August 20, 2008 | posted by Michael Baxter in global economy | comments (1) |

Take a sniff, do you smell it? Asset prices are crashing. House prices are down. It’s more than eight years since the FTSE 100 hit its peak. The Dow is lower than its pre-dotcom bust high. That feels a lot more like the 1930s and Japan’s lost decade than it does the 1970 period of stagflation.

If inflation is always a monetary phenomenon, then the credit crunch will surely lead to a crunch in the supply of money. Money is, after all, created by debt. Economic theory would suggest a credit crunch would lead to deflation, not inflation.

That is why many fear we are close to a 1930s type depression. Well, probably not. The economy has an awful lot going for it right now, and we are supposed to know what we should do to avoid a repeat of the mistakes that characterized that period.

But maybe we can learn from history. This is the scary bit. In the past, economic depression followed every 50 years. Okay, it’s nearer 70 years since the beginning of the last great depression. But these things are not pin point accurate.

The is no shortage of theories to suggest the economy follows a cycle – its turnings and rotation as inevitable as the rising and setting of the sun. If that is true, then we are due a downturn.

Maybe, though, you see this as hocus pocus. The pattern of history, no more than half coincidences, and half the laws of probability, throwing up occasional convergences, because that’s the way numbers work.

So, does that mean depression beckons? Or can we throw the theory of inevitable rise and fall in the dustbin?

Winston Churchill once said: “The further back you look, the further forward you can see.” But on this occasion he may have been slightly off. Circumstances occasionally conspire to throw up similar outcomes, but that does not mean history repeats itself.

Yet, there is a constant. One law never changes – human nature. We are the same everywhere, and every time. When the stock market in China booms beyond all reasonable fundamentals, we are told that in China it is different – that we are mistakenly applying western values to oriental practice. Yet, the Chinese stock market bubble burst all the same. Despite all the grand ideas of Confucianism breeding a way of thought that is alien to western ideology, we discovered that actually we are all the same really. The truth is Humans have the same motivations, always.

And that is the common thread of history. It is human nature. That is why Mark Twain was closer to the truth than Britain’s famous wartime Prime Minister, when he said: “History never repeats itself, but it rhymes.”

The lesson of history then is not that time is a monotonous cycle of repetition. It’s not like classical music with its structure. It is more like jazz, full of improvisation. But, clues still lurk in the manuscript of history which can throw light on the present and hints about the future. There is nothing more important than trying to understand this. Here is an attempt to throw some light on this.

So, as Jimmy Page and Robert Plant once said: “Listen very carefully, for the tune will come to you at last.”

Teenagers. Are you misfortunate enough to be a parent of teenagers? Or maybe you work with them, perhaps as a teacher, or maybe you are one, in which case all that is left to be said is cover up your eyes, for the next few sentences are not going to be pretty.

Teenagers just don’t want to learn from us. You can tell them the right thing to do. You can say, “Learn from my mistakes.” But they won’t. Alas, they learn through doing, and all you can do is pray, just like your parents did, that the learning of the lesson will not be too painful.

Yet, teenagers’ inability to learn without trial and error is not really limited to those spotty gits at all. None of us are really good at taking heed of what our parents say.

Maybe that is why we have the so called Kondratieff cycle.

This cycle was first dreamt up by a man who, funnily enough, was also called Kondratieff. Well, that wasn’t his full name, he was called Professor Nickolai Kondratieff and he was a true wise man who really did seem to hear the rhythm of history – at least of economic history. Yet his wisdom failed him in one respect. He failed to foresee the impact his ideas would have on the Soviet government that controlled his fate. Poor old Nicky, his ideas were of true insight, but he ended his days at the pleasure of Joseph Stalin before being sentenced to death in around 1938.

But his insight was to observe four key stages in an economic cycle – something he reckoned to be around 54 years long.

Stage one was spring – also described as an inflationary growth phase. So stage one in the current Kondratieff cycle would be that period from around 1950 to the late 1960s. In the previous cycle it would probably be from about 1896, which marked the end of the late Victorian depression, to the outbreak of World War I.

Stage two in the Kondratieff cycle is known as the summer stagflation phase. So that would apply to the 1970s and early 1980s.

This stage in the Kondratieff cycle often coincides with war. So in the current cycle it was the Vietnam War, in the previous cycle World War I. It has been suggested that the American Civil War and the Napoleonic War coincide with the previous summer phase in the Kondratieff cycle.

