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Home > Social Issues
In the Long Wave Trough
by Jon Holm, 2/16/05
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The origin of the "long wave" from a system dynamics perspective is described in the paper by John Sterman of MIT on the Long Wave Decline and the Politics of Depression (pdf 21.1Mb) based on a presentation to the Bank Credit Analyst Conference, New York, September 1992 .A Systems Thinking Perspective on Manufacturing & Trade Policy (pdf) has excerpts from Sterman's paper.

Below also are excerpts with a few comments:

Added 7/19/14:

Downsizing creates a vicious cycle that deepens and prolongs the downturn. This is Sterman's Exhibit 5 (p. 18) in the Long Wave Decline and the Politics of Depression. It's redrawn with S, Same (or +), and O, Opposite (or -), causal loop directions of influence shown.

So-called "free market" "conservatives" and libertarians typically deride the validity of Keynesian economics. This is what Sterman writes about the 'Keynesian consumption multiplier'.

"Readers trained in economics will recognize the reinforcing feedback loop just described as the 'Keynesian consumption multiplier.'

During the expansion of the long wave the multiplier feedback helps power the boom, as rising employment, incomes, and optimism lead to more demand and still further expansion. Now [in a recession] the same feedback process runs in the opposite direction, deepening and prolonging the depression."

Government spending can "jump start" the economy when it's in recession." Going around Loop R2, here's what happens, step by step.

1. Increased government spending increases Aggregate Demand (influence not shown ... that would be Govt Spending with an "S" influence on Aggregate Demand).

2. Increased Aggregate Demand reduces Excess Capacity.

3. Less Excess Capacity reduces Downsizing.

4. Less Downsizing increases Employment, Wages, Optimism.

5. Increased Employment, Wages, Optimism increases Expected Income.

6. Increased Expected Income increases Aggregate Demand

The figure at right shows how the structure of the economy can create an Economic Vicious Cycle. Loop B1 shows that during an economic downturn individual companies make rational decisions to downsize to reduce company expenses; this reduces industry excess capacity. But Loop R2 shows the sum of all the downsizing decisions has an overall industry “side-effect” of reducing employment, income, and demand to create even more excess capacity. This economic vicious cycle can lead to overall economic collapse.

Sterman explains that Reinforcing Loop R2 illustrates the "Keynesian consumption multiplier" that works both ways; it can pump up the economy or deflate it. Government spending can be used to increase aggregate demand and counter the fall in the income of individuals. He writes:

Readers trained in economics will recognize the reinforcing feedback loop just described as the 'Keynesian consumption multiplier.' During the expansion of the long wave the multiplier feedback helps power the boom, as rising employment, incomes, and optimism lead to more demand and still further expansion. Now the same feedback process runs in the opposite direction, deepening and prolonging the depression.

Libertarians and economic "conservatives" deny the reality of Keynesian economics (this source is so over-the-top ignorant that it's quite humorous) because they're generally in denial of systems effects. They propagate many false ideas about Keynesian economics. They deny the validity of Keynesian economics because it calls for government intervention in the economy to escape a downturn ... and they hate the idea of government involvement given they believe the "free market" myth that government only makes things worse.

They find this necessary because their ideology is based on the individualistic thinking that, as Margaret Thatcher famously said, "there is no such thing as society" and she had the "firm conviction that society is the sum of its parts" and no more because that would lead to government intervention. Essentially, they deny that the whole is greater than the sum of its parts. This denial is the dagger in the black heart of libertarian ideology in that it denies the reality of "emergent properties".

The major irony relative to Adam Smith's famous statement about the "invisible hand" is that its core tenant depends on an emergent property: unanticipated beneficial effects for all. Smith wrote:

Every individual endeavors to employ his capital so that its produce may be of greatest value. He generally neither intends to promote the pubic interest, not knows how much he is promoting it. He intends only his own security, only his own gain. And he is in this led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.

As Sterman notes, Adam Smith "was thus one of the first systems thinkers to show how the local, intendedly rational self-interested behavior of individual people could, through the feedback processes created by their interactions, lead to unanticipated side effects for all."

Sterman also describes how the political agenda turns "conservative" as the long wave begins its decline. That's pretty much what's happening today with flawed calls for cutting government spending.

