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Global Risk / Global OpportunityTen Essential Tools for Tracking
Minds, Markets & Money
Shlomo Maital and D.V.R. Seshadri
RISK OPPORTUNITY 1
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Chapter Seven
Tracking Booms and Busts
This chapter explains the forces that drive business cycles (periods
of boom and bust), the link between demand components and
recession and the role played by two key deficits -- the trade deficit
and the budget deficit and how they interact. It explains the 2007-
9 global downturn, and the link between prices of common stockwith changes in the real economy.
.
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Toolbox: Tool #7 "Twin Deficits": Budget and Trade Deficits
Supplemental Tool:
"Real" (inflation-adjusted) Common Stock Prices
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Definitions:
Common stock: a document giving its owner a share of the
ownership of the company, a share in its profits, and a share in
the voting rights.
Preferred stock: stock to which dividends are paid before they
are paid to owners of common stock.Shareholders' equity: On the company's balance sheet, the
difference between what the company owns (assets) and what the
company owes (liabilities). It is the 'book value' (i.e. value as
listed on the balance sheet) of the company's net assets, or whatshareholders own after paying off the debts.
Market capitalization: The total market value of a company's
shares, at agiven point in time.
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Definitions: Business cycles are short-term fluctuations in GDP and
unemploymentcycles of recession, recovery, growth and again recession, around a long-
term growth trend, over periods of about four to eight years. They involve shifts
between periods of relatively rapid growth (expansion, or boom) and periods of relative
stagnation or decline (contraction, recession, or bust).Trends are long-term movements in GDP, prices, income and employment, with
consistent direction and nature, over the course of a decade or more.
Recession: Once defined as "two consecutive quarters of decline in real GDP", the
most recent authoritative definition is: "a significant decline in economic activity spread
across the economy, lasting more than a few months, normally visible in real GDP, real
income, employment, industrial production, and wholesale-retail sales".Source: National Bureau of Economic Research, www.nber.org
Downturn: Loosely-used phrase referring to the contraction phase of the boom-bust
cycle. A downturn can mean either an actual decline in real GDP (as occurred in the U.S.,
Europe and Japan, in 2009) or a significant slowdown in the rate of growth of GDP (as
occurred in China, in 2009).
Depression: A prolonged severe economic contraction that lasts longer than a typicalrecession and that afflicts economies in many parts of the world; a global economic
contraction.
Inflation: a general and progressive increase in prices, often occurring during the
'boom' part of the business cycle.
Deflation: a general and progressive decrease in prices, often occurring during the'bust' part of the cycle. 6
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Figure 7.1. World Stock Markets, 2008- and 1929-
Source: "A Tale of Two Depressions", Barry Eichengreen and Kevin H. O'Rourke,
www.voxeu.org
Months from Peak
1929
2008 -
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Table 7.1. Number and Duration of U.S. Business Cycles, 1854-2007
Period Number of Business Cycles Average Duration (months) *
1854-1919 16 49
1919-1945 6 53
1945-2001 10 67
March '01 - Dec. '07 81
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1854-2001 32 55
* Duration: Number of months to peak of economic activity from the previous peak. Source:National Bureau of Economic Research, www.nber.org/cycles.html
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It is worthwhile to remark that a product is no sooner created than it,from that instant, affords a market for other products to the full extent
of its own value. When the producer has put the finishing hand to hisproduct, he is most anxious to sell it immediately, lest its value shoulddiminish in his hands. Nor is he less anxious to dispose of the money hemay get for it; for the value of money is also perishable. But the onlyway of getting rid of money is in the purchase of some product orother. Thusthe mere circumstance of creation of one productimmediately opens a vent for other products.
J.B. Say, 1803. A Treatise on Political Economy, or the production,
distribution and consumption of wealth, 1803 (Engl. transl.) p.138-9)
J.B. Says Law of Markets
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Business cycle TheoriesGovernment policy: It is sometimes argued that government policy itself
exacerbates, or even causes, rather than mitigates, business cycles.
Politics: Related to stop-go is the so-called 'political cycle'. Democracies haveelections every four years or so. In the two years prior to the election governments
stimulate the economy, creating a boom, in order to be elected or re-elected. In the two
years after it, they brake the economy, creating a bust, to resolve the problems createdduring the boom.
Cyclical responses to initial shocks: This theory, due to J.M. Keynes and expanded
by M.I.T. Professor Paul Samuelson, shows how the complex interaction between
consumers (personal consumption) and businesses (investment) can create cycles.
"Real business cycles": External 'innovation' shocks occur, as new technologies
replace old ones, and economies decline, then boom, as investment pauses and then
accelerates. In this theory, business cycles are not a sign of inefficiency or market
failure but rather a sign of rejuvenation, implying that governments should not try tointervene or 'smooth' the cycle.
Marx: Capital accumulation causes profit rates to fall, leading businesses to
merge and create monopolies, to reduce wages, leading to economic crisis.
Credit cycles: In boom times, banks overlend, businesses and people overborrow, as
interest rates fall and real (inflation-adjusted) rates may become negative. When
borrowing halts, as a result of over-leverage, investment slows, asset prices decline andthe economy dives into recession.10
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Four Question Framework
* Do people have money and are they optimistic and keen to
spend it? Or are they concerned about debt and pessimistic
about losing their jobs?
* Are businesses making profits and are they keen to reinvest
them, in creating new assets (buildings, machineries, equipment,software)?
