It is not news that there is a very short-term perspective on Wall Street, in the business community, and among government policymakers. There is a general failure to grapple with long-term problems until they reach the crisis point, and then, ill-conceived and short-term fixes are usually implemented. Almost all economic theory is focused on the short-term business cycle, and very little thought is given to the longer wave forces that affect our lives over generational time frames. Lost in the daily cacophony of 24-hour news and politicized media reporting is the truly long-term view of how our society has gotten to where it is today. This isn’t referring to the typical three-year “long-term” of Wall Street, but a very long-term view that encompasses the balance that must occur for society to survive.
If you think about it, any political or economic system that survives over the long-term must have ebbs and flows because they rebalance the system. No economic sector can indefinitely grow much faster than the economy at large. No asset can consistently have higher returns than its underlying variables. No political system can move forever to the left or right. The ebb and flow is necessary for long-term rebalancing.
The chart above idealizes the main modes of economic behavior. “Growth” is the relatively steady expansion of society’s wealth due to population growth, technological progress, and the accumulation of human capital (knowledge). For the U.S., the annualized 150-year growth trend of real GDP has been about 3.4%. The Long Wave appears as a slow-moving curve with long-lasting periods of rise and decline. While subject to great variability, it is estimated that peak-to-peak cycles of the Long Wave have lasted 45 to 60 years in the U.S. since the 1800s. The “business cycle” appears more rapid and shallow by comparison; typically a few percentage points of growth from peak to trough. Historically, the business cycle has been three to six years in length. Finally, “random noise” is the weekly and monthly data that Wall Street worries so much about.
The “Long Wave” business cycle is a concept new to most investors, since the primary focus of economists and academia is on business cycles. Yet for long-term investors, it is the Long Wave which is the most important cycle, and least understood. Like a glacier, its procession is imperceptible to the eye, yet it can change the landscape dramatically over many years. Moreover, investors can spend their entire lifetimes in one half of the cycle, not recognizing the changing environment until it is too late.
The genesis of the Long Wave is the long-term ebb and flow of capital creation. An example of a trough in this cycle was right after WW II, as the U.S. underwent extensive post-war rebuilding. Before we could produce the consumer goods we wanted, the machine tools and factories that produced these goods had to be built. Factories required ways to get raw materials to them, requiring development of transportation systems, which in turn required production of equipment for the transportation industry, etc. The demand for capital stimulated further demand for capital. There was a very powerful self-reinforcing process that continued for many years and pushed the standard of living well above average.
As capacity catches up with demand, the expansion phase peters out, with the result that the capital goods sector is larger than required for the long run. Capacity caught up with demand in this country in the early 1970s. Excess capacity first appeared in heavy industries such as autos and steel, then spread to durable goods industries, services (e.g. airlines), and ultimately to real estate and the government sector. This created a self-reinforcing cycle that cut into demand well into the 1980s, as the same process that powered the upswing worked in reverse to drag the economy below its growth trend rate for over a decade. This repeated itself in the years after the 2008 recession, when GDP growth remained weak, despite the massive amounts of monetary stimulus generated by the Federal Reserve.
The 2008 economic recession was brought about by an excess of financial capital, rather than physical capital such as factories and inventory. The long decline of interest rates from 1981 to 2008 had provided ample opportunity for the financial sector to encourage borrowing and refinancing until the capacity to fund the debt merry-go-round was exhausted. Like historical Long Wave troughs, the collapse of 2008’s credit bubble created a self-reinforcing cycle that cut into demand, causing huge dislocations in the financial and housing markets, and exposing major defects in government budgets and pension schemes that had been years in the making. The “creative destruction” of the 1970s took place as factories were shuttered, production increasingly moved to Asia, and talent, capital, and labor was freed up for the age of high technology brought on by the invention and application of the computer semiconductor. The creative destruction of 2008 was seen in the wide swath of bank and corporate bankruptcies, the real estate foreclosure quagmire, and widespread stress among over-leveraged federal, state, and municipal governments.
Social Mood and the Long Wave
The Long Wave cycle is so powerful that the pressures it creates spill into our social and political institutions. We first wrote about this phenomenon, called the Social Value Cycle, in 1993, and with the benefit of hindsight, it has broadly unfolded according to theory.