As the long wave peaks and begins to decline, economic difficulties intensify. People start to worry about where the next paycheck is coming from. Their outlook becomes pessimistic; their politics, conservative. The political agenda turns away from foreign affairs to domestic issues, away from the progressive issues of social welfare and justice to economic growth and employment security. Conservatism, with its calls for smaller government, lower taxes, and support for the 'free market', grows in popularity as people seek to preserve their incomes in the face of rising unemployment and stagnant real wages. Social welfare programs are increasingly viewed as costly subsidies to the lazy or corrupt that society can no longer afford. California's Proposition 13 and Massachusetts' Proposition 2 1/2, both of which limited taxes and forced government to cut expenditures, were early signs of the conservative phase, which peaked dramatically in the current long wave cycle with the rise of Reagan and Thatcher.

Conditions continue to deteriorate as the economy moves into the trough of the long wave. Real incomes continue to fall, despite conservative economic policies. Unemployment is high and persistent. The deflation of the debt bubble leads to bankruptcies, bank failures, and foreclosures. Politically, society enters the parochial phase. People are now out for themselves. Increasingly people believe the only way to better their stations or that of their social, ethnic, or religious groups is at the expense of others. The rise of fascism in the 1920s and 1930s in Europe provides the most dramatic and horrifying example of the parochial phase.

He describes the effects of wrongly-timed stimulus (near the peak of the long wave, rather than at the bottom), of over-concern about deficits, of poorly-timed government spending cuts. And he explains the need for government capital spending budgets in order to distinguish between capital investment and on-going operational spending.

A second possible policy error has to do with the US fiscal deficit. A tragic error was made in 1982 when President Reagan cut taxes without comparable spending cuts. The resulting stimulus, coming during the peak of the long wave, allowed the economy to grow even further, to generate even more excess capacity, and build up even more unsustainable debt in even more overpriced assets. The consequence: a more severe long wave downturn. Having made that blunder, it would now be a disaster to compound it with aggressive deficit reduction during a time of depression. Eliminating the deficit now, either by taxes or spending cuts, would be extremely contractionary. Further taxation will further reduce consumer incomes and force aggregate demand down, leading to still more excess capacity and further intensifying unemployment and pessimism among households and consumers. Spending cuts likewise directly reduce employment and lower household income, leading to comparable effects. We should not minimize the seriousness of the explosion in Federal debt. The issue is the timing. Attempts to cut the deficit now will be self-defeating as the resulting unemployment and contraction in the tax base will further erode revenues and boost spending on social programs such as unemployment compensation so that the deficit will not in fact fall.

While the deficit cannot now be cut, I do believe much Federal spending could be shifted away from relatively unproductive Federal expenditures in both military and social programs into more productive, investment-oriented areas. There is a lot of room for reallocation of funds to rebuild the social fabric of our society and improve the quality of our lives. The federal government should adopt a capital budget, in which investments in infrastructure, including human capital (e.g. education, preventive medicine) are separated from operating funds. Such programs should be counted as investments in the future of the nation, not expenditures contributing to an operating deficit.

Such Keynesian stimulus is required to jump start the economy, and put people back to work, and return to tax revenue that reduces deficits.

One might note that what he describes in 1992 is pretty much what is happening now. The long wave did not leave the trough as it should have by now because of stimulus from Federal Reserve pumping liquidity into the economy in anticipation of problems due to Y2K concerns, stimulus from wars in Iraq and Afghanistan, and tax cuts (primarily for the wealthy that massively increased debt). Given these factors, we're a long way from getting out of the long wave trough, and we never will if "conservatives" have their way.

From the Holm Mortgage Finance Report, 2/18/05, By Jon Holm

A PICTURE IS WORTH 1,000 WORDS, or so they say. The Long Wave graph (see below) took us many years to produce (we will explain why later on). It was like trying to re-invent the wheel, but we finally did it. In 1992, Professor John Sterman of MIT wrote an article titled, "Tne Long Wave Decline and the Politics of Depression." The article dealt with the discovery that Professor Jay Forrester and others at MIT made in the ‘70s when applying their new technique of systems thinking to the economy as a whole. Their computer model produced the Long Wave. Then they had to explain how it happened.

