Last week we discussed forces that were supposed to flatten the business cycle. However, they set in motion other forces that actually increased the business cycle. This is hardly a surprise, as it’s pretty obvious recessions are still there, we might be in the middle of one. These new forces work via asset markets, so they’re very important for investors.
The ‘new economy’ forces we discussed in the previous article were real. Information and communication technology (ICT) does enable increased productivity when organizations have figured out how best to take advantage of their possibilities.
Higher productivity growth enables higher economic growth without causing inflation (and globalization and the decline in power of organized labour helped as well here), so central banks do not have to increase interest rate to stop inflation in it’s tracks.
Since central banks more often than not have produced recessions as a byproduct of fighting inflation, the business cycle seemed tamed, and better inventory management and a shift to services muted it further.
All this looked terrific from the point of view of investors. If the economy grows faster and smoother, investing in stocks would be a lot safer so risk premia for equities could be drastically reduced. Since risk and reward go hand in hand, this logic implied that stocks were quite undervalued, so undervalued that some predicted at Dow 36,000 based on this logic.
At the same time, there was a bubble blowing in internet stocks, based on the all the optimism that the ‘new economy’ paradigm ensued. The most bizarre logic was used to justify stratospheric valuations for companies that hardly sold anything, let alone made a profit. The name of the game was landgrab, companies were supposed to dominate their niche on the internet, and winner-take-all forces would set them up for life.
Alan Greenspan, although having described what was going on as ‘irrational exhuberation’ as early as 1996, actually bought in much of the new economy thinking and was very accomodating with monetary policy. In fact, for a while, he was seen to be more afraid of possible deflation.
The financial industry, increasingly important in advanced economies with declining manufacturing sectors, bought into it as well, as they usually do. When the times are good, because new industries and markets are opened up, and things this time really seem different, credit gets lose and restraint goes out of the window.
Easy credit was helped by easy monetary policy, deregulation of financial markets, innovation in financial products, and the belieft that asset prices could only go up. Almost any kid with a single sheet of paper containing a ‘business’ plan with the word internet in it could get funding.
This party all ended rather tragically in March 2000 with the Nasdaq on 5048 (the Dow not quite at 36,000), of course as it turned out that most of the new emperors didn’t have any clothes. It brought down the whole technology sector, which had ramifications for the whole economy mostly through the asset markets.
As stockmarkets plunged, the FED became wary of it’s cosequences and started aggressively lowering interest rates, sewing the seeds for the next bubble, in housing. Suddenly, the price of mortgages halved, and the supply of new housing could not keep up with the exploding demand, with predictable results for house prices.
Deregulation and financial innovation made the cheaper credit available to parties that were not really able to afford them, but free market ideology and the mantra of the ‘ownership society’ put a blanket of approval over the concerns.
As house prices rose, the belief that they would always do strengthened, so demand increased even more, turning into a virtuous cycle that has turned vicous now that this bubble has burst as well, basically under its own weight.
Now, as house prices are falling and credit for mortgages much tightened, the logic reversed and the previous virtuous cycle has turned vicious. We can see a pattern developing though.
Bubbles begin with a combination of some belief (house prices can only rise, internet changes the economy) which get real meat because of easy finance. In fact, the easy finance might very well be the result of the aftermath of the last bubble, when the Fed scrambles to keep things going.
The belief system reinforces itself through rising prices, fueled by easy credit, but there comes a point were it will collapse under it’s own weight, and the beliefs turn out to be false. This will reverse the logic, and the whole economy becomes in serious trouble leading the Fed to reflate not only the economy, but also the next bubble.
So, the business cycle hasn’t gone, it has changed in character. We could call it a bubble cycle.
In the next episode, we will briefly look at policy solutions.