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04.11.2008  

October 25, 2008 (the date of publication in Russian)

Alexander Aivazov, Andrey Kobyakov

NIKOLAI KONDRATIEV AS THE MIRROR OF THE GLOBAL CRISIS. Part 2

Economic surfing: sliding down the long declining wave

Part 1: (http://www.rpmonitor.ru/en/en/detail.php?ID=11609)

THE MECHANISM OF K-CYCLES

How does the mechanism of K-cycles work? The basis of every cycle is a cluster of basic advanced technologies that are able to significantly transform and reshape the direction, scale, and structure of consumer and production demand, as well as the range of fuels and construction materials used in economy. To perform the leading role, this cluster is to be able to absorb, and partially to generate, a number of accessory and servicing branches stimulated by the basic technologies.

The new cluster, along with accessorial branches of industry, absorbs the major share of new investments. It is noteworthy that this cluster is (and is to be) formed already on the declining phase of the preceding cycle. In fact, each crisis contains sprouts of the future growth.

The rising phase of each cycle includes four periods. The pioneer period (1) is characterized with initial implementation of new technologies, products and services. In the period of expansion (2), these technologies are implemented in serial production. The process of accumulation of the products predetermines the period of saturation (3), followed with the period of exhaustion of new possibilities of development (4).

The transition from one period to another is marked with a decline of the rate of return of invested capital. Already in the period of saturation, an observer can easily discern symptoms of overinvestment, overcapacity, and overproduction resulting from miscalculation of the dynamic of demand. This happens because most of the earlier elaborated investment plans are inertial, while decisions of new investments are made by economic agents who don't coordinate their activity with one another, each being interested in grabbing a larger share of the consumer demand. Instead of slowing down investments to meet the decline of demand, these economic agents boost them, introducing methods of aggressive marketing (mostly of accessory goods and services). However, after a short-time positive impact the possibilities of further growth swiftly deteriorate.

Already at the stage of saturation, the rate of return in the real sectors of economy (including the leading cluster of the particular K-cycle) sinks to a level on which investments in real economy are becoming less attractive. Therefore, monetary resources transcend into speculative operations in trade and more significantly in finances, where options for deriving high income appear to be the largest. In their further development, relevant markets take the shape of "financial pyramids" or "bubbles", predetermining the following collapse of these markets and massive evaporation of the fictitious capital. An inevitable crash marks the end of the rising phase and the transition to a decline.

One more typical feature, noticeable in the framework of K-cycles, is the regular shift of management of national economies and related social processes happening at the start of the declining phase. The prolongation of the tendency, originally described as a crash, objectively requires reorganization of the whole system of economic policy, with increase of the role and function of national governments in economic system, and a drastic contraction of the sphere where liberal schemes and methods are appropriate.

On the contrary, the rising phases require a higher extent of freedom of entrepreneurship and investment, suspending many restrictions for trans-industry and trans-border flow of capitals and a higher flexibility of labor market. During the period of the rising conjuncture, liberalization of economy and management processes are becoming a significant factor of assimilating innovative technologies, structural readjustment and economic expansion. However, the effects of these methods inevitably generate speculative bubbles in the period of saturation, thus predetermining the new critical denouement and the inevitable new wave of etatization (statism).

 

THE ELECTRONIC WAVE

After the second default of the dollar (in 1971, when President Richard Nixon arbitrarily decoupled the US dollar from the gold equivalent thus destroying the Bretton Woods international currency system) and the oil crisis of 1973-75 the world economy entered the phase of depression which got a name of stagflation. It was the final part of the fourth K-cycle. A t this phase lots of enterprises in industrial nations were stalled, unemployment was growing, and millions of small and medium entrepreneurs were going bust on the background of inflation of prices for major consumer goods. The collapse of demand drastically reduced the rate of return, resulting in unprofitability of some major industries, and massive devaluation of both industrial and financial capital. But at the same time, the depression played the role of a trigger for the basic innovative technologies of the next K-cycle. This cluster was built upon microelectronics, computing technologies, Internet and mobile communications.

The devaluation of capital on the declining wave of the fourth cycle resulted in accumulation and concentration of capital in the hands of those multinational corporations that sought escape from the crisis by means of reducing costs for the labor force and environment, outsourcing industrial facilities to third-world countries and thus requiring improvement of communications.

Investments in new basic technologies opened the possibility to derive a high innovation rent. This created necessary preconditions for revitalization of global economy that became visible in early 1980s. Joseph Schumpeter characterized that period as a "storm of additional and improving innovations". This storm guaranteed a lengthy period of economic growth in 1990s, characterized with the process of diffusion of innovations of the fifth technological pattern in all the spheres of production and services (particularly, chipization of mechanical devices, penetration of information technologies into business processes and the sphere of management, etc.).

In the rising phase of the fifth K-cycle, the expanding multinational corporations felt themselves constrained with the framework of national economies that rested upon the Keynesian doctrine of governmental regulation. Corporations strongly demanded that all the restrictions for international capital flows be suspended. Their influence predetermined the following domination of the neoliberal doctrine of the state's utmost withdrawal from business affairs, and the ascent of politicians like Margaret Thatcher and Ronald Reagan. Since mid-1980s, the neoliberal revolution had been triumphantly marching across the globe, opening doors for corporate-driven globalization on the base of the newly-formed fifth technological pattern.

