
    2. Excess capacity worked off by massive debt repudiation (or debt default), commodity deflation & economic depression. Inevitably – a ‘trough’ breaks psychology of doom and things move back to the spring cycle
    3. Best investments are cash and gold – as shares and bonds (or debt) are in free fall for the first few years – but then go nowhere for a while

 Implications for 2020 and Beyond

  1. Based on Professor Thompson’s analysis, long K cycles have nearly a thousand years of supporting evidence. If we accept the fact that most winters in K cycles last 20 years this would indicate that we should be coming out of the Kondratieff winter that commenced in the year 2000 soon – but does it feel like it? – Gone on a bit long already and it is a deeper topic – so will cover the current cycle in closer detail next Friday Episode
    1. In sum, the Kondratieff wave appears to be highly pervasive and hence an important underlying function of the world system – think this is an interesting concept and deserves more recognition than it currently receives.
    2. In addition to technology being a major factor in K cycles, credit and banking also play a crucial role.
    3. This is due to the fact that new technology spurs growth, initiative, and risk-taking. This mindset encourages investment and lending, thus when the multiplier effect kicks in, economies expand rapidly.
    4. Moving the focus and analysis on more modern times – can be seen that periods of “K” expansion and contraction bring with them phases of bigger booms and busts.
      1. The picture is doubly exacerbated by increasingly more integrated world funding mechanisms which means these booms and busts are global rather than local and increasingly more political than economic.
      2. Also – the credit capacity of Central banks – in modern times they are on steroids compared to the constrictions placed under the gold standard
      3. The very fact that Central banks since the 90s have been trying to control inflation and the very cost of money may have broken this cycle- as far as following the timelines but not the patterns
      4. A Kondratieff Wave is a long-term economic cycle, indicated by periods of evolution and self-correction, brought about by technological innovation that results in a long period of prosperity.

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