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COLUMN
The Boom/Bust Cycle: Why Thin
Cows Eat Up Fat Cows
By EDWARD E. AYOUB
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.
Reference
1 George Soros, The
Crisis of Global Capitalism: Open Society Endangered. New York, NY:
Public Affairs, 1998.
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