* Do governments have money and are they keen to spend it,
beyond what they absorb in tax revenues?
* Are businesses selling more abroad to other nations than is
being bought from abroad, i.e. do exports exceed (or fall short
of) imports, and is the gap widening or shrinking?11
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Action Learning:Using the Four Question Framework
For the country in which you live or work,
answer the four boom-bust questions above.
How can you find data that generate accurate
answers? How can you supplement such datawith your own observations, in stores, malls and
workplaces? Do your answers lead you to
conclusions that differ from those of the
forecasting experts? Why? Above all, can you
anticipate major shifts in consumption,investment, public spending and trade?
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Keynes Employment Multiplier
Govt. spends $1 b., accruing to households as added income: Households spend 71 % of it, creating $710 m. in new income..creating $500 m. in additional spendingand so on.
$1 b. + $0.71 b. + .50 b. + 0.36 b. + 0.25 b. ., etc.
The formula for the sum of a geometric series is:
SUM = 1/(1- a)
where a is the constant multiplicative factor in the geometric series. In the
case of the Keynesian multiplier, this factor is the fraction of each dollar
of GDP spent on personal consumption, termed by Keynes the marginal
propensity to consume. For the U.S. it is 0.71, as noted.In the above example, therefore, the $1 b. initial stimulus generates
$3.448 b. in overall GDP growth:
SUM = ($1) [1/(1-0.7)] = $1b. times 3.448 = $ 3.448 b.
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Animal Spirits as a Cause of Business Cycles
In Keynes' landmark 1936 book The General Theory, which
struggled to explain the Great Depression then afflicting the major
economies of the world, there is the following passage:
There is instability due to the characteristic of human
nature that a large proportion of our positive activities depend on
spontaneous optimism rather than mathematical expectations Our
decisions to do something positivecan only be taken as the result
of animal spirits - a spontaneous urge to action rather thaninaction
J.M. Keynes. The General Theory of Employment, Interest and
Money. London: Macmillan, 1936, pp. 161-2.
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Action Learning:Gauging Animal Spirits
Do you regularly engage in informal
conversations? Do you cross-check by matching
survey data with your own observations? Can
you acquire a sense of 'animal spirits' throughthese conversations?
Some excellent sources of such data are:
taxi drivers (taxis are sensitive to the business
cycle, because people walk or take public
transportation when their incomes decline);restaurants (also sensitive to business
conditions); shopping malls (are they crowded,
and are people carrying packages, or simply
window-shopping?).
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Toolbox:
Tool #7 "Twin Deficits":
Tracking the Government Budget Deficit and the Trade Deficit
Disposable Income Personal Consumption +
Gross Capital Formation+ (Public Consumption - Net Taxes)
(budget deficit)
- (Imports - Exports)
(trade deficit)
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Change in Disposal Income
Change in the budget deficitminus the change in the trade deficit
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Figure 7.2. United States, 1987 - 2009: Budget deficit for state, local and federalgovernments; and trade deficit (exports minus imports), $ billions.
$ billion
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Country Market cap GDP Market Cap/GDP
$ b. $ b. %
1 USA 17923 13841 129
2 Japan 4615 4380 105
3
United
Kingdom 3722 2770 134
4 China 3059 3242 94
5 France 2653 2556 104
6 Hong Kong 2180 207 1053
7 Germany 1976 3317 608 Canada 1620 1426 114
9 Switzerland 1207 424 285
10 India 1090 1135 96
Table 7.2. Market capitalization of stocks and GDP,
10 countries, August 2007
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Table 7.3. U.S.: Annual Real Returns, Stocks, Gold, Bonds, 1870-2001
Period Stocks Gold Bonds
1871-2001 6.8 % -0.1% 2.8%
1946-1965 10.0 -2.7 -1.2
1966-1981 -0.4 8.8 -4.2
1982-2001 10.5 -4.8 8.5
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Unadjusted AdjustedFigure 7.4 Dow-Jones 30-Stock Index, 1949 - 2009:
Unadjusted and Adjusted for Inflation ("Real")
Toolbox:Supplementary Tool: Real Dow-Jones.
"Real" Dow-Jones index = Nominal Dow-Jones Index / Price Index
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demandpull
cost push
demand curve
supply curvePRICE
QUANTITY
Figure 7.5. Cost Push vs. Demand Pull Inflation
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Definition:
Price-Earnings Ratio (P-E): the ratio between the price of
common stock (what you pay for one share) and the net after-tax
earnings per share, either for an individual stock or for a group
of stocks (such as the Dow Jones Index or the Standard & Poor
500 Index).
PF PN--- = ---E
FE
N
Where:P is stock price, E is earnings per share, subscript F signifies:
(expected) Future, and subscript N signifies (actual) Now.
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Figure 7.6. Price Earnings Ratio forStandard & Poor 500 Index (U.S.) 1900 - 2009
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Fig. 7.6. Company value (1994 = 100%): Fundamental value andExpectation premium, 1994 and 2000
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Tracking and Managing Boom-Bust Cycles
First, think differently -- identify 'bubbles' and'bubble psychology' while others are still caught up in
them.
Second, assess the timing -- try to gauge when thebubble is likely to burst, and when 'boom' shifts to
'bust'.
Third, catch the tide not only when it goes out, but
also when it comes in -- assess when the 'bust' phase islikely to reach bottom, and the economy begins its
recovery.