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Wednesday, September 19, 2007

The Zentay Cycle

Having been born in the early 1970s, I remember coming of age politically to two important lessons. We will never forget, I heard pundits, politicians, and academics sayings, that:

1) The U.S. should not engage in any military action that is not definable and achievable;
2) Inflation should be contained at an early stage, no matter what the cost.

As such, it is with great disappointment that the two unforgettable lessons of my early childhood have seemingly been forgotten, and I haven’t even turned 35. Sidestepping the politics of the war, I’d like to focus on inflation. I’d like to explore why we have abandoned our previous caution and why the later part of this decade threatens to look a lot like the late 1970s.

As my good friend, Michael Nystrom, and I were discussing today, one of the biggest problems – and most frustrating problems – that America faces is that so few people see or care about how credit & money supply growth are creating imbalances in our economy. Because so few people care about monetary policy and economics, pundits, politicians, and academics take advantage of peoples’ ignorance to point them at the wrong causes of the problem (except, of course, Ron Paul, who’s a brave politician who points out the importance of strong money). Backing up and taking a more generalized view, we can see the cycle of money supply growth and inflation in action. The model I have developed for this purpose is the Zentay Cycle (a very modest name indeed). As many readers may recognize, this cycle owns a great debt to the Kondratieff Cycle, after which it is modeled. The difference, or rather extension of the Kondratieff Cycle, is that the Zentay Cycle seeks to bring in politicians and bankers and explain their participation and reactions within the various seasons of the cycle.

Spring of the Cycle – This is the season in which I came of age, from around 1984 to 1992. The Spring is the most intellectually pure stage of the cycle. The harsh Winter of higher interest rates and economic recession has passed (Volcker raising interest rates and forcing the 1980-81 recession), but society remembers the lessons from persistently high inflation. Central bankers are conservative and are supported in their calls for interest rates high enough to fight off inflation. Bankers and investors agree with central bankers. Bond vigilantes sell long-term bonds at any hint of inflation or whenever central bankers appear to be less conservative than is necessary. High interest rates from the Winter have left the consumer landscape with low levels of debt. Politicians may try to raise taxes or increase spending, but they only have limited success, as central bankers and pundits claim that higher taxes will slow economic growth and increased spending will cause inflationary deficits. Gradually, the high government debt levels from the Winter come down somewhat. At the start of the Spring, businesses have high debt levels and low price-earnings ratios. They begin to reduce their debt levels over time. Average interest rates begin to move lower, as the fear of hyperinflation recedes. Shockwaves of fear appear from time to time (such as 1987 and 1991), but in general the Spring is an improvement from the Winter. Central bankers are respected and increasingly well regarded. Politicians are neither popular nor unpopular. Bankers are moderately successful. Average citizens do okay, not great.

Summer of the Cycle – This is the happiest time of the cycle, from around 1993 to early 2000. The shockwaves of fear dissipate. Average interest rates come down more, government debt levels are contained, and economic growth accelerates, creating a wealth effect throughout many levels of society. The more wealth is created, the less conservative participants become. With economic growth, consumer and businesses are more willing to add debt. The debt and credit creation adds more growth and the perception of productivity gains. These productivity gains allow central bankers to relax their conservative stance towards interest rates. Lower interest rates lead to lower costs of capital, the perception of even more productivity gains, and more debt and credit creation, with all the ensuing short-term benefits. Faster economic growth leads to government surpluses. Businesses do very well, keep debt levels reduced, and see their price-earnings ratios expand. Central bankers and politicians are wildly popular. Bankers are successful. Average citizens do well. Class tensions ease. Everyone is generally happy.

Fall of the Cycle – This is the time when problems in the cycle begin to emerge, from around mid-2000 until 2007. A recession or market crash creates a slowdown in economic growth and aggregate demand. Central bankers, less conservative because of their success and popularity in the Summer, lower interest rates to “save” the economy. Debt, credit, and money supply increase even more dramatically, which temporarily leads to a mini-summer and the perception that nothing is wrong. However, productivity levels begin to decline as the burden of debt leads to systemic imbalances. Mild hints of capacity constraints and inflation appear from time to time. As the mini-summer begins to fade, more serious problems emerge. Politicians are increasingly unpopular. Businesses add more leverage, oftentimes through innovative and off-balance-sheet mechanisms. Bankers continue to be successful through increased leverage, but average citizens struggle. Class tensions begin to escalate towards the end of the cycle. Skepticism towards leaders and centralized institutions is rampant.

Winter of the Cycle – In an effort to prevent the onset of Winter, central bankers try to lower rates dramatically, and begin to do whatever they can to create more credit and money supply, but economic problems remain. Politicians, unsatisfied with the results from the central bankers’ actions, call for more government spending and government-induced demand-side solutions. Central bankers continue to call for restrained spending by politicians, but central bankers are less and less popular and lose credibility. Taxes are increased to cover the expenses of government programs. Productivity falls. Inflation begins to increase persistently as capacity constraints spread and demand-side solutions exacerbate these constraints. Pundits wonder at the cause of inflation and many short-term solutions are proposed with little success. Economic growth flounders and unemployment increases. Bankers lose money as confidence in the financial sector falls and long-term interest rates rise. Businesses and banks suffer from lower economic growth and the higher leverage incurred during the Fall. Bankers, too, turn on central bankers. Class tensions are high as different parts of society fight over the validity of different government-sponsored solutions. The Winter is long and hard. Exhausted by the duration of the Winter and already wildly unpopular, central bankers come to the realization that the only way to end the Winter is the opposite of their past solutions. Rather than creating more credit and money supply, they seek to dramatically reduce credit and money supply. Interest rates go up significantly, economic recession is harsh, citizens suffer, businesses and banks are hurt, but the end of inflation and Winter is achieved.

