The Kondratiev Cycle Revisited: Part Two, Economic Implications
This portion of my article attempts to relate the abstract concept of the "fall from plateau" to the economic situation today. A potentially useful way to examine reduced prices is to look at their rates of change. Figures 2, 3, 4 and 5 show rates of price inflation, stimulation, and inflation relative to stimulation (ordinary inflation minus rate of stimulation) for four historical periods, including the present. The graphs are divided into different regions. The peak region covers the period when inflation first picks up to the Kondratiev peak in reduced prices. Note that the peak in inflation rate does not occur at the same time as the Kondratiev peak in prices. For example, British inflation peaked around 1800 (see Figure 3) yet the Kondratiev peak in prices was in 1814 (1813 for reduced prices). Similarly, US producer inflation peaked in 1974, while the peak in reduced price was in 1981. This difference has led many K-cycle analysts to mistakenly identify the 1974 producer price inflation peak as the most recent K-peak. This very natural error reflects the absence of a peak in the price index for the most recent Kondratiev peak. Such price peaks were observed for the three previous K-peaks in 1920, 1864 and 1814.
But the British example from the turn of the 19th century makes it clear that the K-peak does not necessarily occur at the major inflation peak. British interest rates (another longwave marker) also peaked around 1800, not 1814. Kondratiev noted that there were several peaks during this time and that he chose the latest one, because it was only after this peak that interest rates began a long term drop. Similarly, we choose the end of the inflationary period in 1981 as the K-peak because it was only after this date that inflation and interest rates began long-term downward trends.
The next period after the peak is the initial drop in (reduced) price to the plateau, or what I call the fall to plateau. In the early nineteenth century British case (Figure 3), the mid-nineteenth century U.S. case (Figure 5) and the early 20th century U.S. case (Figure 4) this occurred rapidly, and was a time of recession and stock bear markets. The situation was different for the most recent Kondratiev downwave. The most recent fall to plateau (Figure 2) took some six years (1981-87), and although it began with a recession, it incorporated most of the following expansion. Not only that, but it contained a major stock bull market.
A similar effect can be seen in the 1940's drop in reduced prices that led to the 1946 Kondratiev trough. The 1840's and 1890's Kondratiev troughs were significantly deflationary, were times of substantial depressions (the "hungry forties" and the Panic of 1893), and showed serious stock bear markets. In contrast, the 1946 K-trough was a time of inflationary prosperity and a stock bull market. Both the 1980's fall to plateau and the 1940's trough region showed economic characteristics different from those of similar periods in past cycles. This discrepancy suggests that the present fall from plateau may also play out differently than previous ones. This is important because many bearish commentators who hold Kondratiev views similar to mine (i.e. the 2000 stock peak is cycle-analogous to 1929) invoke the dire prospects facing people in 1930 as a template for the future. It is very unlikely that the next few years will be anything like 1929-32, even though they will be "cycle analogous". Let's explore what might be in store.
It is useful to consider why the 1980's fall to plateau was so different from previous falls. If one examines Figure 4 and Figure 5 closely, one can see that the previous two fall-to-plateau periods were accompanied by a significant fall in stimulation. The downward trend in reduced price inflation was accentuated by this falling stimulation, which resulted in a powerful deflation and a sharp depression. Stimulation fell in tandem with the 1864-66 fall to plateau. In contrast, stimulation peaked a year into the 1918-22 fall to plateau, resulting in a brief post-war prosperity and stock bull market, before the onset of deflation. Stimulation continued to increase for two years, before modestly declining, during the 1981-87 fall to plateau (see Figure 2). Fed reserve chairman Paul Volcker briefly pulled back stimulation, using high interest rates to begin the fall to plateau process and then ramped it back up, preventing the development of deflation or a depression. Not only was a depression avoided, but a massive stock bull market developed after 1982.
A similar thing happened during the last trough period in the 1940's. In previous troughs there had been no change in stimulation, whereas in the 1940's WW II led to massive stimulation. The higher degree of stimulation in the 1940's compared to the previous troughs made all the difference in the economic characteristics of the period. The relevance of the economic experience of the 1980's and the 1940's is relevant today because we are now entering yet another period of falling reduced prices. We should expect that like the 1980's and 1940's the economic characteristics of the coming fall from plateau will be much milder and more bullish than those of the previous fall from plateau in 1929-32.
The expected big difference emerged as we entered the fall-from-plateau region last year. After the Panic of 1873 and the 1929 crash, stimulation had remained neutral, but following the 2000 NASDAQ crash, stimulation has been rapidly ramped up. As a result, despite a crash in reduced price inflation, deflationary/depressionary forces have been subdued. This avoidance of a depression, and the bull market that unfolded during the most recent fall-to-plateau and trough periods suggests that some sort of stock bull market could unfold over the next few years as reduced prices fall to the vortex. The extreme valuations of today would almost certainly limit the extent of any bull trend, but the present stimulation, if maintained, may suffice to prevent the market from going lower than the September lows despite sky-high valuations and poor earnings prospects. It is in this sense that use of the 1929-32 period as a template for the next few years can lead to some pretty serious errors. Although that last fall from plateau saw collapsing stock prices, we should avoid this fate this time.
It is instructive to see how this policy of massive stimulation has evolved. The first time it was effectively used, during the 1940's trough period, it was simply a side effect of World War II. The second time it was used was the massive Reagan deficits of the 1980's. President Reagan ran against deficits in his campaign and there is no reason to believe that he intentionally wished to run these deficits as a counter to the deflationary forces of the fall to plateau. It is more likely that the Reagan deficits were a side effect of the massive "supply side" tax cuts implemented in 1981.
It was not until the present that we see a third massive stimulation program. Unlike the previous bouts of stimulation, this one appears to have been consciously undertaken by the Federal Reserve. The series of rate cuts that began at the end of 2000 produced a 72% drop in Federal Funds rate over the next 12 months, the largest such percentage decline in over 40 years. M3 money supply surged 13% in the 12 month period ending last November, the largest such increase since 1973. The decline in the Federal surplus reflecting the Bush tax cut and spending on the War on Terrorism also add modestly to current stimulation. These unusually aggressive Fed actions suggest that Chairman Greenspan may well believe that we are "falling off the plateau" at the present time.