So, the rising phase, continuing for over 20 years, was marked with the expansion of multinational corporations under the cover of the neoliberal ideology. This period corresponds to the protracted rise of world economy up to the millennium, when the potential of growth depleted. Since that time (the end of 1990s – early 2000s) overcapacity and overproduction (in computer technologies, communications industries and Internet-based business) compared to real demand became visible. The first crash took place in 1997-1998 in the area of most intensive production of the ingredients of the new economy Ц in the South-East Asia (in fact, the "Asian crisis" was international); the second one, with collapse of a chain of "E-trading", "E-banking" companies with the most part of Internet-based business, ensuing in the United States in 2000-2001.

In full accordance with Kondratiev's theory, the capital flowed to the remaining areas where super profits were still available Ц namely, into speculative operations at the stock market, in the energy sector, at the mortgage market, etc.

 

HOT BUBBLEGUM

The neoliberal revolution, taking place in the framework of the rising phase of the fifth K-cycle, not only expanded international borders but generated a new kind of financial system enabling huge accumulation of capitals absorbed from all the continents, and their concentration in the global centers of multinational corporations, namely in New York and London. Alan Greenspan, the key protege of the corporate community, introduced "a new financial revolution", creating conditions for new, more sophisticated derivative financial instruments. Though being unrelated to real economy, the derivative market prevented break-up of financial bubbles for several years. Greenspan's logic was built on the assumption that one bubble may be replaced by another. In case the state debt bubble is overheated, the mechanism of derivatives allows redirection of financial resources into the sphere of E-economy, and in case this bubble was about to burst as well, financial resources could shift to the mortgage market.

For a time span of only two decades, the market of financial derivatives grew from several billion to almost a quadrillion of US dollars, more than by an order exceeding the gross global product.

Since mid-1990s, derivatives implicitly determined the whole life of a common American. Banks issued so-called subprime loans for low-reliable consumer, seeing thus to boost demand; after that, specialized financial companies like i.e. Fannie Mae and Freddie Mac, "bundle" these loans into larger packages, issuing bonds on the security of the loans. These packages were repeatedly re-divided and repacked, generating derivatives of third, fourth, and fifth level. A number of risky loans were thus multiplied into a whole cloud of myriads of new securities; the risk was supposed to reduce, by distributing among them.

All the market players were aware that a subprime credit is fraud with bankruptcy. However, it was believed that ten thousand "bad" loans, mixed up with a hundred thousand of "good" loans and secured with a mortgage bond, were becoming less risky. In fact, the price of the bond was not related to particular real estates: it was rather related to the stock market-dominating belief that US real estates are going to become only more and more expensive.

Ostensibly, first-level derivatives were "distributing" risks against credits; second-level derivatives were supposed to secure risks of the first level; third-level derivatives were believed to cover the second-level risks etc. In fact, the derivatives market was growing exponentially and free from any control, developing into a huge financial pyramid. The mechanism, invented for minimization of risks, instead greatly increased the systemic risks. Only judging upon the amount of securities, it was clear that no money in the world would be sufficient for covering all the financial obligations in this chain, the only hope being that local risks won't soar to a systemic level.

 

THE END OF THE FAIRY TALE

Alan Greenspan's initiatives were theoretically substantiated by a number of renowned US economists like Robert Merton, Myron Scholes, Harry Markowitz and Merton Miller. These theorists were even decorated with Nobel prizes for the "convincing proof" that computer-made mathematical models of derivatives are able to endlessly and securely "disperse" risks.

Re-directing capitals from real economy to E-economy, and later to the mortgage market, Greenspan's "financial engineers" believed that the replacement of one bubble with another could be undertaken a lot of times. In early 2000s, after the crash of Nasdaq, the increase of prices at the US real estate market inspired a speculative practice with related derivatives. The situation was encouraging the optimistic assumptions of market-players: even a low-class person, receiving a mortgage loan, could pay back the debt or resell the house with a high profit, as the prices were steadily increasing. The players were seemingly convinced that this increase of prices, along with well-being of Americans, was going to last forever, contrary to the economic laws. And no risk at all Ц with the help of derivatives.

But the fairy tale finally came to an unhappy end. The rising phase was over; the real estate market saturated; prices ceased growing and started sliding down. Defaults on securities, related to subprime loans, triggered the crisis of the whole mortgage market; the ensuing deterioration of inter-bank confidence developed into shortage of liquidity, targeting major banks and opening doors to a full-scale financial crisis. During 2008, major investment banks involved in mortgage derivative speculation Ц Bear Stearnes, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs Ц ceased existence, while the specialized state-protected agencies, Fannie Mae and Freddie Mac, were de facto nationalized, along with insurance giant AIG and more commercial and mortgage banks.

However, that is only the beginning. The economy of the United States is faced with a long-time recession, likely to transcend into the crash of the whole US financial system which is the backbone of the global financial system.

(To be continued)


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