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Pablo Paolucci
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Nineteen years experience as an investor in both emerging and first world markets, ranging from derivatives to fixed income. Partner of the Buenos Aires Stock Exchange and Owner of Terminus Consulting LLC with branches in United States, Argentina and Brazil since 2001. Economist and financial... More
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  • The Kondratieff cycle and the aftermath of the subprime crisis

    Every time a major economic crisis takes place cycle theory gets new attention and the process of assigning blames and the statements that the situation was obvious begins. Truth to be told not much specialists saw the economic collapse coming; blaming of “hysterical blindness” due to high levels of growth it’s not necessary, actually followers of cycle theory in general and Kondratieff wave followers in particular were waiting for it, since that blindness actually is predicted by the so called “long wave cycle”. For non Kondratieff believers the signals were there either way, e.g. the increase of US base rate from 1% to 5,75% was the set up for disaster, it was impossible to think that this behavior of economic authorities was not to be punished when the effect in the credit markets kicked in.

    An interested fact about Ben Bernanke is that he sees himself as a specialist in the great depression, but the interest rate policy he and the FED followed was meant to give birth to an economic disaster. Now, out of the need to save the economy, interest rates are at zero and the new economic bubble its beginning, but that’s a discussion for the future, when that situation will become a problem, now the issue is to get the economy going again. So, enter (once more) Nikolai Kondratieff.

    Nikolai Kondratieff was a young Russian economist that was ordered to analyze cycles in capitalist economies by Lenin itself, the idea was to see when the prediction of a collapse of the capitalist system would be fulfill. In spite of his goal of finding the hypothetical collapse he ended up finding something much more important. In his study of the 21 major capitalist economies at that time including price level, interest rates, wages, production, employment, imports and exports, he found that in 15 of the 21 examples there was a “long wave cycle, with an average length of 54 years. He started his analysis in the late 18th century, since he saw that period as the beginning of a “broad development of industrial capitalism”. When he finished his analysis, two full cycles and the start of a third were identified, this third cycle was ended on 1948 and the beginning of the fourth cycle started, this fourth cycle is still going.

    Kondratieff came to the conclusion that the capitalism was self regenerating and that the end of a cycle sets the stage for the beginning of a new one. The reward of his amazing work was to died in a labor camp after several years in prison.

    The Kondratieff cycle is divided in four periods, spring, summer, autumn and winter. In the spring we have an inflationary phase of growth. In this article we are going to focus in the last part of the cycle, the dreaded Kondratieff Winter.

    Kondratieff identified the winter with economic depression. The economic excesses of the previous period produce a collapse of the price structure. The exhaustion of the cumulated wealth forces the economy into a strong contraction; generally the secondary depression implies a collapse of three years followed by a fifteen years period of deflation. The best way to see this process is in interest rates and wages. These periods were supposed to clean the economy from the previous excesses and form a base for future growth. In this period there is growing innovation, a process in which the technologies of the autumn are refined, become cheaper and more known and implemented. This innovation makes the different industries stronger. At the end of winter there is a final recession before the transition to a new stage of growth; this final recession is mild with low inflation and is remembered afterwards as much harder than it really was. They key issue is that the technological innovation provides a frame for a new social integration with new social values and goals, in this view K-cycle is more than just a simple economic process, includes social changes as the capitalism adapts once more.

    But when we study the Kondratieff cycle we have to take into account new factors that change the time table:

    1 economic policy mechanisms
    2 technological changes that increase overall productivity
    3 the safety net created since the great depression
    4 the close interrelation in developed economies in particular
    5 the strong dependence of economies in development on basic materials production.

    Number one and two have the effect on making summer last longer;  number three has an effect of moderation on the extreme conditions and  an accelerating effect on winter; number four increase the probability  of season to season change since the trigger can be pull in several 
    economies instead of one.
    In addition to the above mentioned we have  two critical issues in  points one and five; in the fifth condition we have an increase of  the speed of the cycle in economies in development, more severe in  direct relationship with the level of the dependency of a particular  economy in basic materials exports, this is due to the increased  volatility phenomenon in commodities markets as a consequence of the  pressure of demand in direct linkage with BRIC economies pressure 
    according to their needs of raw materials. One of the more extreme cases, as usual, can be found in Argentina with a cycle between seven and ten times faster than normal. As for number one, is an example of what can happen if the necessary measures are not taken in a strong and swift manner, the example? The lost decade of Japan, even with a strong safety net the lack of decision regarding economic policy was enough to get a traditional K- winter with all its consequences.

    Kondratieff saw winter as a time for  a cleanse of previous excesses, the attempt to resist this process is  not only futile but bad as this increases the negative effects both  quantitatively and regarding the amount of time that takes, the  process shouldn't be resisted, instead the efforts should be focus in soften the negative consequences of this process. He saw capitalism as a self regenerating “beast” that was able to adapt to avoid a total collapse, this time the probable adaptations will include a new view on how leverage can be negative for economies as a whole and not just dangerous for private individuals as well as a new view in the dangers of the “false god” of securitization as a means to reduce risks.

    If one asks: is the worst behind us? The answer is both yes and no,  is yes if we think in terms of a free falling economy, that's behind  now; but at the same time is no, now policy makers will have to deal with the aftermath of a crisis that was responsible for the worst  capital destruction since the fall of the Roman Empire.
    The damage to the economic structure of the developed economies was substantial; including a major hit to the principal engine of these economies: consumption (considering personal consumption or its corporate counterpart: investment). The recovery of consumption to levels consistent with long term growth will be a major issue during economic recovery in times to come and will set the pace of that recovery and the length and strength of the Kondratieff Winter.

    Disclosure: No positions

    Oct 18 2:08 PM | Link | 2 Comments
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