A set of twin brothers separated at birth, leading identical lives and doing the same kind of work should be able to accumulate the same level of assets during their lifetime. However, the capitalist system works in such a way as to diminish this probability if not negate it. Understanding how this can happen sheds light on the mechanism by which cycles of boom and bust grip the developed economies -- which is the goal of this discussion.
I begin with a description of what is meant by the word cycle and use the pendulum to help in the presentation. As can be seen from the left-to-right-and-back movement of the pendulum, a cycle is said to exist when a metal disc attached to an arm undergoes a repetitive back and forth motion called oscillation. With this in mind, let us visualize the disc at the highest point on the left side about to begin its descent. If it takes it one second to reach the bottom of its path, it will take it another second to reach the highest point on the right side. The disc will then reverse direction and do the same thing going the other way. That is, it will take it four seconds to do the back and forth trip which is the full cycle, also called a complete wave.
Now imagine two identical pendulums doing the same thing with the exception that when the first begins to come down, the second does not follow until half a second later. We say that the two pendulums have the same cycle but that they are out of phase with each other; and we specify that the phase shift here is equal to half a second. And since the full cycle is run in four seconds, a division will show that the shift in this case is equal to one eighth of a cycle. Of course, we could have made it a quarter cycle or half a cycle or anything in-between. What must also be noted about the wave is that when it is drawn on a graph, it is shown to have a high peak and a low peak. The spread between the two peaks is called the amplitude of the wave, something that will play an important role in the discussion as we shall see later.
Meanwhile, the set-up need not be a pendulum because any oscillation between two states qualifies as being a cycle even when the back and forth is done by something other than a physical mass. Thus we may imagine a number of enterprises making up an economic jurisdiction where they undergo the normal business cycle of building up their inventories and selling them. For example, there is a time to start constructing homes and a time to sell. A time to ramp up the production of cars and a time to sell. A time to start stocking up on school supplies and a time to sell. The list goes on but what is important is that if the forecast done at the beginning of the cycle by a business turns out to be correct and the build up is matched by the drawdown, the cycle is said to be normal for this business. Thus, the ideal situation would be for each and every business to have a timetable proper to it and a cycle that is independent of its competitors and of its peers.
To visually express a business activity, we draw it as a curve with an amplitude whose size depends on how good the good times are and how bad the bad times are. In most business cycles, the amplitude is maintained within acceptable limits, and when the economy does not overshoot these limits, it is said to have a moderate cycle because it does not create the conditions for boom and bust. A moderate cycle is, therefore, welcomed by most people because they expect it and, when it happens, they see it as a reflection of the rhythm of life.
But because all the economic entities have the same suppliers, customer base and bankrollers, the fortunes of the largest among them spill over and affect the smaller ones. Most of the time, it is either good times for everyone or bad times for everyone. This is to say that the bigger entities drag the smaller ones into a cycle that gradually approaches theirs. Eventually, all the entities will have one group cycle common to them except that each entity will have the option to maintain a phase shift proper to it. However, human nature being what it is, an increasing number of entities will deliberately harmonize their investment strategies with the big ones and try to narrow even the phase shift between them as much as possible.
As this happens, the loss in the size of the phase gap becomes a gain that is added to the amplitude of the wave. And when the amplitude becomes large enough, it turns the economic cycle into one of boom and bust. Furthermore, the more that credit is made available and the cheaper it is, the more that the speculators will borrow and add still more to the size of the amplitude. When ordinary investors are encouraged to join the frenzy with talk of the good times lasting forever, they become the vehicles by which money is borrowed from the lending institutions and channeled to the brokerage firms, investment bankers, hedge fund managers, specialists, arbitrageurs and all those who pocket the millions of dollars doing nothing more than play the shell game with “Other People’s Money.” And this is where the dreaded economic bubble begins to form.
Let us now discuss some investment strategies to see how things ought to work and how they do actually work some of the time. Two entities such as the twin brothers of our story may adopt different strategies. One may follow the group and be safe while the other may take a risk by adopting a contrarian posture. That is, he will phase shift his moves by half a cycle in relation to the group. Thus, when everybody is selling at a low price, he will be buying. And when everybody is buying at a high price, he will be selling. The result of buying low and selling high consistently will be that he will get rich and may even accumulate a million dollars during his lifetime while the twin brother will remain average all his life. Of course, there is nothing wrong with someone taking a risk and getting rich or with someone playing it safe and be content; neither of the twins can be faulted for their choice of strategy.
But an interesting question poses itself at this point: Why is it that everybody does not go contrarian and get rich? Well, beside the fact that most people prefer to play it safe, it is clear that the question is absurd because if everybody goes contrarian, the contrary becomes the norm. And if a minority does not follow the group, it finds itself standing in what used to be the norm but is now the contrarian posture. And the reason why the question was asked in the first place is because to think about it helps to understand how the big business entities profit from the cycle despite the fact that they cannot be contrarian by definition. To think about the question also helps to understand how the medium size entities profit by narrowing the phase gap between them and the big entities.
The big entities profit by leading the cycle, and to understand how this happens we visualize a curve such as the famous Bell curve. In reality this curve is only half a wave but it is good enough for the purpose of this discussion. If you are an economic entity that is so big you dominate the market, the entities that are too small to affect your operation can go contrarian as did one of the twin brothers, and benefit from your activities without affecting your operation. But the somewhat larger entities that can irritate you but are nevertheless too small to challenge you outright will have to follow your lead or be left behind if not trampled upon. Thus, deliberately or not, they will trace the same path on the curve as you but will remain slightly phase shifted and lagging behind you all the time. What some of them will do, however, is try to narrow the phase gap between them and you thus contribute to the condition of boom and bust.
To see this, let us follow the action blow by blow. When prices rise, you will at some point decide that this level ought to be the peak of the curve. You will sell and thus force the prices to fall which will cause the level you have chosen to indeed be the peak. Sooner or later, the other entities will realize that you are selling and they too will start to sell but will do so at a lower price. Then, at some point, you will decide that you have reached the bottom of the curve and you will start to buy at the lowest of prices only to be followed by the other entities who will buy at higher prices. Thus, when you consistently buy at a price that is lower than anyone and sell at a price that is higher than everyone, you will make gains that are bigger than all the others. And you will have accomplished this feat because you had the financial clout to lead the market in the first place. As for the medium sized entities that lag behind you, the narrower they make the gap between them and you, the more they will buy and sell at prices closer to yours and thus benefit the most. But they will also contribute considerably more to the amplitude of the wave and to the swing in the economy.
As can be seen, the interface between the various entities in this game is a complex one, and the possibilities offered to those of medium size to make decisions independent of the leader are limited. There is no doubt, however, that most of the entities will want to remain as independent as they can not only from the leaders but also the vagaries of the marketplace. Consequently, they will take a realistic approach when doing business and will make the decisions that will help them stay alive and avoid ruin. For as long as they can, they will walk a tightrope between the need to avoid doing the things that can bring them into conflict with the leader and doing the things that are called for by sound business practices.
But because the first imperative of human nature is to stay alive, most people will in the end synchronize their activities with the rhythm of life that rhymes with success. If this means they must follow the leader and narrow the phase gap with him or her, they will do so and will knowingly exaggerate the amplitude of the wave which they realize may turn the cycle into violent booms and busts. And if the whole thing turns into a bubble and then burst, so be it. If they can, they will jump ship before the disaster strikes or will stay put and go down with everyone else. To most people, this is a better outcome than to stand for principle and go down alone.
The discussion continues in part 4 of the series.