In many ways, the dynamics of an economy is a reflection of the volume and value of all underlying transactions, which is often ‘assumed’ to be quantified in terms of either the GDP or GNP of a nation-state, although the accuracy and make-up of such measures might be questioned. Irrespective of the measure, it is obvious to almost everybody that the economy can be subject to good times and bad times, which we might initially characterise in terms of a ‘boom and bust’ cycle.
So what defines a ‘boom and bust’ cycle?
We might start by simply describing this cycle as a period of economic expansion followed by a period of contraction, which can then repeat itself, but not necessarily in the same way or for the same reasons. During the ‘boom phase’, the economy grows and employment rises, leading to an increase in government tax revenues, while investors see higher returns on their investments. The subsequent ‘bust phase’ usually reverses all these positive trends, although astute financial institutions can make profits within both phases. These cycles can extend into years depending on the severity, e.g. the US depression of the 1930’s or the global financial crisis of 2008. While the financial authorities often cite the need for lessons to be learnt, there is often an underlying assumption that these cycles simply reflect an inherent instability within most capitalist economies. However, such cycles are only an effect and we have to look more closely at ourselves for the cause, which can invariably be traced back to the self-interest of individuals, i.e. human greed. From a historical perspective of the 20th century, the US economy has experienced 12 boom-bust cycles since the mid-1940s with understandable repercussions on the rest of the global economy given its position as a preferred or reserved currency.
So why is it so difficult to manage steady economic growth?
Well, in many ways, we have already partially addressed this question in the previous discussions of currency dynamics and debt dynamics, although we possibly need to look a little closer at the details. In the boom phase, we might simply assume that the balance sheets of banks and other financial institutions have more assets than liabilities, such that they have the confidence to lend into the wider economy at interest rates that do not deter borrowers. Likewise, within this boom phase, employment increases along with wages, which in-turn increases government tax revenues and reduces the burden of the welfare system. Of course, there is a human tendency to think that the ‘good times’ will simply continue and therefore many over-reach themselves in terms of investments and loan risks, which they cannot afford should market confidence start to evaporate.
So what causes a loss of confidence in the markets?
While human nature probably has a part to play in answering this question, this loss of confidence is often initially triggered by those who know what to look for in terms of unsupportable inflation, be it currency, stock and shares or property-house prices. History also suggests that some markets are undermined by fraudulent practice, as in the case of the sub-prime assessment of the US housing market. However, irrespective of the cause, institutional investors are invariably much better positioned to see these tell-tale signs long before most private investors, although as the 2008 crisis highlighted, nobody is necessarily immune from the financial fallout. Of course, any loss of confidence can quickly spread, especially if the initial rumours turn out to be true, which can then lead to wholesale panic, i.e. the bust phase starts. Once started, credit can quickly become more difficult to obtain, which is then compounded as boom-time borrowers find it increasingly difficult to make all their loan repayments. The subsequent slow-down in credit then affects the consumer sector and all businesses dependent on the flow of currency in the market, such that many businesses are forced to cut costs, which further reduces economic spending and may ultimately lead to job losses. This downward spiral of the economy reduces government tax revenues at the very time that social benefit costs are increasing due to unemployment.
Note: Monetary policy involves changing the interest rate and influencing the money supply. Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy. However, recent history suggests that such strategies now only have a limited ability to stimulate a stagnant economy, when interest rates are already near zero and both public and private debt is high, especially if an initial recession develops into a longer term depression.
However, these cycles of boom and bust do not happen in isolation of other dynamics within the economy, such that we might want to try to represent some of these other factors in a series of simple models. At one level, it has been said that an economy is the sum total of all transactions that take place between both individuals and businesses. Within the simplicity of the following model, we might represent these individuals or businesses, numbered as 1 & 2, which seek ‘income’ in order to finance their ‘spending’. However, in a stagnant economy we might recognise that both income and spending would broadly remain unchanged, if amortised over the entire economy, such that overall ‘growth’ would also remain stagnant .
However, within the simplicity of the first model above, there is an assumption of incrementing growth that is proportional to ‘productivity’, which effectively increases income and the ability to spend more. Let us assume that each business produces an ‘output’ using an ‘input’ of labour and capital, where the idea of capital covers materials and machinery, then productivity is the ratio of the output volume to the input volume in some given unit of time.
