Continued from Part 1 ....

Something reverse can happen which would be even more damaging

than the just discussed case. Instead of Consumption growing at

a faster rate than Savings, it might so happen that Savings and

Investment grow at a much faster rate than Consumption. For

example, prior to Great Depression, the importance of aggregate

demand as explained by Keynes was not understood. As a result

government policies normally favored huge Investments and were

not geared towards propelling aggregate demand. It is well

documented that one of the reasons for the Great Depression was

US government policies which led to uneven distribution of

income heavily in favor of the rich and the consequent

depletion of the buying power of the households. So Great

depression could have easily resulted from Investment/Savings

growing at a much faster rate than Consumption. Huge

Investment/Savings would mean that huge surpluses are realized

by the producers of the Consumption sector. This would prompt

them to invest in an even bigger way in plant and machinery and

this huge Investment/surplus pattern continues for a few years.

After a few years, we have huge capacities with insufficient

Consumption or buying power!

The capacities of production rise to an extent where the

producers would not really be interested in investing their

surpluses as they already have huge unutilized capacities much

in excess of the buying power of the households. As a result

Savings are not invested i.e. Investment lags behind Savings.

Money is hoarded, the circular flow of income in the economy

stops and the economy gets paralyzed. Demand gets constricted

which in turn constricts Supply. These constrictions worsen the

situation even more because, on account of drop in production,

the percentage of unutilized capacities increases even more

than before which makes Investment in new capacities even more

unattractive further increasing the hoarded money. The economy

gets involved in a vicious downward spiral that can

dramatically reduce incomes and severely aggravate

unemployment. Ultimately after a few years, some huge

Investment opportunity prompts entrepreneurs to start investing

all of the Savings and the economy restarts on the expansionary

path. Or it can so happen that the huge excess capacities get

destroyed on account of lack of demand – for example, some new

technology makes plants with older technology unsuitable to the

new needs and such plants and factories become useless. This way

excess capacity is weeded out making the economy conducive for

Investment and growth. I believe that most business cycles in

US and Europe prior to 1930s occurred in this way, they were

all mostly Investment propelled. I would call those cycles –

the Investment led Business cycles.

How can stagflations occur? During the Consumption led cycles,

after several years of growth, Consumption eats away into

Savings and surpluses realized would fall short of expectations

for the producers of Consumption sector. Savings are low and a

correction is required by cutting Consumption and increasing

the Savings. The extent of correction defines the strength of

the next boom. If the correction is big and Savings are piled

up in a large manner during the downturn, then, at the

beginning of the next boom, it gives the chance for Consumption

to nibble away at Savings slowly and steadily for a large number

of years – booms can last very long. If the correction is very

small, if Savings are not too large at the beginning of the

boom, the boom is then nipped in the bud itself. As there are

no large Savings made, as soon as Consumption tries to nibble

away Savings, Savings would immediately fall below the danger

mark and the surpluses expected by the Consumption sector are

not realized and a recession would start as immediately as the

boom starts. In such cases, the booms might not last for more

than one or two years. Such cases of insufficient corrections

can occur on account of government intervention. Government

tries to arrest the downward slide by trying to propel the

aggregate demand using expansionary policies such as cutting

down interest rates or indulging in deficit spending.

Government’s intention in doing so would be to arrest the

downward slide and decrease unemployment. However the effect of

the government intervention would be that, economy starts

expanding even before the Consumption is cut and Savings are

increased to the required extent. As the economy starts

expanding, Consumption tries to eat away at Savings and this

immediately brings the Savings below the danger level and an

immediate onset of recession. More workers are fired and a

downward slide starts once again. Once again the government

intervenes and tries to arrest the slide and once again the

same thing would repeat itself and more workers are fired.

Unemployment keeps soaring. Ultimately the producers realize

that low surpluses are here to stay along with expansion.

