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How The Boom And Bust Cycle Affects The World Economy

In recent years, the world economy has seen many dramatic changes, from the credit crunch, to widespread bankruptcy in Europe, and the emergence of India and China as economic powers.

Recently, I spoke to Peter Rodriguez, senior associate dean and economist at the Darden School of Business at the University of Virginia, on my radio show, Goldstein on Gelt. Professor Rodriguez spoke about how these events have shaped the world economy and why many economies are still affected by the "boom and bust" cycle.

You can listen to the interview on Goldstein on Gelt or watch the video on YouTube.

Below is a transcript:

Douglas Goldstein: In the past few years, we've seen how subprime mortgages have crushed America and bankruptcy in Greece. Can you explain to us a little bit what lies behind the cycle of boom and bust that a lot of economists have seen and why we can't seem to flatten that out.

Peter Rodriguez: This question really strikes at the heart of modern economics and points out the gaps that we have in our understanding. In a difficult way, it also tends to divide economists over what they believe about the economy and how it really works. People talk about Keynesians, neoclassicists, Austrians, and so forth, but what it really lets us know is that economics still has a way to go into making the management of the economy into a science. Beyond that, we can see a few other things. Booms and busts aren't new, and we know that. We've always had booms and busts, especially in modern economies, but there are a few things that really stand out in recent cycles. Among the top ones in my mind are changing demographics and a changing world order, where we see giant economies like China and India. But there are others that are also emerging from the doldrums that they had in the 60's, 70's, and 80's and are really beginning to take center stage. This means changing roles for existing economies in western powers, and adjusting to that is hard. Lastly, I see that there is a combination about innovations and finance and other technologies that meets up with our ignorance about how people behave and aggregate their behavior in the economy, and we've missed in a pretty big way on a few of these recently, and our institutions haven't caught up with that.

Douglas Goldstein: You referred to being able to manage the economy as some sort of science. Do you actually think that will ever happen, or is the economy just so strange because it's basically human nature?

Peter Rodriguez: I definitely think that we can avoid the most extreme circumstances, that we ought to be able to predict extraordinary collapses. Some would disagree with me right away, but I think we've already seen some ability to do that. It's hard to mistake just how much smoother the path of the global economy became in western economies that were mostly high income after the Second World War. They're really sort of flattened out, and we even have this great period of calm and peace which we call the great moderation in the United States and in other places. What we really meant by referring to it that way is that things like inflation, rapid swings, and unemployment were present, but not extreme as we've seen in the past, and I think that is definitely possible. We can smooth that out a bit without viewing it as a perfectly manageable system, but all the way is probably not realistic.

Douglas Goldstein: It seems one of the major tools of the central banks is their ability to control interest rates. Is that enough to allow them to control the economy, or is it better or perhaps worse to give governments more involvement in our day to day economy?

Peter Rodriguez: The interest rate is a tool that's highly influential and insufficient. You couldn't manage all that together. You also have to have sound banking rules and understand when the banking system changes or creates innovations like collateralized debt obligations, or even deregulates in a way where we can't really predict what's going to happen. It's a highly complex system, so interest rates are only one tool that's needed. It would also be a little bit aggressive, and I think I'm wise to suggest that governments are smart enough for having the foresight to make these big changes. They can make nuanced changes that occur over the long run, and they can manage and regulate and provide good timely information, and then you just have to let the system run, and we have to be prepared for that. Interest rate management is going to get more difficult and weaker, and the monetary system is always inventing new things, new monies, and new things that allow people to make transactions, and that keeps a constant state of pressure on the system to adapt quickly. That's where you often run into the biggest problems. We just don't adapt quickly enough. It's hard to do.

Douglas Goldstein: Well, let's talk about another tool that governments have, which is taxation and there are those people who are more in the libertarian, low taxation side and the others on the other side who want to distribute the wealth in a different way, and that's certainly a great power that the government has. There have been tests all over the world for at least decades, if not hundreds of years, if we are talking about the modern economy. How come we can't come to a consensus about what's really best for the economy in terms of high or low taxes?

Peter Rodriguez: I think what happens with tax discussions is that they are inherently personal and political, and we understand that they are at some fundamental level about doing two things, finding a way to finance the needs of government, everything from the military to social services, to other things that reflect the values of the society, and also their redistribution tool one way or the other, and that becomes quite difficult. What we've seen recently is that we have a predominance of income taxes around the world, and that's great, but you don't necessary want to tax productive behavior. There are many great ways to produce income, and often producing income is consistent with job growth and entrepreneurial activity, all of the things we like and want to encourage. But it also reflects another objective, and that objective is to ensure that those at the lower end of the socioeconomic spectrum have ample chances to succeed in life, and that's become more difficult, especially now that the income distribution has grown wider in most economies and appears to be doing so continually.