Stage three in the Kondratieff cycle is known, strangely enough, as the autumn phase. This is considered to be something of a plateau period, and often sees the combination of growth and deflation. So that is the roaring 1920s in the US, and one assumes the period during the late 1980s and 1990s, and no doubt including that era central bankers now refer to as Nice – non inflationary consistently expansionary – which has only just come to an end.

Bet you can’t guess what season applies to stage four. Give up already? Well, it’s winter. And quelle surprise, winter is not associated with a particularly pleasant economic period.

The last Kondratieff cycle ended with the Great Depression – which led into World War II. In the previous cycle the global economy fell into a phase now known as the Long Depression, between around 1873 to 1896, and the 1830s too saw a deep depression.

Now that is all very interesting and a little uncanny, when you consider the similarities with today. The noughties crash in stocks and shares, followed by house prices, had all the hallmarks of previous precursors to depressions. The 1930s and Japan’s lost decade being obvious examples. The credit crunch, too, seems likely to lead to deflation – again the hallmark of a depression.

So that is all a bit worrying.

But then consider this. We have all heard of the theories of Nostradamus, and no doubt we have all been subjected to some kind of mumbo jumbo prediction of doom. Well, social science has its own theories, but they differ from astrology because they do at least try to apply science.

Back in the 1990s, book authors William Strauss and Neil Howe published a book called The Fourth Turning.

To be honest, the book does ramble on a bit. But it does contain an interesting idea: in fact the idea is pretty core to the book’s underlying thesis.

Strauss and Howe say society goes though four stages – each stage roughly the length of a human lifetime – which they say is around 80 years. But their base idea does make sense. Consider family businesses. They start off with their innovative founder, often they are passed on to an even more innovative son, followed by a not quite so focused grandson and the next generation really are more interested in partying.

Without getting too hung up on the four-generation thing, consider Ancient Rome; Augustus and Julius Caesar himself seem to have been quite brilliant. But go down the family tree, and you find monsters like Caligula and Nero.

But Strauss and Howe try to be more specific than that. They detail four stages: survivor, creator, consumption driven and, finally, the flaccid generation. But their theory uses more colourful language and they refer to four “turnings”– a High, an Awakening, an Unravelling, and a Crisis. They then argue we are not stage four- crisis in the cycle.

The big problem with these theories though is that they are rather inclined to take a series of coincidences, and try and extrapolate a correlation that isn’t really there.

Mathematicians have claimed to prove the Bible follows a mathematical formula. Do you believe that?

But the real problem seems to be us. Have you noticed that the last the last 1o paragraphs either begin with the letter S and T, which come immediately after each other in the alphabet, the letter B, which, spookily enough, is the second letter of the alphabet, or M or W, which kind of look like each other, especially if you turn one of the letters upside down. Strange indeed.

The truth is, though, that there is no pattern. You can create any pattern you like after the event – but it is no guide to the future. So the first year Bjorn Borg wins Wimbledon he doesn’t shave for the whole fortnight, therefore he doesn’t shave again when he plays at Wimbledon. And would you believe it, he wins every year.

But of course Borg did get beaten eventually. And this is where these theories of patterns break down. Once a pattern stops working it ceases to be meaningful. This is what Nassim Nicholas Taleb was referring to in his book The Black Swan. We used to believe all swans were white, until, that is, the discovery of black swans in Australia.

The repetition of history only exists in hindsight.

And bear this in mind too. Modern history is a short affair. Just because economic depressions came about 50 years apart for a century or so, it doesn’t mean they always will. This is a terribly unscientifically short sample from which to make a conclusion. Besides, some argue, the Long Depression of the late 19th century wasn’t a depression at all, just a series of recessions.

But human nature, however, is a constant. We tend to react in the same way to similar circumstances.

So when markets rise, we tend to get over excited, and we then get carried away and jump on like lemmings.

When demand for a good is higher than supply we quickly see an opportunity. But this in turn crowds the market. It becomes a victim of its own success.

There is no inevitable cycle – the cycle is simply the product of human folly and our refusal to learn from the past.

That’s why bankers in the early noughties failed to spot the similarities with the previous banking orgy. That’s why the oil industry failed to realise that when oil was priced at $10 a barrel demand would rise to such a level that supply would be incapable of meeting demand.

This is why the truly insightful investor buys when everyone else is selling and sells when everyone else is buying.

But it is a risky strategy. Get the timing wrong and you look stupid. So fund managers often find it safer to go against their instinct and run with the herd. No one gets fired if they make the same mistake everyone else is making. But the contrarian who goes against the pack and gets it wrong is out of a job as fast as you can say Kondratieff.