The Boom/Bust Cycle: Why Thin Cows Eat Up Fat Cows


Release Date: December 15, 1999
© 1999 Macroknow Inc. All Rights Reserved.

Genesis recounts how Pharaoh had a dream that troubled his spirit: Seven fat cows came out of the Nile, then seven thin cows followed and ate the first seven up. None of the magicians and wise men of Egypt could interpret Pharaoh’s dream; but Joseph, whose family had sold him into slavery in Egypt, could. Joseph's interpretation was as follows: "Behold, there come seven years of great plenty throughout all the land of Egypt: And there shall arise after them seven years of famine…"

The boom/bust cycle has a long and venerable history. Its interpretation has preoccupied clever minds since archaic times. Some, like George Soros, made a great fortune out of deep insight into the cycle’s workings. It should be quite interesting, I mused, to probe the mind of billionaire money manager Soros to discover why thin cows eat up fat cows.

The biblical reference to cows devouring cows is ironic. In the Preface to The Crisis of Global Capitalism [Open Society Endangered] (PublicAffairs™, New York, 1998)1, Soros wrote that he sometimes felt like "a gigantic digestive tract, taking in money at one end and pushing it out at the other." Apparently, the "two ends" are connected by "a considerable amount of thought." Luckily, the essence of Soros’ thought can be encapsulated in one word: "Reflexivity."

Should you care about reflexivity in financial markets?

What is "reflexivity"? According to Soros, reflexivity is the dynamic two-way interaction between reality and thinking. Reality affects thinking, and thinking affects reality. By its very nature, reflexivity gives rise to uncertainty. The gap between expectations and reality can expand out of control -- in a "self-reinforcing" or "self-defeating" way. This is especially true in financial markets.

Why should you care about reflexivity in financial markets? Because financial decisions based on expectations about the future can affect the very financial future the decisions anticipate. And what does reflexivity have to do with boom/bust cycles? According to Soros, "what are considered fundamental values or objective criteria [e.g., the price of a share of common stock and earnings per share] are often reflexive and it is the failure to recognize this fact that engenders a boom/bust process." In other words, for Soros, the cause of the boom/bust process is the failure of market participants to recognize the reflexive gap between their collective expectations and reality. But is this really so?

Yes, especially if market participants move in herds. According to Soros, "Trend-following behavior is not necessarily irrational. Just as certain animals have good reasons to move in herds, so do investors." But do clever money managers follow financial trends the way herds do? Most certainly not. Soros, for example, knows financial values are reflexive; and he awaits the opportunities to exploit them -- "both on the upside and the downside."

Why is Soros sounding the alarm? Should you worry?

While Soros does not cling to the fundamentals, many in herds do. And what happens to investors who cling to the fundamentals? They risk getting "trampled by the herd."

Unfortunately, those who cling to the fundamentals are not the only ones to get trampled. The money making game can destabilize whole sectors of the economy -- if not whole countries. The game can be so rigged it can despoil the economic life plans of millions of families. The recent Asian, Russian, and Latin American crises are proofs of massive economic destruction from speculation. More important, they are a forewarning and an omen. With globalization, the money making game can get out of control globally. Unfettered, global financial crises can lead to the collapse of capitalism itself. No wonder Soros is sounding the alarm!

Should you worry? Unemployment and inflation are at record lows and the stock market is at a stellar high. This has led Bill Clinton to boldly proclaim that the U.S. economy is at "the pinnacle of power and success" [Economic Report of the President, February 1999].

So what can threaten the financial world? The thin cows of the global financial market, that’s what. And why is that so? Because the boom/bust cycle is not just a self-accelerating self-defeating process; it has, to borrow the words of the philosopher Schopenhauer, an "unité de plan" -- and a dark side. Joseph uncannily revealed the unity of the plan to Pharaoh with these simple words: "The dream of Pharaoh is one."

The real essence of the boom/bust cycle

Soros’ model reveals the hidden dynamics of the boom/bust cycle. Clever investors can use his model to exploit the collective fallibility of other investors who move in herds. Unfortunately, Soros does not reveal the real essence of the boom/bust cycle. What is this essence? Let me reveal it -- in the form of a hypothesis which I challenge Soros to falsify.

The essence of the relationship between entrepreneurs and their lenders is encapsulated in this bit of Solomonic wisdom: "The borrower is servant to the lender" (Proverbs 22:7).

Here's my hypothesis. The purpose of the boom/bust cycle is to induce entrepreneurs and their employees to create new wealth for lenders. Here's how the scheme works.

  • Money creation. First, lenders create fictitious money (book entries) in the form of debt. The word "fictitious" is not mine, it is Schumpeter's. Joseph Schumpeter was Austria's Finance Minister during the Austrian inflation. While at Harvard, he authored Business Cycles, a great analysis of the capitalist process.
  • Entrepreneurial wealth creation. The debt is used by funding-limited entrepreneurs to fuel wealth creation -- and by lenders to earn interest and fees. Fictitious as it is, much of the debt is guaranteed by the borrowing entrepreneurs.
  • Speculative overinvestments and tightening of credit. Wealth creation is followed by speculative overinvestments. In the late 1980s and early 1990s, the overinvestments were centered on commercial real estate. These days, huge investments appear to be centered on stocks and mutual funds. Overinvestments are financed in large part by lenders -- the same lenders who created the fictitious debt in the first place.
  • Transfer of wealth from wealth creators to debt creators. The overinvestments are not random occurrences. They signal the onset of the bust phase. That's when lenders, low on cash, move to reduce, freeze, or cut loans. These actions destabilize large numbers of funding-limited enterprises -- small and large. Overinvestments, and the concomitant illiquidity, are an integral part of the game plan. Illiquidity shifts risks to entrepreneurs (the wealth creators) and forces those who are destabilized to unload their assets at debased prices. The acquisition of the devalued assets is nothing but a transfer of wealth -- from wealth creators to debt creators. The transfer of wealth is facilitated by vulgar Darwinian advantages that favor lenders over borrowers. The lenders' advantages are not slight and are firmly entrenched in the practices of financial markets -- and in legislation.

The "constructive destruction" (another Schumpeterian expression) of the bust phase and its human tragedies are explained away with such utterances as Soros’ "Financial markets are not immoral; they are amoral." The essence of the relationship between entrepreneurs and their lenders is encapsulated in this bit of Solomonic wisdom: "The borrower is servant to the lender" (Proverbs 22:7).

Now that you know the real essence of the boom/bust cycle, what should you do? You must familiarize yourself with the motives and inner workings of the financial system. Most important, you must understand that lenders never create enough money to pay off the debts they create. Until recently, the total money stock of the United States could not redeem more than about 44% of America's domestic non-financial sectors’ debt. More bluntly, the total currency of the United States could not redeem more than 2.8% of that debt!

The lesson is clear: Anticipate and prepare for the oscillatory changes in the money stock and the debt -- or risk being destabilized then devoured by thin cows. One last forewarning. Unless it is delayed by the millenium celebrations, the next Schumpeterian bust in the U.S. and Canada may well start around 2002.



1 George Soros, The Crisis of Global Capitalism: Open Society Endangered. New York, NY: Public Affairs, 1998.