Fashionable cycle paths

Asset Prices and the Real Economy
January 23, 1998

The economic troubles of recent years, and now the crises in the Far East, mean that business cycle analysis is back in vogue, with lively interest from worried directors, politicians, and even (The THES, December 26 1997), vice-chancellors. People want to know if economists and economic historians understand what is going on, and can they advise policy-makers and other important people on how to stop the rot? And, if not, do policy options exist which will relieve the worst of the business cycle?

This highlights an old inquiry: can we separate the inherent dynamism of capitalism, with its voracious expansionary culture and entrepreneurial behaviour, from the periodic instability in which firms slide into crisis and bankruptcy? This question has been asked by virtually all writers on trade cycles since the industrial revolution raised new questions about the relationships between money, debts, the foreign exchanges and price levels.

There is a huge literature: ideas range from the influence of sun spots and climatic change to more recent mathematical modelling, and, inevitably, their relevance to business and banks varies. Widespread interest is now shown in debt deflation, early popularised by the US economist Irving Fisher, whose Booms and Depressions (1932) followed the early years of the interwar slump. Debt deflation comes to the cycle when confidence is evaporating, when people have had their party, and are into the hangover phase. Ideas on debt deflation focus on asset values, especially on those purchased during the boom, when things turn sour and the economy enters the downwards spiral. While some prices fall in the normal run of things, as stock adjustments, and serve little threat, Fisher noticed something worse. After the rise in indebtedness by which buyers acquired assets, the distress of the boom phase forced some debtors to sell their assets at low, even "distress", prices. Some are successfully realised and bank loans repaid, but the need for bank liquidity, and the fear about (usually) the property sector, sees fewer loans, with tougher conditions. So the money supply contracts, the overall price level falls, more debt is off-loaded, and the downward spiral reaches even sound business, now competing with bankrupt stock. So profits decline alongside a rise in the real rate of interest. In Fisher's words, looking at the interaction of debt and deflation, "the very effort of individuals to lessen their burden of debts increases it". So the efforts of all parties to reduce debt results in the real burden rising, and, inevitably, blue-chip becomes less than blue-chip.

Fisher's own experiences helped formulate his views. In 1923 he sold his small manufacturing concern to a company that became Remington Rand: the stock soared, but he lost when the crash came in 1929. Borrowing $1 million from a sister-in-law, his burden of debt mounted as prices fell. Knowing the classic literature on cycles as he did, Fisher advised the president and the public that there was no slump, this was just an adjustment. His work of 1932 was an adjustment, all right, and his rethink focused on the relationship of asset price decline with deflation, as a cause of the downward spiral, largely unstoppable by pundits and politicians.

Asset Prices and the Real Economy is a valuable collection of essays, focusing on debt deflation, which repays close reading. It has well-put-together descriptions of what happened to debts, households and firms, during the crisis phase in Sweden, the UK and Japan, the US and the interwar slump, with statistical series and modelling on the way debts behave. There are important ideas here, and lessons for the management of the economy, and for businesses and households. The authors ask interesting questions about how stock adjustments can lurch into recessions, why credit losses build up, and what households do as they re-adjust expectations.

The recent recession in the West, and the current worries in the Far East have property speculation, and financial deregulation, in common. There must be many THES readers who wished they had taken the advice of such as W. R. Scott, of Glasgow University, who in a Board of Trade report (1932) questioned the assumption that property and house investments were sound, and easily sold, where the debtor, with little capital, takes on a level of debt many times current income. Given assumptions readers of the THES are familiar with, such as the area around the purchase not descending into a social exclusion zone, haven for drug dealers, etc, then the debt can be realised. Fortunately, the past decade has returned the middle classes to the scepticism which is necessary for those on modest and uncertain incomes.

Several essays here, including excellent contributions on Sweden and Britain, bring out the problems for the banks, as speculation and 1980s deregulation adversely affected previously well-managed financial systems. We have witnessed this in the crass stupidity of Canary Wharf, "starter homes", replacement of the high street by megastores, and inappropriate products and competition in the mortgage market. This meant that several segments of bank assets suffered, at the same time as another, vital part, the lending to industry, came under pressure. The essay by Leigh Drake and David Llewellyn asks some fundamental questions, applicable everywhere, about banking systems under strain, and how problems were exacerbated by government. But for the capital strength of the clearing banks, and the secrecy of information which is necessary to protect banks, things would have deteriorated further.

And the West European system is far more sophisticated than the flimsy constructions of the Far East; which may be why so many of their newly rich prefer to keep their money in Edinburgh, London, and Paris. The depth of learning in Western European banks is simply superior to anywhere else in the world. Banks in the outback will continue to suffer until they learn that relationship banking is a low-profit and potentially high-risk operation, and that over-exposure to speculation and property development is a certain route to trouble. Much of the nonsense of these tiger economies' banking systems comes down to basic management failings; but some to political conditions: banks will continue to have problems where they associate too closely with military juntas (Indonesia, Korea), fantasy property speculators (Malaysia, Thailand, Japan), and deranged politicians (any guesses?).

The fact that mismanagement in the Far East is likely to continue, and the old lessons of the business cycle remain to be learnt, guarantees interesting times. There is thus a future for collections such as this one. The World Bank should mail it to a variety of politicians who still blame George Soros and a conspiracy of financial markets. This might be more cost effective, over the long term, then shovelling billions into the depths of Korea, etc, and worried vice-chancellors might ask for funding for setting up master of business cycle courses to teach these politicians the old-fashioned lessons absorbed in Western Europe over two centuries.

Richard Saville is lecturer in economic history, St Andrews University.

Asset Prices and the Real Economy

Editor - Forrest Capie and Geoffrey E. Wood
ISBN - 0 333 62892 6
Publisher - Macmillan
Price - £47.50
Pages - 286

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