Kondratiev Waves and Joseph Schumpeter

I have been doing a little reading up on Kondratiev Waves and Joseph Schumpeter.

If you are willing to accept that our current economic situation is more akin to the 1929 Wall Street crash, than more recent booms and busts, or bulls and bears, then the theory of Kondratiev Waves, and the work of Joseph Schumpeter will be of interest.

Nikolai Kondratiev was that most thankless of creatures a Soviet Economist, in fact so thankless was his role that he was sentenced to the Russian Gulag and received the death penalty. He put forward a theory of Major Economic Cycles, in his book of the same name in 1925. It was the subsequent European economist Joseph Schumpeter, who proposed calling these cycles Kondratiev waves in his honour.

These are the familiar theoretical sine waves, smoothly going up and down, but over a period of fifty years, or more.

These are long terms trends, trends that are beyond the means of individuals, or individual businesses, or countries to counteract. So the 1929 Wall Street crash was an inevitability, better decisions might have smoothed off some rough edges but it was still an inevitability.

Using Kondratiev as a prism to consider the twentieth century, the economy rose steadily from the turn of the century, slowing from 1921 to 1929, before it tipped into full scale depression. The next cycle started around 1950, with the economy rising steadily until 1980, when it tipped into recession, this continued, until the recent banking failures led to our dip into depression.

In theory these cycles are not just economic, they also reflect what the economy was about,
the Industrial Revolution starting in 1771
the age of steam and railways starting in 1829
the age of steel, electricity, and heavy engineering starting in 1875
the age of oil , the automobile and mass production starting in 1908
the age of information and telecommunications, starting in the 1950's.

Kondratiev waves are not accepted economic theory, nor are they the only economic wave proposed, there are
Kitchin inventory 3-5 years
Juglar fixed investment 7-11 years
Kuznets 15-21 years
Bronson asset allocation 30 years

Also if you are familiar with the principles of waves, if waves operate to independent timings, they will amplify or cancel each other out. So if you were to propose that only a couple of theoretical waves operate, then their interaction could easily provide an interesting pattern over a longer time period. Like the perfect storm, peaks could coincide to create once in a lifetime events.

One of the conditions for a scientific theory is that it should have some predictive ability. On the one hand it is possible to fit evidence into Kondratiev waves, but on the other it is impossible to use the theory to predict when different stages will take place. The holy grail for investors is to be able to call the top of the market, or the bottom. Kondratiev does not let you do this. It is arguable that the predictions are banal, things will get better for a while, then they won't, then they will get worse.

The most obvious point in the whole cycle would appear to be the 1929 Wall Street Crash, 2008 Banking crisis moment, where slowing down, tilts into a undisputed nose dive. In the theory of Kondratiev this is the transition from the Autumn Recession, into the Winter depression. Or the top of the sine curve, and the downward slope.

I also like to test any theory with the intuitive, does it seem plausible that it might be true. Not exactly scientific, more common sense. I suppose I can see that economic cycles might exist, stages within the economic cycle will create their own environment, create their own perceptions of risk, on appropriate reward, on appropriate strategies. Our attention is swamped by recent events, more distant events are easily discounted. So we are easily persuaded by talk that there is no more economic boom and bust, or that house prices can only go up. Such views seem to be validated as people make money out of them.

It could be that rather than this rather too straightforward explanation, what is really at play is a variety of variables, which were we sufficiently wise we could isolate, understand and use to predict economic activity. However I do feel that human nature is at play in these things, rather than technical variables. We are talking about how confident people are, and how they behave, experience teaches us that human behaviour is more predictable than it is rational.

It may be that Kondratiev waves capture the underlying paradigms of the economic cycle. The economy is based on an expanding railway network until the cost of building railways exceeds any possible return on them. Old industries are driven out, new ones are driven up.

The economy is based on an expanding internet and knowledge economy until the cost of knowledge and the internet exceeds any possible return. Do we really need so many university graduates, so many social networking sites, so many server farms, so much wifi connectivity, so much always on, connectable, contactable, super loquacious, pundit driven, never stopping 24/7 information? Having we truly tested the knowledge is power paradigm to breaking point?

If there is a perfect economic theory out there, then whoever figures it out, certainly won't be publishing it in a peer reviewed journal. They will be keeping it to themself, while they make lots of money.

I'm not convinced that Kondratiev Waves actually have much predictive power, but on an intuitive level they do seem to encapsulate much of our recent capitalist history. As an investor, I should consider the theory, and its characterisation of our current economic stage as being the Winter of the economic cycle, a time of fear, panic, and despair. Falling inflation turning into outright deflation, and a lack of credit.

The theory predicts the best investments are gold, cash, and bonds after the credit crunch.

As an investor, the theory does raise the very real possibility that we are caught in a falling market, one that might continue to fall for the next decade. You will need to be incredibly smart to be able to make the sort of profits that even unsophisticated investors were recently making.

If you invest, because that is part of what you do, then you will probably continue to do so, and if you are lucky you will make modest returns. If you are a fairweather investor then the market is not for you, when Kondratiev says it is Winter, the market is a cold and merciless place for the unwitting investor to be.

Further reading
wikipedia on Kondratiev Waves
wikipedia on Joseph Schumpeter
the best charts I have come across