Boom and bust – every half a century
Working as a finance official in the newly-established Soviet Union, Kondratieff was researching the fundamental flaws of the capitalist system when he made his powerful discovery. Through his study of price and production trends over many centuries, he noticed a repeating pattern of upswings and downswings occurring at roughly 50-year intervals.
Kondratieff called this 50-year pattern "the long-wave" – see Kondratieff's long wave chart below. The first half of each long wave sees rising inflation. At the beginning of the cycle, prices rise slowly and then gather pace. A tipping-point occurs midway through the cycle, giving way to falling inflation. This falling inflation finally gives way to falling prices ending in a deflationary bust.
Kondratieff's long wave
Long wave goodbye
Stalin was delighted at his economist's observation that capitalism was naturally doomed to suffer crises in this way. But he was less thrilled at Kondratieff's conclusion that capitalism also tended to reinvigorate itself and emerge stronger from each crisis. Kondratieff was rewarded for his amazing discovery with banishment to Siberia, where he was put to death in 1938.
The force beneath the waves
Although Kondratieff's long wave appears as inflationary and deflationary phases, the actual force driving these periodic cycles is credit. Early on in the cycle, the build up of debt is good for the economy, as it finances new production and greater prosperity. As more and more credit is created, inflationary problems begin to emerge. Ultimately, the weight of the debt becomes too much for society to bear. Borrowers seek to pay back loans or default on them. Prices fall, often dragging production and profits with them.
Including the present one, four long waves have occurred since 1775. Measured from bottom to bottom, each wave has tended to last between 52 and 68 years. Why these debt bubbles should occur at such regular intervals over time is something of a mystery. But they appear to have been around for much longer than the last 240 years. A similar cycle of debt was even recorded in the Bible, with a 'Jubilee' year write-off of all obligations bringing each one to an end every 50 years.
The four seasons
A complete long wave consists of an up-wave and a down-wave. Each of these has two phases. The two phases of the up-wave are usually referred to as 'spring' and 'summer', while the two phases of the down-wave are called 'autumn' and 'winter'. The up-wave and down-wave have tended to be of roughly equal duration, although the individual seasons can last variable times.
Spring is a time of recovery for the economy following the harsh effects of the previous debt bubble. Lending picks up and prices rise gently. The last springtime in the global economy was after the Second World War, as Europe underwent reconstruction and Japan began to develop into a major economic power.
As lending increases and there is greater competition for resources, the world economy experiences overheating. This is summertime and the last one was the 1960s and 1970s. Inflation becomes more uncomfortable in summer and interest rates rise accordingly. A recession ensues, taking the economy into autumn.
Inflation falls in the autumn, which is good for the economy. Real borrowing costs come down and growth tends to be steady and consistent. The last autumn period was the 1980s and 1990s. Declining interest rates and steady economic growth encourage businesses and individuals to borrow more and invest in more capacity. Although technically part of the 'down-wave', autumn is usually described as a 'plateau' within the cycle.
Winter arrives when the debt load becomes too great. Companies and households struggle to repay their liabilities, while overcapacity in the economy pushes prices down and squeezes profits. Prices slip into outright deflation, which can create a vicious spiral of falling profits, bankruptcies and asset sales. The last winter phase was centred around the Great Depression of the 1930s.
Where we are today
Today's economic situation definitely qualifies as a long-wave winter. Companies in the west began to unload their huge debts from 2000 onwards, while consumers are now following suit. Thanks to huge over-investment in China and elsewhere, there are huge amounts of slack in the world economy, which is putting downward pressure on profits. Deflation has reappeared in a widespread way for the first time since the 1930s.
So how long will winter be and how severe are its effects? Strikingly, the last three winters all lasted 19 years. Assuming the current winter began in 2000 or thereabouts, that could mean the current long-wave winter period won’t reach its final bottom until around 2019.
As well as having some years to run, the current long-wave winter is likely to be harsh. Given that the debt bubble that went before it was the biggest of all time, the theory also suggests that we will suffer a bust of similar proportions.
The process of paying off debt – 'de-leveraging' – has only just begun. Japan – which entered its current long-wave winter before the west – is still living with slow growth, falling prices and a weak stock market two decades after its debt bubble burst.
Can't central banks melt the winter snow?
Long-wave winters are, by nature, deflationary. But unlike during the 1930s, the authorities of today are determined to do everything to prevent deflation from taking hold. As a result, central banks everywhere have resorted to printing money and buying bonds in order to drive down long-term interest rates, with the aim of stimulating economic growth and inflation.
Despite the massive international efforts so far, the deflationary forces remain intact. This fact alone warns us that the authorities have limited ability to deal with the effects of a full-blown long-wave winter. That said, the attempt to create inflation could still succeed if they are really determined to do so.
Nevertheless, rising prices are not the same thing as economic growth. If central banks and governments do manage to stoke up the flames of inflation, the likelihood is that we will experience stagflation – a painful mix of low growth and rampant price increases. This would definitely hurt stocks and bonds, and probably gold and copper, too.
