Policymakers have a hard time making sense of the fallacy of composition. We all, of course, now know about the paradox of thrift from our readings of the Great Depression where an excess of private virtue (greater private savings, debt prepayments) led to public doom (fall in effective demand, collapse in broad money supply). More recently we saw another kind of fallacy of composition at work. Our interconnected financial system stood on the verge of disintegration when the rational response for any single financial institution was to cut back on counterparty exposure, but when every other institution wanted to do the same thing it threatened to produce a wholesale collapse. The US Fed’s hub-and-spoke system of liquidity support – and equivalent measures by other central banks as well – was belatedly designed to thwart the market’s self-destructive tendency to freeze credit.
They are the three elements in most magic tricks: a diversion, then a lightness of fingers and, finally, the astonishing result. The first is called the “pledge”, the second the “turn” and the third the “prestige”, the last meant to be accompanied by the magician’s “hey presto” call ringing over the heads of the spectators. On March 15th 2009 US Fed Chairman Ben Bernanke had his hey presto moment when he talked about the green shoots of recovery.
This article is an adaptation of some of the main themes in Arun Motianey’s forthcoming book SuperCycles: The Economic Force Driving Global Markets and Investment Strategy, to be published by McGraw Hill in early 2010.
Dean Acheson, President Truman’s Secretary of State, with characteristic immodesty called his biography Present at the Creation. From his vantage point – top diplomat for a victorious power that had emerged from a destructive war in better condition than any of its allies and in a position to shape the world according to its interests – he could be smug about it. Those who have presided over the near- demise of the financial system could not be feeling as confident that they have the blueprint for a new order. Two years after the scale of the crisis became evident we are still struggling to understand what caused the financial system to so nearly collapse.
And here there is no dearth of candidates. At some populist level it was about greed and venality (bankers, loan originators and borrowers, politicians); elsewhere it is about incoherence (the porous regulatory system) and conflicts of interest (credit rating agencies). But in some parts of the policy world the search is on for deeper causes; and global imbalances appear to be the prime culprit.
If so, we risk missing the full picture. Imbalances on the current and capital account are mere symptoms of an underlying phenomenon of great power and complexity that I have named the Global Supercycle. It has been the dominant force over the last century and a quarter in the history of modern capitalism, exceptfor the forty year period, 1930-70, from the Great Depression to the breakdown of the Bretton Woods Arrangement, during which time it became dormant.
THE SUPERCYCLE AND THE GLOBAL ECONOMY Economists have long seen the global economy as the aggregation of many national economies, whose business cycles spill over through trade and finance and impinge on each other. The Supercycle requires us to push that idea out of our heads for now and to think of the global economy as one very large economy where sectors rather than countries experience fluctuations, sending shockwaves coursing forwards and backwards through the rest of the structure.
What are these sectors? Whence these fluctuations? Let us consider each in turn.
Sectors are points on a single vast global production pipeline that runs from commodities at one end through manufactures—capital, intermediate and finished goods—to household consumption at the other end. This is easy to understand intuitively. All goods begin as commodities, get processed through various intermediate stages of production, drawing in labor along the way, until their final stage, at which point they are consumed. (Even services can be thought of as a bundle of goods and labor—think of the X-ray machines and the radiologist who diagnoses your medical condition or the pipes and tools that the plumber uses to unclog your drains.) Where these sectors lie in the global pipeline is all that matters at this stage. Where they may be found in the individual economies is quite irrelevant, (1) at least till we introduce the notion of moveable exchange rates.
The arrival of a new monetary standard—whether the expanded Gold Standard in 1879 or the Enlightened Fiat Standard in 1979—bringing the promise of price stability after a long period of purchasing power debasement sets in motion a series of price declines throughout the pipeline. First to fall in price are commodities, followed by goods and services, and finally we get declines in the price of labor, i.e. nominal wage deflation. The Supercycle is the name we give to this process of falling prices— leaving credit-induced booms and busts in its wake everywhere—as it winds its way through the pipeline.
PIG IN A PYTHON This is how it works. The force that propels disinflation—and then creates deflation—through the pipeline is shifts in the barter terms-of-trade for each point on the pipeline. Specifically, if the cost of inputs for a particular sector should fall and the cost of its output was to stay the same, or increase, it is a terms-of-trade gain for the output and a terms-of-trade loss for the input. A gain in terms-of-trade—sometimes also called its relative price—for that sector amounts to a boost in operating profit margins. In turn this boosts optimism. Employment and capacity in that sector start to expand, soon spreading outwards into auxiliary industries. Credit availability booms as returns on investment are ramped up with leverage to maximize returns on equity. But in every case overinvestment follows, a debt crisis results, and prices begin to fall as excess capacity is unwound. Deflation in this sector then becomes the reason for a terms-of-trade gain for the next sector further down the pipeline.