An analysis of social mood by social scientist Zvi Namenwirth was conducted by studying political party platforms, state of the union addresses, key speeches, and major social legislation and is dubbed the Social Value Cycle. It is based on the theory that political parties exist to be elected and re-elected, and therefore, perhaps more than any other institution, have an interest in capturing the mood of the electorate. A social mood is not a theory for them, it is the reason they win or lose elections.
Under this model, the social mood of a country cycles around four phases:
- The progressive phase—when liberalization occurs with government becoming actively involved in social policy with justice and equity becoming dominant cultural issues.
- The cosmopolitan phase—in which a wealthy, confident nation is outwardly focused, has little hesitation in telling others what to do, and is fairly imperialistic.
- The conservative phase—in which stresses appear, economic issues come to the fore, and the focus turns inward.
- The parochial phase—by far the least attractive phase, and often driven by economics, it is characterized by high social stress as divisive issues dominate, often with moral overtones. It is a very difficult time for political parties.
While these phases are far from exact, and the timing of the cycles occurs with great variability, it is interesting how history follows this model in a broad sense. A brief stroll through U.S. history illustrates the cycles.
The parochial phase represents the trough of the Long Wave, and is the nastiest phase of the Social Value Cycle. It is marked by weak business cycles, rather extended recessions, and an increase in government regulation. Also characteristic is a debt “hangover” as the exuberant lending of previous days is replaced with bankruptcy and falling asset prices. Moreover, the social focus shifts inward. Individuals are out for themselves; the only way of bettering one’s lot in life is at the expense of some other group. Examples would include the rise of fascism in 1920s-30s Europe, America’s isolationism in the 1930s, the malaise of the late 1970s, and the heightened religious tensions directed against Muslims in America today.
As Long Wave troughs give way to expansions, political values tend to become more liberal, as rising incomes and economic security seem to provide a basis for more cultural “risk-taking” in a society. This is the “progressive” phase of the Social Value Cycle. Public mood is focused on civil rights, social equity and justice. Examples include the abolitionist movement (circa 1855), Child Labor Act and women’s suffrage (circa 1907), and the Civil Rights movement (circa 1959). Two of today’s most intractable financial commitments, Medicare and Medicaid, were born in this period as Lyndon Johnson’s Great Society vision was implemented. But business is good during this phase, and there is confidence about jobs and spending.
At the peak of the Long Wave expansion social mood moves into the cosmopolitan phase. There is an outward-looking, almost imperialistic attitude in society. Wealth creation is in high gear during these periods, and the population is very confident about itself with little hesitation in telling other countries what they should be doing. Cosmopolitan periods have occurred around the time of the Napoleonic Wars (1816), the Civil War (1860s), World War I (1918) and the Vietnam War (1967), and each represented a bid for dominance of their respective continents. In 1969, the ultimate colonization quest was achieved--Neil Armstrong walked on the moon. Fast forward about 30 years to 2001 and 2003, and we found ourselves initiating invasions of Iraq and Afghanistan in the wake of the 9/11 attacks. That period also coincided with the peak in S&P 500 returns.
As the Long Wave declines, the conservative era emerges. Conservative eras have been marked by major economic slowdowns, and rising fears of job security. 1829 marked the beginning of major depression of the 1830s-40s. Late 19th century depressions began in 1881. 1929 saw the infamous stock market peak and subsequent Great Depression. In 1985 we saw a peak of a conservative phase, with the popularity of Reagan and Thatcher and conservatism in economics. A deep recession in the early 1980s was followed by major dislocations in farming, S&Ls, and real estate. Pro-business and anti-government sentiment during these phases has often led to massive tax reductions. In the 1870s, Civil War taxes were reduced to the point where the income tax disappeared by 1880. In the 1920s the highest tax rate was reduced from 73% to 25%, and in the early 1980s rates dropped from 70% to 28%. Many thought Ronald Reagan unique in this regard, but in a sense he arrived right on schedule.
A look at the unfolding of events since the turn of the century reveals that the Social Value Cycle is still playing out. While the interval between cycles seems to have speeded up, the cycles appear to be broadly following their predicted pattern.
