Economic Cycles – Understanding the Crash

Kim has a good acronym for the current financial meltdown; GFHF or Global Financial Hissy Fit.  I was out to dinner the other night with a renowned pessimist who was quite outspoken in relating the various tales of woe and impending doom (his name is not Hanrahan by the way).  And so to the Review of 19 December and the lead article sourced from Prospect on the popping of the bubble in the contemporary art market.  I know nought about this market but it appears to have links to other bubbles that are popping (and they are not from champagne bottles!).

In his book Manias, Panics and Crashes, Charles Kindleberger observed that manias typically start with a “displacement” that excites speculative interest.  It may come from a new object of investment or from the increased profitability of existing investment.  It is followed by positive feedback as rising prices encourage less experienced investors to enter the market.  Then, as the mania gets a grip, speculation becomes more diffuse and spreads to other types of asset.  Fresh assets are created at an ever faster rate to take advantage of the euphoria and investors try to increase their gains by borrowing to buy assets or using derivatives.  Credit ultimately becomes overextended, swindling and fraud proliferate, and the mania ends in panic as investors seek to liquidate their positions.

The authors comment that the art market has adhered spookily to this model.  It seems that the sub-prime fiasco in the US is the “super-prime” example of such mania.  The markets work when asset prices are increasing so long as you are not the one holding the lemon at the end of all the wheeling and dealing.

That paragraph reminded me of a great book that I read about 5 years ago by Carlota Perez called Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages.  She describes the process of going through the following stages of a cycle commencing with the discovery of a new technology:

  • Maturity: Financial Capital Planting the Seeds of Turbulence at the End of the Previous Surge
  • Irruption: The Love Affair of Financial Capital with the Technological Revolution
  • Frenzy: Self-Sufficient Financial Capital Governing the Casino
  • The Turning Point: Rethinking, Regulation and Changeover
  • Synergy: Supporting the Expansion of the Paradigm across the Productive Structure

The main described by Kindleberger contains the particular stages in the irruption and frenzy components of Perez’s cycle.  We were enamoured with the book as we were reading it after the dotcom and telco crashes of the 1999-2001 period while working in an information economy area of the Australian government.  Little did we know that the financial excesses and losses of that period are minor in comparison with what is happening now.  It is clear that while billions of dollars were lost at that time, there was no turning point in rethinking and regulation.  There was still too much loose money sloshing around in the finanical system seeking short-term returns.

What we did like about the book was the expression of hope in the synergy phase where after the losses of financial speculation, money continues to be invested in the productive use of the technology.  Unfortunately, we are yet to see this period as more regulation is still required and the bodies on the shore as the tide washes out still need to be exposed before credit becomes available once more.

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