It is the nature of markets to reward success and eliminate what is unsustainable. During the past year we have seen a dramatic manifestation of this process, which has created the conditions necessary for renewed global growth. Although many people claim markets have failed, what has happened is actually a triumph of markets, which has forced changes that the political system would never have made.
It was a communist article of faith that ultimately capitalism would destroy itself. Accordingly, during the 1920s, the Communist Party of the Soviet Union commissioned the economist Nicolai Dmitriyevich Kondratieff to advise when this would happen. After giving the matter much thought, Kondratieff came up with two conclusions. Firstly, capitalism would not end or collapse. Market-based economies have an astonishing ability to reinvent themselves and to emerge resiliently from economic crises. Secondly, there is a market cycle of about 55 years. On the basis of this cycle, he predicted the travails that would follow 1929. Why 55 years? Kondratieff did not offer an explanation, but his work points to the probable answer. Fifty-five years represents two generations. People do learn from their mistakes, but not from history. Their behaviour changes with personal experience. A new generation with different experiences tends to repeat the mistakes of the past.
Kondratieff did not find favour with his Soviet masters. The Great Soviet Encyclopaedia restricted mention of him to one sentence: This economist was reactionary and wrong. He was exiled to a labour camp in 1932 where writer and future Nobel Prize winner Alexandr Solzhenitsyn once had a fleeting sighting of him. Kondratieff was executed in 1938. However, his insights remain valuable and very relevant to our current economic situation.
Have markets failed?
It is commonplace to read, and hear comment on the financial crisis which has unfolded over the past two years, that the market economy has failed. British Prime Minister Gordon Brown has said that markets are discredited. The reality is somewhat different. Indeed, many individuals have been made to look very foolish. How did economists get it so wrong? was the title of an article written by Nobel Prize winner Paul Krugman. Again this is nothing new. In 1300 Dante consigned the equivalent of errant economists, whom he called soothsayers who make false prophesies, to the lowest circle of hell. However, errors by individual bankers, economists and politicians do not mean markets are wrong. Over time markets, which are the aggregation of human behaviour, expunge error in a Darwinian process which rewards success and eliminates what is unsustainable.
PEOPLE DO LEARN FROM THEIR MISTAKES, BUT NOT FROM HISTORY
Prior to 2007 a set of unsustainable imbalances was developing on an astonishing scale. They included:
- Property bubbles financed by reckless borrowing
- Reckless lending by banks
- An almost total absence of saving in many countries, including the United States
- Massive trade imbalances and an Asian growth model based on exports
- An overheated global economy forcing commodity prices up
It was apparent that we were on a path which could not last. The uncertainty was how we would get off it. Many market participants believed that somehow we would muddle through without too much suffering. However that was not to be. Market forces acted with a vengeance and astonishing rapidity. As a result the behaviour of individuals and institutions has changed dramatically. Within two years:
- The private savings rate is up strongly and, in all probability, the baby boom generation will remain significant savers. The shock of what has happened has fundamentally changed the way people regard the future and is creating a savings culture.
- Irresponsible lending and imprudent borrowing have practically ceased. There is much talk of the need to regulate banks to ensure that the bad practices, which contributed so massively to the debacle, are not repeated. In reality, the experience of the past two years has so changed behaviour that it will not be necessary to regulate bankers for a generation.
- Asian countries are increasingly redirecting their economies to domestic rather than export-driven growth.
- The shortage of commodities has eased significantly.
The triumph of markets
Recessions are an essential part of the process of economic growth. To a large extent, growth is synonymous with rising productivity and efficiencies. During long periods of prosperity inefficiencies and bad practices accumulate. In a recession these are eliminated, or at least reduced, and a platform is created for the next expansionary wave. What we have experienced recently is therefore not a failure but a triumph of the markets. Within two years market forces have imposed necessary adjustments and changes in behaviour which the political system would never have done. Much of what was unsustainable has been eliminated and the world economy is now building foundations for the next up cycle.
As world trade and the financial system imploded after Lehman's collapse, many commentators sought parallels with what happened in the 1930s. This is a misreading of history. The present recession has far more in common with the downturns of 1975 and 1982.
The recent recovery of markets has followed a path similar to what happened in those two years. It is encouraging that 1976 and 1983 witnessed strong growth, which gives confidence about the prospects for 2010. One intriguing parallel with 1975 is the sense of shock that the financial collapse caused. Between 1948 and 1974 the world experienced a continuing boom with relatively minor recessions. So events of 1975 took everyone by surprise. The same thing happened in 2008 when a generation of businessmen and investors had been lulled into complacency by what has come to be called the Great Moderation 25 years during which markets were increasingly stable and benign. In both cases, the lessons of history were forgotten.
The political response to one crisis may create another
While the world's economy is recovering we still face considerable dangers, partly due to what may be unintended consequences of governments' reactions to the crisis. Political systems do not readily accept the harsh judgement of markets. Too many people have been hurt in what has been the most severe downturn since 1982. The response has been to slash interest rates and to print money in the hope that this will alleviate the pain. While this has proved to be a short-term panacea there will be longer-term costs. In effect, governments are trying to prevent the adjustments required by market forces. Those economists who advocate money creation as the solution to our current economic problems have much in common with a French minister of agriculture in the 1930s who, in order to increase the sale of wine, advocated wine as a cure for alcoholism. Money creation is like a drug, a difficult habit to break. Newly printed money is finding its way into asset prices. There is the danger that, in their response to the consequences of one asset bubble, governments are going to create another. If there is another bubble, it is a certainty that market forces will again take their toll.