This is a challenge. Income is the full variable, wealth of the stock variable and over time, wealth has tended to accumulate and then needed to be redistributed to keep societies peaceful and working, and that's not easy. I think that we have seen an increasing tolerance and enthusiasm for taxes that penalize behaviors we don't want to see, where there's the use of carbon or unhealthy habits, and I think we'll continue to see that take place, and I think we recognize that income taxes have some sort of a political upper threshold beyond which it's very hard to proceed. It's not easy to know what to do after that point. It becomes very personal.

Douglas Goldstein: You have a real expertise in Latin America, and people talk about Latin America as an emerging market, but it's a pretty big place. Is that the right term to use for it, and are there investment opportunities there, or does it continue to be a place that just might be so dangerous?

Peter Rodriguez: It's an economy with a lot of variety within it. There are absolutely great investment opportunities there and many of the economies are emerging, but some of them are quite mature and I would say emerging is probably the wrong moniker. If you look at Mexico or Brazil, they are very large, they are really middle income economies that don't have much danger of really backsliding, or doing the things that we often worry about, and then there are host of other smaller economies in a variety of states of development. The big opportunities there are around natural resources, but also around some small businesses and in particular in the larger economy. Brazil has enormous potential. It also has significant challenges, but I think there will be great opportunities for investment there, particularly in energy and other agricultural-based fuels. I think they will develop in other ways too, but the long term prospects for that are huge.

Douglas Goldstein: In terms of their political stability, is this something that we can count on that they are getting more-stable or are we dealing with regimes like Venezuela where, for example, it seems like you don't know who is going to be in charge next year.

Peter Rodriguez: They have one of the most difficult situations around their very wide income distribution. It's a real have's and have not's problem. I think it's going to be put on display more prominently at the World Cup and at the Olympics, which will follow very soon, but I don't think they are going to backslide to become a Venezuela. I think they already have some fairly strong social institutions in place, they are always tested but I don't expect back sliding, but they could grow kind of slow. There was always this bad joke about Brazil that it's the country of the future and it always will be and I think that there are some lingering sense of "we're due, we're overdue," but my optimism is pretty good for them.

Douglas Goldstein: When you spoke about investing you said natural resources. Do you mean actually buying the commodities, or simply investing in companies that are exploiting those commodities?

Peter Rodriguez: I think it's the latter more than anything else. I think what's going to happen for the commodities is they are going to be made cheaper, or the prices will be held in check because of the productive capacity of a nation like Brazil. Their ability to expand and produce anything from sugar, and that includes ethanol and other fuel sources, but also oil and natural gas itself, will be hugely important. Their ability to become a bread basket for certainly the Americas, if not most of the world, has barely begun to be realized and I expect a lot more from them.

Douglas Goldstein: In terms of government corruption, a lot of these countries are not rated high on that scale. It's a little bit worrisome. Do you think that if someone is investing, it's okay to put his money there?

Peter Rodriguez: You have to be really careful. Corruption is a bit problem in many parts of the world. It is a problem in Latin America, almost everywhere. I think in the larger, more publicly traded firms, you can have some security that the institutions will protect you, but in smaller firms, if they can survive it and manage it, they are quite skilled. There are many traps for that. Foreign investors have a hard time in Latin America and other places, and they will for a while.

I think I'd be more worried about Venezuela. That's a reasonable example of that, or even Bolivia, where there's not so much corruption as a mistrust of markets and a very hesitant attitude towards business investment that I think is going to make them grow more slowly and be ultimately a poor place to invest. An economy that might surprise you would be Colombia. Colombia is highly stable, and it's showing a lot of great development. It looks nothing like the economy of the 1980s. They have a way to go, but they've made a lot of progress, so I'm surprised.

Douglas Goldstein: How can people follow your work?

Peter Rodriguez: You could always find me at the Darden School of Business website, and that's just You can also find me at the Great Courses and find some of my work on why economies rise and fall, and the future of economic supremacy, and that's a great company offering products for download or video. If you want to, you can follow me on Twitter. I tweet aggressively and my handle is @profp_rod.