Financial Cycles

Sovereigns, Bankers, and Stress Tests

Dimitris N. Chorafas

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9781137497987
• Topic: Economia
• Subtopic: Storia economica

As financial positions expand, the economy becomes more vulnerable to adverse and unexpected developments taking place outside the six to seven year business cycle. Over 50 years ago Nikolai Kondratieff developed the theory of "The Long Waves in Economic Life", which incorporated an extended cycle of innovation and upward thrust, and changed our understanding of business cycles in financial settings.Financial Cycles concentrates on two areas that have thus far been omitted from mainstream economics. The first is the impact of the longer term financial cycle; the second is the beginning of de-globalization as the world enters an era of iron-glad economic blocks. Chorafas argues that to overcome the more narrow limits of the business cycle, we need to go beyond its traditional six to seven year focus and address the longer term. This includes the building-up and running-off of economic risks characterizing the financial cycle, as well as the appreciation of forces underwriting both its growth and its decay. An ever-increasing public debt and the behavior of the banking industry are two principal reasons why the structure of analysis characterizing the previous financial cycle no longer fits present-day realities. A new methodology starts getting in shape, even if it still has to acquire political legitimacy.

1

Financial Cycles

1. The Difference between a Financial Cycle and a Business Cycle

Ancient Egyptian mythology spoke of seven fat cows followed by seven lean ones. Unlike other accounts based on hearsay and traditions, this one had an evidence. The fat cows represented the good years when the assets of the king and the citizens increased; the lean cows reflected the misery associated with bad harvest, floods, and the destruction of wealth.

The Bible, too, speaks of cycles of decay and renewal, without making it explicit that they are integral parts of economic life. They have been so since the beginning of civilization, predating commerce, banking, and the early financial transactions. The invention of money and the structure of institutions specializing in creating and holding virtual assets, gave a new meaning to these cycles of decay and renewal.

Over the centuries economic life acquired its own momentum and the creation of excess reserves saw to it that those possessing significant wealth could not remain indifferent to the demand for loans. Economic historians developed the theory that this was for the better, because the existence of a capital base could act as lifesaver in lean times. Without it, something in the normal regenerative process would have been missing. The absence of a force promoting recovery from the business cycle’s bottom would have deprived the economy of an upside.

The theory of the business cycle established itself on these premises that reflected the switches in the tempo and mood of business activity over a period of six to seven years. Typically, though not always, those swings between rich and lean years were influenced by a variety of more or less objective events that repeated themselves, but there have been as well less-tangible psychological factors.

Also, typically, the high time in the business cycle’s pattern has been a period of prosperity that bred confidence and led to revised standards of what is prudent and what is risky. Good years led to risk-on policies, while risk-off policies characterized the lean years. In the case of both renewal and decay, the underlying process was self-reinforcing but also contained some seeds of its own demise as:

• Natural limits to the trend supporting prosperity were reached,

• Excesses and extremes multiplied, battering the economy, and

• The prevailing risk-taking could not be sustained for much longer.

As financial positions expanded, economies became more vulnerable to adverse and unexpected developments, many of which went beyond the usual six to seven years boundary of a business cycle. In the early 1920s, Nikolai Kondratieff, a Russian economist, developed the theory of long waves of 50 years or so, incorporating in it an extended cycle of innovation and upward thrust, despite the setback of recessions, and followed by a longer era of decline than business cycles classically admit.

Economic historians suggest that in his theory Kondratieff was influenced by the record-breaking global boom from about 1850 to the early 1870s, followed by a couple of decades of lean years and of economic uncertainties. Though neither he nor other economists could give a satisfactory explanation of this long wave, he did point out that social and economic forces were propping it up.¹

Proposed for equities, Elliot’s Grand Super Cycle theory is close to Kondratieff’s long leg cyclical analysis. Elliot used statistics from financial assets prices. Some economic history books suggest that in an effort parallel to that of Elliot, the Russian economist had also looked into crucial fluctuations in commodities in terms of patterns characterizing financial instruments and their behavior.

In the background of these studies, and of theories based on them, lies the fact that the longer cycle of growth eventually exhausts itself followed by a chute. Recovery requires a period of consolidation, which, compared to the good years, represents depression and retrenchment before the economy can regain self-confidence; hence, vigor and growth. The long wave is the concept underpinning the “Kondratieff cycle.” Other economists, like Arthur Burns, the former chairman of the Federal Reserve, too identified long swings of up to 25 years, when economic growth and capital formation:

• First reaches a peak, and

• Then retreats to an era of slower expansion, or deleveraging.

Neither should the role played by human capital be underestimated. Kondratieff’s 50-year cycle represents two successive generations of economists and market players with plenty of psychological effects coming into the picture. The third generation that follows the 50 years of a financial cycle has practically forgotten the decay earlier on in that period and therefore is more likely to repeat the same wrong-way moves and mistakes. This also happens, though at a lower intensity, with the 25-year cycle.

