So much for all the recent chatter about the power of central bankers and the New Economy to eliminate business cycles. Business cycles, or "trade cycles," as they used to be called, have long been a fact of economic life. In the Bible (Genesis 41) Joseph interprets the pharaoh's dream to mean that there would be seven years of great plenty followed by seven years of famine. Acouple millennia later another Joseph, Schumpeter, that is, repeated the theme when he wrote (in his seminal Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process, published in 1939) of "excursions into prosperity" and "excursions into depression."

Business cycles come in many styles and flavors, in terms of both their causes and their lengths. Some, such as inventory (Kitchin) cycles, have a duration of about 4 years. Others, such as the Juglar cycle, last between 8 and 12 years. The Kondratieff Long Wave is supposed to stretch over a period of 45 to 60 years.

Understanding cyclical times past will help us understand the problems that currently challenge the global economy. Consider the economy of the U.S. in the 19th century. The U.S. was still a predominantly agrarian economy. Despite rapid industrialization, agriculture in 1900 still employed twice as many Americans as manufacturing and accounted for 75% of U.S. exports.

Cycles back then were caused by foodstuff prices. When farm prices rose, farmers thrived and bought manufactured products. This in turn boosted the incomes of workers in the growing urban sector (the population in urban areas began to exceed that of the rural areas only in 1918). Conversely, when agricultural prices fell, farmers purchased fewer manufactured goods, and the economy tanked.

But to explain 19th-century American business cycles only as a function of agricultural price movements is an oversimplification. In periods of falling commodity prices, the only way businesses could increase income was by cutting production costs, through the application of new inventions and technological innovations. We find all the great waves of innovations in periods of weak prices--American examples include the canal boom in the 1830s, the railroad boom of the 1870s and the rise of the electricity, chemical and automotive industries in the 1920s.

These periods of falling commodity prices and great innovations were driven, however, not only by the desire to cut costs and improve productivity. Equally important was a favorable environment for financial assets. Declining commodity prices led to falling interest rates and rising bond and stock prices. This lowered the cost of capital and improved the profits of the manufacturing sector. Avirtuous circle, while it lasted.

All the big American financial manias--the canal and railroad boom, the 1920s stock market and also the 1990s U.S. stock market boom--occurred during weak pricing environments. But booms are not sustainable. The innovation waves and stock market frenzies preceded financial busts, which boosted the cost of capital, reduced demand and led to recessions.

Why do booms generate busts? During periods of weak prices, since there is no inflation, monetary conditions remain very accommodating. Moreover, the combination of new inventions, rising corporate profits, vibrant financial markets and easy money fuels a capital-spending boom. In fact, as the Austrian economists observed, easy money brings about massive overinvestment and a misallocation of capital. The innovations and expected profit opportunities are so great that they lead to excessive borrowing (see related story on page 56). Eventually the overinvestment leads to excess capacity and a collapse in prices. This drives down profits and financial asset prices, reinforcing the weak pricing environment that helped build the wave of innovations in the first place.

Sound familiar? The weak pricing and easy-money environment of the 1990s led to a huge stock market and capital-spending boom, which was financed largely by debt. The capital-spending boom has now entered the colossal-bust stage. More easy money may cushion the immediate shock; but it will only aggravate the excess-capacity problem in the high tech sector, because it will finance further investments--if not in the U.S., then certainly in such countries as China and India--as companies run in circles to cut costs even more rapidly to restore profitability.

In short, Alan Greenspan's accommodating monetary policies will remain largely ineffective. Corporate profits will continue to slide and lead to more layoffs. The trough of the current excursion into depression is still far below.

Dr. Marc Faber
Gloom Boom & Doom Report
mafaber@attglobal.net
contrary@pacific.net.hk