Economic Cycle
Alexander Liss
Just when the end of economic cycle was
declared it had shown itself with the vengeance.
There is something in capitalist economy
that causes it cyclical development and it is very important to understand the roots
of it.
This is not an oscillation, which one could
detect in any stable system; this is something more important, something
essential to nature of the market.
Basic needs of people could be satisfied
with very primitive economy, even when population grows.
The market is based on ever growing
desires, support for this growth is a major function of the market (usually it
is done with sells and marketing).
Even something that qualifies to be called
a need as food, shelter, etc. is wrapped up into the mechanism of satisfaction
of desires. This works – a market based society produces an excess of food,
shelter, that only a small part of population feel shortage of it.
Perpetual generation of desires and
building systems to satisfy them leads to exploration, exploration in all
possible direction – human psyche, places around the world, ways to construct
buildings and connect banks of the river, etc. As long there are things to
explore, there is the way to expand the market.
A new idea, which fits the market (new product or
service, improvement of existing product or service, novel way to increase
desires for products or services, etc.), could start a process of local
expansion. Numerous local expansions interact with each other and serve as a
basis of market expansion.
Finding an idea, which fits the market and getting
funding for it always require exploration in various directions.
In addition, in the process of expansion, limits of
environment, society and knowledge are tested and loosened. This is
exploration.
The idea, which got funding, continues to
receive funding as long it could support sufficient market expansion. Support
of market expansion is measured in generated profit and it is sufficient as
long the level of profit is sufficient.
Expansion is done with putting more efforts
into the area of the market “surrounding” this idea, as product or service
creation, marketing, etc. The quantity of these efforts is determined with
funding. Hence more funding is put in the area.
Often, the level of additional funding is
defined as a share of additional profit generated because of this idea. In a
simple case, the profit is proportional to level of funding and hence in any
given moment, funding increment is proportional to funding. This is an
equation, which defines exponential growth of funding and profit.
Experience shows that profit stays
proportional to funding only for some time. Inevitably, the moment arrives,
when the ratio of profit to funding starts to diminish. Often, this happens
because some bound is encountered, which was not present at the beginning of
the process of expansion. It could be that one reached limits in resources, or
limits of ability to generate desires (for example, many people already have
the product, or there is a limited speed of
consumption of the product or service).
When such bound is encountered, the
expansion slows down; it is not exponential any more.
This is a familiar pattern; one often
observes it in the growth of company’s stock – a famous S-shaped curve. It
starts with exponential growth, slows down to linear growth and eventually
stagnates.
Note that the “location” of this bound is
not known upfront, had it been known, it would be avoided. Hence, the market
“finds” this bound through its natural process of expansion. It is a tool of
exploration.
There is another reason why the ratio to
funding start diminishing – competition.
In the market practically always there are
a few competing products and services, which correspond to competing ideas.
Different competing products and services are not identical, they differ in
what they offer and how much they cost; they form a set of partially
exchangeable products and services.
Often, not a separate product or service
and corresponding idea should be analyzed, but a complete set of partially
exchangeable products and services. In such set, there is an overall volume
(quantity of units) and a distribution of volume among elements of the set.
As in the case of a single product,
initially the ratio of profit to funding is fixed for all elements of the set
and there is exponential expansion for all of them, however at some point, the
entire set hits the bound in its expansion. Some elements in the set are more
affected by this bound then the other. Hence, two results could be observed,
when the bound is hit. First, overall expansion slows down. Second, this
slowdown is distributed unevenly between elements of the set – the distribution
of volume changes.
Eventually, some elements in the set meet
their end, while others continue to exist. New elements are added at some point
also, elements, which fit better in newly discovered situation with the bound
present. Hence, the set of partially exchangeable products and services is
changing.
Had it been only a few such bounds, and had
they been known, the society would learn well, where they are and found ways
around them. Hence, it would be no issue with bounds.
However, there are many bounds and they are not
known upfront. One has to expand the market just to find them and only then one
could invent the ways to work around them.
This pattern could be seen in all views on
the market: local view, focused on one company or even on one product line, an
aggregate industry-wide view or even nation-wide or global view of the market.
This phenomenon injects genuine randomness
in market operation. It is not known, when these bounds are to be hit, and it
is not known how to work around them.
