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.
The one we’re in—the Modern Supercycle now thirty years old, since I date its birth to the formation of the Volcker Fed in 1979— has proceeded much further than its predecessor, but it has also moved much quicker. Today the global economy is at a different, indeed later, stage of the Supercycle than it was at the time of the Great Depression. Or to phrase it differently: the policy failures of that earlier era essentially short-circuited the natural progression of the Supercycle and brought a depression crashing down on many parts of the world economy. Avoiding those errors in the late 1920s and early 1930s would have probably thwarted the Great Depression but would still have brought us to a point similar to where we are now. We cannot frame the issue that way without then asking whether our policymakers truly understand this crisis and whether they sit on the threshold of another epic intellectual failure.
So this is the question we must put to ourselves: today’s policymakers seem so determined that we not misapply the solution, but are we sure we are not misdiagnosing the problem? We should ask ourselves whether this crisis at this stage of the Supercycle warrants these stabilizing responses.
WHERE DO WE GO FROM HERE? Let me not equivocate about where I stand on this. My comments apply largely, but not exclusively, to the situation in the US economy. I am convinced that our policymakers simply do not understand the crisis they confront. Here it is briefly. The Great Depression has taught us a few important lessons but none more important than this: the government is the buffer of last resort, both to catch falling demand and as a final guarantor of the financial system. The government sector is attempting to insert itself into the Supercycle process and grant a reprieve to the most distressed sectors. Its overriding objective is to give them enough time to repair themselves. This “verity” will be sorely tested during the crisis and I believe will be found to come up short.
Transferring debt from the household sector to the government or from the financial sector to the government (after some kind of household debt forgiveness is mandated on the banks) is unworkable, mainly because it is unfeasible given the political and cultural power of US financial firms as commentators like Simon Johnson have demonstrated so eloquently. Neither will the policy of forbearance, where the government will not so much provide direct relief to the problem of over-indebtedness as promote the conditions for some sort of healing to begin, through guarantees and fiscal stimulus. Forbearance is simply a broad term that means an indirect government intervention in the economy’s debt problems by attempting to restore health and therefore solvency through government spending rather than a more direct approach of taking on the bad debts in the system and then spreading debt-forgiveness around like some sacred balm. It has been the preferred approach in the crisis-afflicted economies recently because it satisfies the fiscal tidiness that the market demands from governments. Cyclically-induced deficits now are expected to be paid back with cyclically-induced surpluses later.
I have no confidence that either transference or forbearance would be enough to get us out of this crisis. The household sector in the US is going through a slow-motion version of what the banking sector experienced: a simultaneous balance sheet and income statement correction. But with one important difference; it does so without the direct support of the government so enjoyed by the banks. The fall in asset values and the rise in joblessness dictate not just a rise in the savings rate but its continuation for several years. As nominal wage deflation sets in the challenges become insuperable.
This will be prove to be the real parallel with the Japanese economy but with far more serious consequences; instead of over-indebted Japanese corporations think over-indebted US households. The sorry excuse that passes for US financial sector reform, all in the name of returning to a status quo ante so that asset values on US household balance sheets go back to earlier levels and debt outstanding falls back to the same low percentage of net worth, will be crushed by these corrective forces. It will be seen by history as an act of collective self-delusion. The causality needs to be understood. Because the household savings rate will stay high for many years to come the US government’s debt stock must necessarily keep growing to soak up those savings. The external imbalance problem of recent years will be replaced by an internal imbalance problem.
THE WHEEL OF MISFORTUNE Inflation, painful though it is, seems to be the only solution. The Supercycle is at its core a process of disinflation that culminates in deflation; it necessarily implies indebtedness. We therefore reduce the debt overhang by unraveling the Supercycle, which is to let go of our commitments to price stability – that is, by creating inflation.
How do we that? I stated earlier in this piece that the iron law of the Supercycle dictates a correction of relative prices. Gains in terms-of-trade are temporary and must be given back. Nominal wage deflation is the natural outcome but it risks entrenching price deflation permanently.
However, misaligned relative prices can be corrected by inflating other points in the pipeline at a faster rate than nominal wages. Debt, meanwhile, where it is locked into fixed rates cannot adjust to inflation and so loses value in real terms. The trick then is to bring in inflation in both prices and wages but to keep the nominal value of the existing debt stock constant. Is this a free lunch? No, creditors will pay for this solution but given a choice between mass defaults or high inflation, I cannot see why they would prefer the first.
I argue that our hallowed central banks may have no choice but to behave “irresponsibly”, to stop talking the talk of price stability and to quietly monetize the debt on their books. Think of it as a noble lie: technically simple, politically difficult. The weakening US dollar will do the rest.
None of us wishes to get sucked into an inflation whirlwind. I argue that the way we will fight our way out of this coming era of superinflation with price rises in the double digits—if not hyperinflation where inflation is over 100 per cent per year— or possibly stagflation where high inflation coexists with low growth is by introducing a system of indexation after the initial surge of inflation designed to correct the misalignment in relative prices in the pipeline and cut down the real value of debt. Later we could embrace a new monetary standard. That could mean a return to the Gold Standard or some other kind of bullion-backed system. Or else a new kind of monetary economics that emerges from a new kind of macroeconomics that eschews the easy temptations of a naïve reductionism—that equilibrium economists call microfoundations and lies at the root of our intellectual failure—will point the way out.
(1)Individual economies within this framework could be thought of collections (or “portfolios”) of sectors. Large developed economies tend to be more diversified than smaller developing economies. Hence, the US, although services dominated, also probably has more sectors from the global pipeline represented in its national economy than any other. Yet even here the dominance of services—and of financial services in particular—delivered a crippling blow to the US economy when the Supercycle made its way to the end of the pipeline.
An economy like Ecuador’s or Angola’s or even Russia’s is dominated by a small number of usually commodity-related sectors. Of course, there also tends to be ancillary growth that occurs alongside these sectors. These (usually) service industries that spring up to support the dominant one will suffer the same fate as its symbiotic partner in the up- and down-phases of the Supercycle.
In general, though some of this is the result of endowments though globalization of trade and finance have worked to reduce these dispersions and increase concentrations of sectors within national economies, as one would expect from the workings of comparative advantage.