Note: By way of an example, let us assume two firms 1 and 2 make the same product. Firm 1 produces 6 units of output in one year requiring 2 units of labour and 8 units of capital, where 5 units of this capital figure is associated with raw materials, such that its productivity is calculated to be 6/(2+3+5)=0.6. In contrast, firm 2 produces 10 units of output in one year requiring 2 units of labour and 13 units of capital, where 10 units of this capital is associated with materials, such that its productivity is calculated to be 10/(2+3+10)=0.667.
In this example, firm-2 is deemed to be more productive because its output to input ratio is higher. However, we might note that firm-1 produces its output using considerably less material, such that we might consider this firm to be more efficient, at least, in the material capital used. Therefore, we might speculate that firm-1 might be able to sell its product at a cheaper price, such that over time it gains more market share over firm-2. In this context, we might realise that productivity is a somewhat historic measure of what happened in the past, not what might happen in the future, if firm-A eventually puts firm-2 out of business on product pricing. However, given that the discussion is more orientated towards the productivity of an economy, as a whole, we might prefer to use the idea of labour productivity as a measure of economic growth within a nation-state, which measures the amount of goods and services produced by one hour of labour, such that labour productivity might be defined in terms of the ‘real’ GDP produced by one hour of labour.
Note: Again, only by way of an example, let us assume the real GDP of an economy is $10 trillion and the total labour is estimated to be 300 billion. Then labour productivity would be $10 trillion divided by 300 billion resulting in $33 per labour hour. If the real GDP of the same economy grew to $20 trillion the next year and its labour hours increases to 350 billion, its labour productivity would increase to $57 per labour hour. This would reflect an economic growth in labour productivity of 57-33/33=72%.
However, if we return to the previous model, we might realised that any increase in the productivity would effectively increase the ability to spend more. This increase in spending then becomes an increase in income to other businesses in the economic chain. However, while productivity can support the idea of ‘real’ growth, if its calculation is linked to GDP, which is inflated by debt, as suggested by the chart below for the US economy, we might have to question the real state of growth.
In the context of the simple model being explored, we might initially assume that firms 1 and 2 are small businesses, which produce a physical product that has a market value that contributes to the overall GDP of a nation-state. However, what is not clear in this model is whether firms 1 and 2 actually made a profit or loss in the process. For example, if we were to assume an economy comprising of 1000 businesses that produce products having an output value of 10,000, but where each makes a loss, then the GDP figure would simply represent a backward looking statistic without any inference to the potential fact that most of these businesses would probably have to cease trading in the future, i.e. there is the suggestion that GDP would soon crash. Today, the GDP of most nation-states includes the output ‘value’ contributed by its financial sector, which may account for up to 10% of the GDP total in some cases. However, some question the output value of a bank loan, which includes the new currency created by interest, as its seems to be too far removed from a tangible product. As such, some economists have suggested that the ‘output’ of the finance sector should be quantified in terms of a ‘transfer payment’ rather than as an output value of an actual product. Within this debate, some have even gone as far as to argue that the majority of the finance sector represents ‘unproductive labour’ and therefore ‘unearned income’ as per the following quote:
National account economists of the 20th century could not see anything but paradox in the notion that such a prosperous industry as banking, with such self-evident utility, could do anything but detract from national output or add only marginal value to it.
If we were to take such an argument at face-value, it might then further question the accuracy of GDP growth assumed by most economies, if inflated by debt interest. On the basis of this argument, it would not be gains in productivity that were driving GDP growth but the accumulation of public and private debt, as well as interest, as possibly reflected in the following chart.
OK, if ‘real’ productivity is not driving the economy, how else might we explain GDP growth?
If we modify the previous model by removing the feedback of productivity on income and spending, we might then discuss the effects of credit and debt in isolation. In the revised model below, we see our two conceptual firms 1 and 2 have their spending increased by credit in the boom phase, while income is reduced by debt in the bust phase, which the chart left assumes causes a cyclic effect on growth.
We will qualify the growth cycle shown above as essentially a short-term cycle when viewed at the level of small businesses and individuals because it is often self-regulated by how much they are allowed to borrow plus how much they can afford to borrow without over-reaching themselves.
Note: We might assume that credit is a good thing when it finances investment spending, which leads to increase income. However, credit can also be a bad thing when it finances over-consumption, which cannot be paid back. However, all credit implies an increase in the currency in circulation, which in-turn invariably leads to price inflation.