Some forecast and modeling could be done, and it is
done. This reduces uncertainty, but does not eliminate it. This modeling and forecast is an important
part of the activity of market participants.
Expansion ensuing from the idea could be
restricted by bounds to a different degree. In mild cases, expansion slows
down, but still exponential. In more severe cases, expansion becomes linear or
even could stop and become stagnation.
In even more severe cases, expansion is
impossible and the only way left to operate could be contraction.
Operating during contraction is
substantially different from operation during expansion. For example, covering
warranty obligations during contraction is relatively more “costly” than during
expansion. During contraction, fewer new units of the product are coming to the
market, then during expansion, and correspondingly the cost of covering
warranty is spread over smaller number of new units.
Hitting contraction is natural market phenomenon;
usually it precedes the end of useful life of the idea.
When the market in its expansion approaches the
bound, it is felt. Business situation starts deviating more than usual from
business forecasts – uncertainty increases. This leads to less successful
business planning and increased volatility of markets. A formerly promising
idea suddenly does not work as well as expected – it does not produce expected
expansion or even related business could start contracting.
Sensitive market participants read the signs and
bring in new ideas. However, often, people try to solve the problem by doing
more of the same – cutting cost, increasing advertisement, etc. When there is a
bound hit, doing more of the same does not help.
First, from a large number of potentially
useful ideas, only a few get funded. From those, which get funded, only a few
fit the market and start the process of (incremental) expansion.
Initially expansion is exponential, but
eventually a boundary is hit and it slows down and even could be replaced with
contraction.
To analyze this slowdown, one needs to take
in consideration a set of all other ideas ‘active” in the market, which brought
to existence products and services partially exchangeable with a given one.
The end of life for the idea could be discontinuation
of the product or service, or introduction of new ideas, which supersede this
one.
Many ideas go through all phases from expansion
through stagnation and contraction. It is rare that ideas are cannibalized and
new ideas are introduced before useful life of the original idea is exhausted.
Note that it is impossible to predict the duration
of life cycle of each idea from introduction, through expansion, stagnation and
contraction to the end. The duration shortens, when a new unknown bound is hit.
Hence, one has to assume that the duration and the distribution of phases of
the life cycle of an idea are random. One could try to predict it, but
essentially cannot extend it.
Note also that when a severe bound is hit, many
ideas quickly come into a contraction phase simultaneously.
There are “large” ideas and ideas “improvements”.
For example introduction of a new product or service should be viewed as a
“large” idea and incremental modifications of it should be viewed as
“improvements” of this “large” idea. Another example would be setting up a
business, which controls production of many different products and services
should be viewed as a “large” idea in relation to ideas causing existence of
these products or services.
Depending on point of view, one could focus on
particular type of ideas and ignore related ideas “increments”.
Hence, this approach with ideas in the market allows
generation of large variety of useful models.
In the market, there is a perpetual stream of ideas
driving its overall dynamic.
Ideas are introduced into the market randomly and
they vary in speed of their initial expansion.
All ideas have similar shape of life cycle, but
different durations and distributions of phases. These durations and
distributions are essentially random.
Sometimes, lifecycles of many ideas are cut short
virtually simultaneously, because the market as a whole hits a set of bounds,
which affect many ideas. For example, harsh social situation, as a war, could
reduce overall variety and extend of desires of the society and thus reduce
durations of lifecycle of ideas caught in such period.
In developed markets, funding is done by
specialists. Such division of duties leads to more efficient functioning of the
market. This division could be done inside one company, where there is
specialization in design, production, sales and financial decision-making. In
many cases specialization goes even further with mechanisms of credit,
borrowing, bonds, etc.
Such specialization is warranted, because funding
decisions have to deal with long time horizon, take in consideration potential
losses associated with risk taking and have to provide means to survive during
downturns due to economic cycles.
Economic modeling and forecast are main tools used
in funding decisions.
The mechanism of ideas and induced expansion of the
market is based on specialization of market participants.
One type of specialists invents large number of new
ideas.
Second type filters these ideas and provides funding
for some of them.
Third type generates desires and support matching of
desires with products and services associated with the idea (marketing, sales, and
distribution).
Fourth type maintains stability of the process (introduces
minor updates, maintains uniform production of units of product or service in
spite of varying conditions).
