Listener 31 March, 2001.
Keywords Business & Finance; Macroeconomics & Money
As I write, there is vigorous debate about the current US economy downturn. In the jargon the question is whether it will be a V, U or L – the second half of each letter indicating a quick rebound a slow rebound, or a drawn out depression. It is noticeable that informed opinion is moving towards the more pessimistic end of the possibilities, although most commentators currently reckon on the U rather than the L.
Cyclical downturns are not the end of the world. Market economies have always experienced various cycles around a rising trend of economic growth. If one thinks of the economy as a giant servo-mechanism with feedback loops, then cycles are inherent. Every so often someone announces the death of the business cycles and that the economy will trend continuously upward forever and ever. Shortly after, the feedback mechanism cuts in, and down we go again. (Recall the panic in early 2000 when that happened to the New Zealand economy. Now we are in an upswing, and it is all forgotten – until the next time.)
The business cycle and economic growth are intricately linked. Certainly, as I show in my ‘In Stormy Seas’, that is the evidence for the ‘three year’ New Zealand cycles. (It generates quite different policy prescriptions from ‘the knowledge economy’ – but that is another topic). However the US long growth boom of the 1990s, and its following downturn, belong to another integrated mechanism described 60 years ago by one of my heroes, Joseph Schumpeter.
What Schumpeter would say, were he alive, would be something like this. Revolutionary electronic technologies have generated a remarkable growth boom as entreprenuers seized opportunities to invest and provide new products to businesses and consumers. But such technological innovation does not go on forever, even though many investors behave as if it does. Some firms make enormous profits – Microsoft, Intel, Cisco (which that makes the internet routers) – but many are not fundamentally profitable and depend upon shareholders and credit for funds, most of which will be eaten up in costs that fail to generate profits. ( Schumpeter would have delighted in junk bonds as a new mechanism for credit creation.)
The innovation stage of the upswing passes on to the credit creation stage. But credit created booms are not sustainable. Eventually the cash flow to some businesses are insufficient to service the debt and some begin to fall over. That adds to doubts about the viability of others – which are probably having cash flow problems to. The distrust begins to swell and investors move out of the market (as they have been doing with the NASDAQ (high technology) stocks in the US), while worried banks start to call in their loans.
By now the boom is looking soggy, and the downswing begins. A major factor in the severity of its contraction is the balance sheets of the core commercial institutions. If they carry too much worthless advances and useless other assets, they may write off all their shareholders equity and still owe some. Technically they become bankrupt, although as we have seen in Japan, it is possible to hide the negative net worth behind smokescreens for long periods. If too many become technically bankrupt and the government does not bail them out, then the downswing will be prolonged (the New Zealand experience of the late 1980s).
In the credit dominated phase there are a lot of incompetent business managers and worthless activities. Schumpeter sees the downswing as an integral part of the growth cycle, for inefficient and inept firms are cleaned out in a process he called ‘creative destruction’. Crucially, the bottom of each downswing is markedly higher than the previous one, because of the technological innovation, while the cleaning out provides a foundation for the next boom when a new technology comes along.
That does not tell us directly whether this downswing will be a V, U or L. But there is a clue in the financial position of the core firms. If too many have balance sheets which are not robust, then the more pessimistic outcome is likely. Of course there are many firms on the periphery in a dreadful state – at worst a pile of liabilities and no assets worth mentioning – but that happens in an entrepreneurial society all the time.
I do not know how robust are the core business balance sheets. If I had to guess I would begin by looking at a number of international telecommunications corporations, which have just spent a fortune leasing the third generation radio spectrum, often financed by junk bonds (whose high interests rates undermine the cash flow), and who must be having increasing doubts about the usefulness of their purchases in the immediate future.
Schumpeter thought this boom and bust inevitable, integral, and ultimately healthy. Even so, if his model proves right and there is a longish recession, or worse (the really gloomy talk about replicating the Japanese stagnation in the US), we will move from the extravagant glorification of the market system we have today, to a more realistic appraisal of its strengths and weaknesses. In the Schumpeterian view, the strengths are not inconsiderable.