Apart from low surpluses there is the problem of rising

interest rates. As the economy tries to expand, there would be

good amount of Investment demand. However as Savings are low

and Investment demand is high, there is a huge demand for the

limited funds available causing the interest rates to rise

vertically. Government borrowing and deficit spending in order

to boost the economy eats into the already low Savings and

aggravates the situation even further. The situation mimics

that of a boom time when both short term and long term interest

rates are very high. Abnormally high interest rates lead to

cost-led inflation. Very high interest rates coupled with low

surpluses make Investment as well as production expansion

unattractive to the producers of the Consumption sector. They

start pocketing their profits without either investing or

expanding production and the economy starts stagnating without

growth. Under normal circumstances, pocketing of profits would

lead to hoarding of money and paralyze the economy on account

of stoppage in the circulation of money. However in this case,

on account of government’s expansionary policies as well as

cost-led inflation, capitalists do not hoard the money as money

would lose its value on account of inflation. They start

spending the pocketed profits and the circulation of money is

not disrupted.

However the demand does not increase despite the lack of

hoarding – why? What should have been saved and invested is now

being spent directly by the capitalists. The income that would

have reached the hands of a hundred Investment workers is now

in the hands of a single capitalist. As a result, where hundred

toothpastes would have been purchased by hundred Investment

workers, only one toothpaste is purchased by the solitary

capitalist! As a result the demand for goods suffers despite

the fact that money is not being hoarded. Capitalists are high

earners; they consume a small portion of their income and start

spending the rest of their income on speculation in real estate

and shares. Shares and lands are bought and re-bought at higher

and higher rates leading to a speculative bubble and soaring

inflation. Housing becomes very costly and the workers find

their buying power reduced as a large portion of their incomes

goes in providing housing for themselves. Workers then start

demanding for higher wages and periodic wage hike agreements

become part of the wage agreements making inflation a

relatively permanent phenomenon. Unlike what some economists

say about the unreasonability of wage hike demands by labor

unions, the wage hike demands of workers were actually

beneficial to the stagflationary economies of the 70s. The hike

demands of workers actually act as some sort of a small check on

the speculation of capitalists – instead of wild speculation,

some money in the hands of the capitalists gets diverted

towards wage hikes. Overall, stagnation and inflation co-exist

together. This is how you get stagflation.

There was a continuous boom for two decades in US and other

nations during the 80s and 90s. How could the booms last so

long during this period? The booms during this period were

Investment led. Huge amounts of Investments in IT

infrastructure propelled these booms. However these huge

Investments in IT are completely different from those that

propelled the Investment led booms prior to 1930s. The huge

Investments prior to 1930s led to piling up of new capacities

in a big way. This gave in to the chance of there being

over-Investment on account of huge unutilized capacities which

ultimately led to further Investment being unattractive thereby

resulting in Investment lagging behind Savings. However the

Investment of the 80s and 90s was not that way. Investment in

IT technology did not increase the plant capacities. For

example, more cars cannot be produced just because car

companies invest huge sums in IT. Therefore depressions of the

type that occurred prior to 1930s are ruled out and the boom

lasts as long as the IT spending lasts. Why couldn’t

Consumption eat into Savings during this period? On account of

the fear of being replaced by computers, the bargaining power

of the workers reduced dramatically upon which wage led and the

subsequent cost led inflations were completely absent. Therefore

producers could save their surpluses and invest them without

having to spend them on increasing costs. Also the prime reason

for Investment in IT being cost cutting, cost cutting ensured

that Consumption would never eat into Savings. This way neither

Consumption would eat into Savings nor would Savings/Investment

lead to excess capacities. Both types of downturns are ruled

out. Booms would last as long as the IT spending would last.

This is how booms lasted so long during the 80s and the 90s

leading to a virtual absence of business cycles.

That roughly sums up two and half centuries of Business Cycles!

A small note before closing out. From the capitalists’ point of

view, it would be great if the households immediately spend all

that they earn on Consumption – sales would get boosted. So

household savings make a dent or a hole in Consumption. This

hole is then filled by the immediate Investment of those

household Savings. So the phenomenon of investing the household

Savings is like digging a hole and filling it up. Therefore

household Savings do not affect the financial position of an

economy as much as the Capitalist Savings. A shrinkage in

household Savings would not directly affect the margins of the

firms. So just make a mental note that the above discussion on

Savings had more to do with Capitalist Savings and less to do

with Household Savings.

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