Now let’s move from the abstract to the concrete. Within this framework of sectoral expansions and contractions moving through a global pipeline, our recent history of economic crises –the lost decade of Latin America, the crises of the Japanese and emerging Asian economies, the near-collapse of the US and UK economies and of the international financial system in the last few years – cannot be seen as different events but as successive points on the same extended pattern that is the Supercycle. The bust in Latin America (commodities-dominated) in the 1980s necessarily fed the boom in Japan and the Asian tigers (manufacturing) just as the bust there in the 1990s fed the upward spiral in the large services-dominated and goods consuming economies of the developed world, most notably the US and UK economies, for most of the last decade.
Households in these economies were the latest beneficiaries of the Supercycle’s disinflation trend since nominal wage growth remained strong after 1997 even as goods prices were starting to decline. True to form, households would exhibit their own form of exuberance by leveraging up and investing in housing, their preferred asset. All this would end up as crushing deadweight on the balance sheet of households in these goods-absorbing economies. The unwinding of housing asset excesses led to the financial system bust with all its well-chronicled effects and this is where we find ourselves today.
Now there is one last hobnailed shoe to drop: at every stage in the Supercycle the misalignment in terms-of-trade must eventually correct. Since US households, the main consuming sector in the global pipeline, had experienced a positive terms of trade shock they must now give back that gain. This will come from nominal wage deflation, a nasty outcome; or, as I shall argue presently, we inject inflation everywhere else in the pipeline, which carries us to the same goal but in a less agonizing way.
IMF AS SUPERCYCLE’S HIT MAN But first we need to turn one piece of conventional wisdom on its ear; namely that our system of floating exchange rates is superior to fixed rates because it absorbs these kinds of shocks better. I shall argue that this is utterly false and the IMF has unwittingly and in its customary short-sighted way contributed over the years to aggravating the effects of the Supercycle.
If we lived under a pure Gold Standard regime we would experience something like the barter terms-of-trade shock that I have just laid out and the world economy would experience the succession of crises I have described. Yet I am convinced that the propagation mechanism of the Supercycle—the shifts in the nominal terms-of-trade and the ups and down in economic activity that have resulted from it—has been made more extreme because most economies have flexible currencies. What I am saying here is that the amplitude in output swings tends to be much greater in the floating exchange rate system. The crises tend to be deeper but the recoveries tend to be sharper. From the perspective of the individual country this is probably a good thing; from the standpoint of the Supercycle it is unquestionably bad.
This will seem counter-intuitive to most readers. Don’t Gold Standard countries have to adjust to the harsh price-specie-flow arrangement where capital outflows reduce the money supply and hence force the sector (and the economy in question) to deflate? Didn’t the in-built flaws of the Gold Standard produce the Great Depression? The answer is No to both questions; it was a breakdown in the Gold “Exchange” Standard (where payments imbalances were to be remedied by borrowing from a pool of funds created by the leading economies of the world in the mid-1920s and so obviating the need for gold to flow across borders and force adjustments of money supply) that led to the Depression. It was a failure of policy coordination—compounded by other policy mishaps in the US economy in particular— and not a failure of the underlying arrangement that produced an appalling outcome.
A better way to illustrate the broader point of fixed vs. floating currencies is to simply compare Malaysia and Thailand between 1997 and 2001—or Argentina and Mexico between 1995 and 2001. Unit export prices in each case fell much more sharply in the economy that had devalued its currency (Thailand, Mexico) than in the economy that held the nominal value of its currency (Malaysia, Argentina). These falls translated into lower input costs to the foreign buyer, widening his margins more than would have been possible if the supplier was simply deflating in a fixed-exchange rate regime. The problem was being handed on to the next sector in the supply chain; the terms-of-trade shock was getting magnified. Once we stop seeing crises as individual events but as part of the fabric that is the Supercycle it occurs to us that problems at each stage were simply cumulating.
The international Monetary Fund, goaded in each case by the Rubin-Summers-Fisher troika, acted to enforce a program of devaluations and tight monetary policy. The idea was to engineer a large real depreciation of the exchange rate in each of the crisis economies, all in the name of restoring competitiveness, and foster a quick adjustment of these countries’ imbalances. The boom that would follow in the US economy and elsewhere starting from ten years ago was a direct consequence of these exchange-rate policies and of the flawed advice given to these countries by the Fund and its supporters in the US Treasury. The Supercycle had been given a powerful tailwind and so came roaring into the US economy.
A TALE OF TWO SUPERCYCLES That earlier Supercycle—the Classical one, stretching for more than half a century from the widespread adoption of the Gold Standard in the 1870s to the Great Depression—ended abruptly in the mass liquidation of goods-producing capacity in the Gold-Standard economies of the early 1930s. The modern global economy has already had its own (arguably milder) versions of the Great Depression in the off-and-on catatonia of the Japanese economy and the fast-motion collapse in East Asia and the manufacturing sectors of the US economy. In each case we forestalled the most severe effects of the 1930s—where the economy folds in on itself—because today’s policymakers have learnt from the mistakes of the past, though as explained earlier they have also made some of their own, the move to flexible exchange rates being the biggest one.