According to Paul Volcker, the former chairman of the Federal Reserve, as the long financial cycle is unfolding, its duration is crucially influenced by what is inside people’s minds: the psychology of investors, consumers, businessmen, and government executives. Peoples’ reactions vary:

• They could be disappointed and try to preserve the status quo by aggravating the crisis,

• Or, they may adjust to the inevitable and accept the more modest prospects imposed by the new economic conditions characterizing the lower part of the cycle.²

If economists, market players, politicians, and bureaucrats fail to honor the limits to growth, then the economy is destined to suffer turmoil and a greater crisis. Essentially, the statements of Volcker, Burns, and Kondratieff have been articulating the classic perspective of central bankers that dictates the choice of order and financial stability, hence moderation of aspirations aimed at rebuilding the economic infrastructure.

Volcker, Burns, and Kondratieff have seen the reasons why attention should be paid to the long wave. So did other economists, but the majority kept on working on the shorter-term, hence more limited, business cycle. This is attested by statistics.

It needs no explaining that to overcome the more narrow limits of the business cycle, we have to go beyond its traditional six to seven years focus and address the longer term, including the building-up and running-off of economic risks characterizing the long wave of the financial cycle. The impact exercised by the longer term underlying economic forces is much greater than it might seem at first sight, because it means shifting away from debt as the main engine of growth and targeting policies such as:

• Repairing balance sheets, and

• Implementing structural reforms.

Indeed, economies that escaped the worst effects of the most recent economic and financial crisis have more or less followed assets-based policies, with an eye on dampening the extremes by way of prudential monetary and fiscal frameworks. Ducking away from reform, the way France and Italy have been doing, ensures that the worst continues to worsen as room for policy changes runs out.

In the shorter run accommodative monetary conditions theoretically help in keeping volatility low. But they penalize the financially weaker citizen, while signaling a strong appetite for risk on the part of the better-off investors. Eventually, economies become vulnerable to shifting global conditions as no market is completely insulated from bouts of turbulence.

As long as the economy is in doldrums, companies, sovereigns, and banks face severe balance sheet weaknesses largely stemming from overexposure to risky holding and (in the case of banks) to highly indebted borrowers. Debt drags the recovery at all levels. Following the aftereffect of the Great Recession, from 2007 till today, households and industrial firms have tried to reduce their debt but sovereigns and many banks continued accumulating red ink and toxic “assets”—therefore adding to the problem they intended to solve.

A visible part of this discrepancy has been the diminished monetary policy effectiveness all the way to the central banks’ puzzle on how to address unexpected disinflation (chapter 3). Central banks also discovered that unorthodox measures, like quantitative easing (QE), present unexpected consequences. One of the more puzzling is how to siphon an excessive liquidity injected into the financial system out of it,

• Without rattling the market, and

• Prior to it creating significant damage.

According to a mounting wave of opinions, several present-day difficulties can be traced in part to a kind of overconfidence generated by a long period of prosperity that did away with a more conservative and cautious approach in the hope that the “New Economy” represents sustained growth to infinity.³ Instead the economic players, including financial markets and political leaders, should have appreciated the importance of caution as the better way to avoid a long cycle of retreat, failure, and disappointment.

2. Financial Cycles in a Sophisticated Economy

The message conveyed by section 1 is that the more complex and more global the economic and financial environment becomes, the less adequate is the classical business cycle timeframe. A six to seven years perspective is simply not enough for understanding and analyzing the prevailing economic conditions and to elaborate ways and means for influencing their future behavior.

Past theories did not fully account for the interaction between debt, input, output, and asset prices as well as the prevailing impedances. Yet, these help in explaining why many advanced economies are now characterized by poor health. To do so, we must explore the roles played by debt, leverage, and risk-taking in driving economic and financial developments, as well as assess where different economies stand in terms of the financial cycle.

The length of time of rise and fall in economic output is not the only factor that distinguishes a financial cycle from a business cycle. In contrast to classical business cycles, financial cycles also include existing interactions between perceptions of value, profits, risks, and constraints that translate into booms and busts. Their aftereffects are measured by a combination of:

• Credit aggregates, and

• Property (assets) prices.

Such combinations may be self-reinforcing or self-defeating. Critical variables can move in different directions for a relatively long period of time, turning booms into busts and vice versa. Quite often the downturn coincides with banking crises and deeper recessions than those that characterize the typical business cycle.

High debt levels undermine sustainable economic growth by making vulnerable the sovereigns, households, and financial institutions at large. Alert minds can see this coming but their advice is not heeded by politicians and by populist economists. In an article he published in the Financial Times Raghuram Rajan, governor of the Reserve Bank of India and former chief economist at the International Monetary Fund, warned: “Some of our macroeconomists are not recognizing the overall build-up of risks. We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.”⁴

In the same issue o...

Table of contents

• Cover
• Title
• 1   Financial Cycles
• 2   Financial Stability
• 3   Dismantling Globalization by Changing the Rules
• 4   Twists of Monetary Policy and of Supervision
• 5   Debt and Democracy
• 6   Debt Sustainability
• 7   What Is Special about Banks?
• 8   A Structure of Analysis through Stress Testing
• 9   The Hydra of Financial Exposure
• 10  The European Banking Union: An Exercise in Abstraction
• Appendix   Bitcoins: A Solution or a Hoax?
• Notes
• Index