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Sunday, February 5, 2012

Understanding The Business Cycle

In The Great Recession Conspiracy (available everywhere ebooks are sold), I explained that for over 800 years every developed economy in the world has been driven by the Business Cycle.  The book also explained that The Business Cycle is driven by psychology, NOT by finance.  Last week's Economist had a short piece discussing how psychology drives the Business Cycle.

The article gets twisted in its underwear when it gets confused and thinks that the Business Cycle drives psychology.  That is exactly backward and displays a fundamental failure to understand how the economy works.

Nevertheless, there are some insights here that you will find useful.


In praise of pessimists

Sometimes it helps if investors are gloomy

BARELY a week goes by without a report on the level of confidence among consumers, businesspeople and investors. Optimism is what’s wanted—Keynes talked of the “animal spirits” that influence economic activity. Pessimists are routinely denounced as Jeremiahs. Those who try to bet on falling prices find their activities are restricted.

A cheery disposition may be necessary for societies to function. Daniel Kahneman, a psychologist and Nobel economics laureate, has a chapter in his book “Thinking Fast and Slow” which describes overconfidence as “the engine of capitalism”. No entrepreneur can be sure that his planned investment will succeed but if no one took a risk, new products and jobs would never be created. A certain blindness to the odds may be necessary. According to Mr Kahneman, the chances of an American small business surviving for five years are just 35%. But ask individual entrepreneurs about their prospects and 81% think they have a better than seven-in-ten chance of success.

This self-confidence may be innate, just as most people think they are better-than-average drivers. And it would seem logical that the most optimistic people gravitate towards entrepreneurship. That is good for consumers, who can select from a wider variety of products. Even the failed businesses serve a purpose. Daniel Gross, a journalist, wrote a book claiming that bubbles were good for economies since they leave behind infrastructure (canals, railways, fibre-optic cable) that can last for generations.
But it is hard to make such a case for all bubbles. Anyone who has driven past a row of empty houses in the Irish countryside will realise that optimism can lead to wasteful investment. And Mr Kahneman cites studies that show how overoptimistic chief executives (as measured by the amount of stock they own) were more likely to gear up their balance-sheets and pay too much for acquisitions.

The problem with overoptimism was illustrated by the investment-bank collapses of 2008. The men who reached the top of such risk-taking organisations had, by definition, been successful in their previous bets. They believed this was due to skill, not luck, making them too sanguine about their ability to ride out the crisis.

A further problem with optimism is thus that it is pro-cyclical. The greatest moment of success for optimists will occur at the peak of a boom, when they will feel their instincts have been justified. Previous house-price rises will make buyers more optimistic about borrowing more money; and banks will be more optimistic about the prospect of being repaid.

Financial assets are highly unusual in that rising prices tend to elicit higher demand. Analysts extrapolate recent rapid profits growth into the future, even though profits cannot rise faster than GDP indefinitely. If markets were truly efficient, price-earnings ratios should be lower than average at the top of the cycle, since investors should anticipate a reversion to the mean. Instead, high p/e ratios and rapid profits growth tend to go together.It used to be the role of central bankers to take away the punchbowl when the party was in full swing. Under Alan Greenspan, however, the Federal Reserve ended up spiking the punch with more rum by cutting rates whenever markets wobbled. The hope is that in future central banks will keep an eye on asset bubbles under the guise of “macroprudential” policy. This might involve the use of broader measures than just interest rates. For example, the Fed could pop housing bubbles by imposing a maximum loan-to-value ratio for mortgages.But what if the bubble this time is in government bonds, not equities? The last time long-term Treasury bonds yielded 2.1% was in 1949. Investors who took the plunge into Treasuries then earned an annual negative real return of 1.6% over the following 30 years.

On this occasion, however, the central bank is one of the main purchasers of Treasury bonds in an effort to keep yields low. Such low yields could be attributed to optimism that American politicians will agree on a long-term plan to sort out the government’s finances. But it seems likely that the main driver is pessimism about the outlook for other asset classes.

In this case the gloom seems entirely beneficial. Low rates stimulate the economy and are good news for the American government, which can finance its deficit cheaply and without facing the dilemmas that beset the Italian and Spanish governments, which must impose austerity at a time of economic slowdown. But the pessimists can’t expect to be thanked.

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