The bear market and recession of 2008-09 clearly marked the most recent low of the parochial period. Consistent with previous cycle lows it was a time of great financial stress brought about by investor complacency, widespread deregulation of financial industries, and overconfidence in the ability of the Federal Reserve to control the economy. The impact of the credit bubble collapse resulted in anemic economic growth for years afterwards.
The election of Obama represented a clear shift in the political mood underscoring the movement into the progressive phase. Not only did Obama break the color barrier by being the first African-American elected to the White House, his reelection in 2012 seemed to reflect the electorate’s desire for government to fix the economy. Numerous social issues came to the fore during this period, including the legal right to gay marriage, healthcare rights through passage of Obamacare, increased consumer financial protection, and the legalization of marijuana.
Trump’s election in 2016 marked a move into the cosmopolitan phase, we believe. His “America First” policy regarding international affairs and trade, and his willingness to tell foes and allies alike how to behave, fits neatly into the cosmopolitan era’s confident and imperialistic characteristics. Trump’s unilaterally imposed tariffs on China are a stark example of the “my way, or the highway” attitude of this phase. Moreover, a comparison of previous cosmopolitan phases shows many parallels to today.
The periods of the 1880s, 1920s and 1980s were all periods that marked the end of cosmopolitan periods. In each case, the electorate felt that government was part of the problem, and therefore, less government would be better. A pro-business bias, deregulation, and tax cuts were the order of the day. In each period, a two-tier economy developed, where the coastal parts of America prospered, but the middle heartland did not. There was massive financial restructuring in these phases, as witnessed by the merger waves of the late 19th century, the holding companies of the 1920s, and LBO/takeover craze of the 1980s.
Mark Twain nicknamed the 1870s “The Gilded Age.” He was not referring to the color on the walls of Newport mansions. He was referring to the practice of gilding the securities of otherwise mediocre companies to polish them up for sale to unsuspecting investors. Jesse Livermore, the great stock market manipulator of the 1920s, and Michael Milken, the junk bond king of the 1980s, are the poster boys of their own “gilded age.”
Each period was marked by an excessive buildup of debt. The land and railroad speculation of the 1870s, the holding company pyramid schemes of the 1920s, and the leveraged buyout craze of the 1980s were all fueled by cheap debt and easy money banking policies.
All three of these characteristics are present today. Strong stock and real estate returns have been driven by cheap and available credit, thanks to a decade of central bank interest rate suppression. Central bank policies have also created a mountain of debt, with the result that corporations and governments find themselves deeper in debt than at any time since the 2000 market peak. Finally, today’s technology titans, Facebook, Google, and Amazon, wield nearly monopolistic power in their industries, and are now coming under fire for their willingness to sell customer’s private data to secure their own goals. They are now so big and pervasive they are coming under increasing anti-trust scrutiny here and abroad. The characteristics of these cosmopolitan phases all appeared in time more or less about when they could have been predicted.
The implication of being in the cosmopolitan phase is that more stressful times are ahead of us, as we head into the conservative, and then parochial, phases of the Social Value Cycle. This will be many years in the future, and not worth the attention of candidates jockeying for the 2020 election. However, it seems that the stage is set to follow the pattern, with stock prices at the second highest level of overvaluation in history, debt levels that are well into historical danger zones, and a political system creaking under the weight of partisan politics and control by lobbyists and “dark money.”
Can we look forward to a “progressive” phase sometime in the next 30 years? It sounds farfetched, but capitalism’s “invisible hand” has proven its adaptability over time, managing to hold together despite lurching from boom to bust and back again. Can our society find the backbone to deal with the daunting challenges of debt, slow growth, reluctant politicians, and threats from abroad? Probably, because we have solved intractable problems before. Is there reason to believe our will to carry on is less now than it was in times past? We don’t think so, but the process of owning up to our self-made problems (e.g. precarious debt levels), and then working on solutions for them will be a messy, tense, and fractious affair. Political power will vacillate back and forth until the right leaders are found, who will either lead an effort of “shared sacrifice,” or have it thrust upon them. So political fragmentation will continue, along with the negative campaigning, surreal promises, and spineless short-term thinking that goes with it. It’s likely to be frustrating for the left and right alike, but as mere Band-Aid solutions run out, the collective wisdom of voters will grind toward a resolution. And from that a progressive period will emerge, and the Social Value Cycle will carry on.