This is quite different from the research that Russian economist Kondratief did back in the early 1920s when he produced his theory of the long wave (or K-wave) which many since then have hijacked to try to predict the stock market and other such unrelated things. For this reason, many contemporary economists shy away from the theory because it has been tainted by the get-rich-quick schemers. It is unfortunate that the MIT researchers chose to use the term "Long Wave" to describe their findings. A more appropriate name would probably increase its popularity today and separate this remarkable academic work from the K-wave stock market timers. This is unfortunate because MIT’s Long Wave explains why we aren’t seeing more job growth in this recovery. Sterman’s article reveals how this newly discovered cyclical phenomenon operates; it does not attempt to predict future trends.

We do know that MIT’s Long Wave exists. We know how it behaves and why. What we don’t know is exactly when trends will change, but we can logically conclude that after a long decline in economic activity, the trend will reverse. We can see from the graph that we are not in an economic uptrend. Based on the Long Wave theory as produced by Sterman and others, we know we are in the trough of the Long Wave–the period after a long decline but before a new uptrend has started.

The problem we all face now is one of being in the trough and not knowing when the new Long Wave uptrend will begin. Our guess is that we will find ourselves in the new uptrend through hindsight. As we continue to update the graph, at some point we will see that the line is advancing upward. But we know for certain that such an uptrend is in the future–still many years away.

The graph, as mentioned earlier, was a work-in-progress project for us. The original graph was presented in Sterman’s article in 1992 but included the data only through then. The basis of the data and calculation method were revealed in the article, but there was no formula presented that would allow one to re-create the graph, not to mention extending the graph to the present day. Through trial and error, we just recently managed to "break the code" so to speak.

Sterman’s data was based on GNP, the measure of economic growth that everyone used back then. But now we all use GDP. By applying the methodology that MIT used to create their graph, we used GDP to create our updated graph and extend it through 2002. There are slight differences when comparing the two, but the overall result is amazing.

What we can see from the graph is that the peak of the Long Wave began in the early 70s. Not only did economic activity reach its peak and begin to decline but so did average real hourly wages. Intuition told us that the long boom of the ‘90s that ended with the bursting of the dot.com bubble was a period of strong economic activity, but was it the beginning of a new uptrend?

The graph clearly indicates that it was a false start. Indeed, it was a bubble that quickly reversed and probably led to conditions that will keep us stuck in the trough for longer than we would like to be. With the huge budget deficits hanging over the economy and much of our resources going into the war, is it any wonder that we are not producing strong job growth? Add in the exporting of jobs to the equation and it is easy to see why we will not be in an uptrend for some time.

What does the graph tell us? Based on the findings of MIT, the uptrend of the Long Wave began after WWII ended. During that war-time economy there was rationing of goods and a scarcity of consumer products such a cars. After the war, the pent up demand generated the building of much infrastructure and capital investment to produce durable goods. Since it takes a long time to bring capital investment on line, the economy grew robustly until the 70s when supply caught up with demand and enough factors of production were created. Since that time we have not needed all that capacity, and the decline in the Long Wave is mostly the result of excess capacity. Add in the boom in computer technology and communications in the 90s, and we can see why we are suffering from an even greater glut of capacity.

When looking at the graph, some may wonder why there is no label for the Y-axis. This graph shows the relativity of where we are rather than assigning it an absolute number. We can clearly see that 1973 was the peak of the Long Wave. The sharp decline from ‘73 to ‘75 indicates a recession, but the magnitude or difference between the two points in time is not important; it only tells us that economic activity contracted. What the points on the graph show is the difference between real GDP growth for that year and the average annual long-term growth trend since about 1800.

Apparently, the economy grows on its own at a rate of about 3.4% a year, based on technology advances and the growth in population. It compounds on its own. If it grows more than 3.4%, it must be due to factors that are identifiable and vice-versa. For example, the period from 1979 through 1982 illustrates the efforts of the Fed to squeeze inflation out of the economy. The Fed-induced recession halted economic activity, even though GDP grew 2.5% in 1981. However, that 2.5% growth was below the normal 3.4% growth, so the graph indicates a decline. It does not necessarily indicate that GDP growth was negative, only that it was below its normal rate of 3.4%.

Essentially, the graph illustrates the history of GDP growth over time, stripped of its 3.4% normal compounded growth rate. So when we hear the analysts crowing about how the economy grew 3.1% we know that we left money on the table for some reason. And when the experts predict that the economy should grow about 3% to 3.5% in 2005, we know we are still stuck in the trough of the Long Wave because that is basically no growth at all.

The Long Wave. This graph is derived by subtracting out a long-term trend of exponential growth of the economy of 3.4%, primarily due to population growth


















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