In the boom phase of this short-term cycle, credit is generally easier to obtain and the interest rate charged may appear to be offset by the opportunities within an expanding economy. While this credit does not immediately increase income, it does allow spending to be increased, which can be translated into an increase to the income of downstream businesses, which it is hoped will eventually cycle back around as an increase in the income of everybody within the economic chain. However, in-line with the note above, this general increase in income invariably creates inflationary pressures that inflate prices and therefore the cost of doing business. However, this effect does not necessarily cause a problem while income increases in-line with inflation, although it should be highlighted that this entire ‘boom phase’ has been fuelled by credit, such that debt has been injected into the economy along with the additional inflationary effects of new currency being created in the form of interest payments against the debt. So, at some point, our small firms hit their debt ceiling, such that economic growth cannot be fuelled by any further debt and markets start to lose confident, i.e. a bust phase can be triggered. While this cyclic process at the individual level does not translate into a ‘ boom and bust’ cycle within the economy, as a whole, its aggregated effect can create a ‘perfect storm’, which not only affects the local economy, but also have far reaching consequences on the global economy at large.
So what conditions might be associated with a perfect storm?
If we make reference to some of the US debt figures already quoted, public debt was estimated in the region of $18,000 billion, while private debt to be in the region of $35,000 billion. As such, today’s US economy was estimated to be underpinned by some $55,000 billion of debt, which in a historical context has generally increased year-on-year.
This discussion has raised the possibility that GDP is inflated by debt, such that any implied growth in an economy may have little to do with increases in productivity. If so, it would require an additional dynamic to be added to the previous credit-debt model in order to prevent each short-term boom and bust cycle escalating within a much longer economy cycle driven by increased debt. However, we possibly need to be a little more specific on how the financial sector, especially private banks, help drive the cyclic dynamics of debt through their ability to create new currency in the form of loans, when it is in their self-interest, irrespective of whether it might create a credit bubble that may eventually lead to financial instability. So, given this bias, we possibly need to table another question:
What would constrain a private bank from simply creating evermore currency in the forms of loans?
Well, while we might assume that the ‘raison d'etre’ of the financial sector is profit, this process is based on the overall confidence in the economy and the ability of its customers to repay their debts. We also need to factor in the capital liquidity of private banks in terms of their asset/liability balance sheets. For the state of their overall liquidity could be seen as a measure of a private bank’s capacity to absorb past risk and their perception of future risk, which might then constrain the creation of currency in the form of new loans. Of course, for reasons already outlined, confidence in the economy can be subject to ‘boom-bust cycles’, but where the financial sector, as a whole, can amplify both the underlying causes and effects. In ‘boom’ times, the rate of debt default rates will generally be low and the private bank loan-debt model remains profitable, which contributes to their overall capital liquidity status, such that it may encourage them to issue more debt-loans and in so doing create more new currency in circulation.
Note: It is worth noting that 97% of the currency in circulation exists in the form of an electronic fiat on a balance sheet, while only 3% now exists in the form of physical cash, where private banks are responsible for the former and the central bank the latter. So, based on this skewed dominance, debt-loans increase the amount of currency in circulation, which might be seen as an inflationary effect, while debt repayment reduces the amount of currency in circulation, which might be seen as a deflationary effect. Of course, it should also be noted that the interest gained on the loan by the private banks also amounts to new currency that never leaves the system and historically has caused the currency in circulation to double every 14 years, which would equate to a 5% compound growth rate.
So, as a generalisation, we might assume that confidence grows throughout the ‘boom’ phase, such that private banks might become more willing to issue loans into what might have otherwise been perceived to be higher risk markets, e.g. productive industry, that does not necessarily have the same equity guarantees as the property market. We might also assume that this increase willingness to lend to industry helps the overall economy to grow, while also causing an inflation of property prices. However, somewhere within this process, the level of increasing higher risk debt leads to problems and the confidence in the economy begins to decline, i.e. a ‘bust’ phase is triggered. As a consequence, private banks may see a reduction in their capital liquidity, as loan assets on their balance sheets default and no longer offset their liability. As such, confidence begins to evaporate and private banks seek to protect their balance sheets by reduced lending, except possibly for guaranteed loans, and may even start to call-in higher risk loans. As the source of new currency in circulation begins to dry-up and existing loans paid off or cancelled, the currency in circulation decreases and, if unchecked, may lead to a financial recession and ultimately economic depression. Even if longer recession is avoided, recovery can often be slow as private banks continue to be reluctant to lend and the wider economy suffers because of a shortage of credit and spending, which economists sometimes described in terms of debt-deflation.
Note: Debt deflation is an economic theory used to explain the cause of economic depressions based on over-consumption, over-spending, and under-investment, which leads to a destabilisation caused by debt and deflation. The combination of decreasing confidence, increasing debt and decreasing prices, results an increased value of debt leading to financial distress.