Sometimes the same person acts in roles of different
specialists, but more often different roles are played by different people.
Specialists are market participants in a more
organized part of the market. They are compensated for their efforts according
to rarity of their skills.
At some point, it was discovered that it is possible
to use the market to satisfy needs of the society as food, close, shelter, etc.
This allowed much higher level of specialization and hence much higher level of
overall efficiency of the society in this area.
From this point, a lower bound was imposed on speed
of expansion of the market. The market should expand with at least the speed of
the population growth.
Theoretically, such growth could be achieved through
extensive expansion, where the majority of ideas provide linear expansion
matching population growth and expansion is achieved simply by adding
specialists with the speed of population growth.
However, this is highly unrealistic. There are
disastrous events, and the society has to accumulate cushion to survive them.
Society grows unevenly and the excess of growth is needed to compensate for
that. To avoid internal conflicts members
of society have to see their well-being improving, hence excess of growth is
needed.
Practically, the market has to grow with the speed
higher than the growth of population. There is only a
limited number of situations, when such growth could be achieved with linear
growth – the society has to occupy highly advantageous position for that. The
general way to archive it is with the stream if ideas, which provide some
periods of exponential growth.
When the market hits a set of severe bounds, many
lifecycles of ideas are cut short virtually simultaneously. This leads to
contraction of the market in many areas simultaneously.
Hitting such bounds is inevitable; however there is
no way to predict when the next such event will happen.
To an observer, who ignores effects of hitting the
bounds, this looks as random oscillation of the market, where period and
magnitude of this oscillation is unpredictable.
This is exactly what astute observers say about the
economic cycle. Each downturn has something new, which never happen before,
however in hindsight one could find numerous similarities. The reason of it is
unpredictability hitting the bounds.
Market oscillations of high magnitude could bring
periods, when society is uncomfortable; hence, decreasing the magnitude of
oscillation is desirable.
This could be done with “cannibalization” –
perpetual introduction of new ideas, while old ideas are not fully utilized
yet. New ideas allow better adjustment to boundaries, which substantially slow
down expansion brought by old ideas.
In addition, such regime of market functioning
brings overall growth of the market closer to exponential growth and this even
could masks oscillations.
Note though that generally the market does not
support such behavior. Old ideas, which are close to the end of their life is
usually sufficiently profitable and easy to maintain. It is difficult to get
funding for new ideas to replace old ideas. Special socio-economic conditions
need to be created to stimulate perpetual “cannibalization”.
Various limitations imposed on the market do not
eliminate unpredictable nature of hitting the bounds and hence do not decrease the
magnitude of oscillations.
Temporary increasing production of existing products
and services or temporary increasing demand for existing products and services
does not affect oscillations in a positive way.
New products and services, which fit new desires,
products, which have a good chance to perpetuate for a long time, are needed to
overcome effects of hitting the bounds causing market slump.
Marxism attributed economic cycle to poor planning
and consequent overproduction, which in turn shuts financing.
Curiously, too many still think that this is a cause
of economic cycle and try to treat a market slump with increased demand to
clear overproduction.
Description above shows that causes of the economic
cycle are much deeper; they are at very roots of the market. Hence, the market
slump cannot be treated through increase of demand for the existing types of
products and services. It should be treated using different means, which
stimulate introduction of new ideas.
Another mistake was caused by Marxists’ mechanical
approach to analysis of the production. In Marxism, the emphasis was made on
routine operations of production – churning large quantities of the product
(what is called here maintaining stability of the process). The perpetual
changing of products, the creation of new desires in the market participants
was (deliberately?) left out.
This in turn was used for political means. Those,
who churn large quantities of product, were declared a main element in
production and political power was demanded on their behalf.
These mistaken views are shared by surprisingly
large group of people engaged in study and management of economy. When they
apply these views, results are disastrous. They waste resources trying to
control the economic cycle through increase of demand in times of economic
slump with consequent higher taxation in one form or the other. This leads only
to deeper economic slump.
When they are in control of the economy, they orient
it on satisfying needs of population and this immediately leads to destruction
of market mechanisms and stagnation, because the natural market property of
simultaneous expansion of desires, products and services is deliberately
constrained in such case. Often, to stimulate economic expansion weapons race
is introduced, which naturally leads to aggressive policies.