If the Zentay Cycle is in fact correct, I believe we are at the cusp of generating higher inflation. Productivity gains from the Summer are fading, credit and debt levels are too high, central bankers are beginning to try very hard to increase liquidity, and politicians are starting to talk about demand-side solutions. However, employment levels are already high, capacity utilization is high, and other parts of the economy show little excess capacity. Certainly housing is in decline and has excess capacity, but housing seems to be the exception rather than the rule. For example, more oil is being consumed worldwide than produced. Fertilizer companies are reporting significant demand and an inability to meet some customers’ orders. Hotels are often full and prices are going up. Airlines are operating near full capacity and starting to raise rates for the first time in many, many years. The important core-driver of unit labor costs is now increasing 5% a year. In other words, economic volatility is NOT reducing costs.

Unfortunately, those in power have not seemed to have learned the lessons of the past. The late 2000s is unlikely to be identical to the late 1970s. “History,” Mark Twain said, “doesn’t repeat itself, but it does rhyme.”


  • Hello,
    I am truly amazed that someone so young in age really gets what is happening. Today, economists looks at debt as a percentage of GNP. As long as people keep borrowing and spending then things are OK. Maybe the bubble keeps growing (debt) but so what. Idiot foreign countries will always buy our Treasury Securities (he he).

    In my former life, I was a bank regulator. Believe me, people were put in jail for some of the mortgage shenanigans that have transpired over the last five years or so. People who buy to flip properties are called "investors" by the press instead of the speculators that they are. No doc 120% financing teaser rate loans has pushed up the cost of real estate far above what housing is worth. Now Congress wants to bail out these poor lying unqualified buyers with subsidies that I as a taxpayer will have to absorb. Why? One of three jobe created during this period are directly or indirectly tied to real estate. Have to keep the cycle going.

    The Federal Reserve is in the hip pocket of the politicians. Benecke (spelling) does not have the balls that Volker (spelling) possessed.

    Check out the foreign exchange rate on what the dollar is really worth.

    CZ, the one thing that you have not addressed is how can someone can protect their net worth in the troubling times to come.

    By Blogger Steve, at 2:22 PM  

  • Steve,

    Thanks for your kind post.

    My recommendation:

    Buy gold and oil.

    Personally, I love DVN as an oil and gas play. They have the best management in the business.

    I also have a lot of NEM leap options. I find that to be a nice leveraged way to play gold and protect my capital.

    By Blogger Charlie, at 8:58 PM  

  • Charles,

    Indeed a modest name!

    I'd like to point out on your blog that capital preservation tactics should include foreign investments. The US no longer has whip hand on the pricing of hard commodities as for the first time in anyone's living memory (not just us whippersnappers) the US is not the major end user of copper, zinc etc.

    Countries that have bee wise enough to add reserves in what have been good business years will not escape the downdraft, but will have the gumtion to bounce back more quickly from winter storms.

    Nice essay Charles, you should work on this idea and refine it.


    By Anonymous Anonymous, at 7:19 PM  

  • Mark,

    Thanks for your words as well.

    I agree that capital preservation should include foreign investments, and I also agree that the build up of dollar reserves by foreign central banks will help cushion them for what is ahead! For a long time, I've feared what it would mean if foreign countries start spending those reserves. And there are now so many of them with lots of U.S. money - even former defaulters like Russia and Argentina.

    As you so interestingly point out, it doesn't put the U.S. in any kind of position of power. Instead, the U.S. will have to live through whatever happens, with the Fed no longer able to influence the direction of events. Bernanke talks out of both sides of his mouth. If inflation occurs, we'll stop it! If recession occurs, we'll stop it!

    What these guys don't seem to realize is that it's all about debt levels and the currency. Once people are running from your currency, you can get both recession AND inflation, and you're powerless to do anything about it.

    Look for my next piece, title "It's the currency, stupid!"

    Finally regarding purchasing foreign assets, it's a tough game, because you really need to know what you're buying. Foreign disclosure rules are not what they are in the U.S. I fear that most investors buy anything just to have some assets abroad. Personally, I like to know what I'm buying.

    Mark, keep posting!

    By Blogger Charlie, at 8:12 AM  

  • Buy support, sell resistance and listen to good music. This should keep you profitable every single day.

    The rest is discussion, and in that regard, this site is quite good.

    By Anonymous Anonymous, at 6:46 PM  

  • As we examine the 'cycle' from 2000 to 2007, do you see anything related to who is President and what Congress is doing?

    Regardless of your political slant, we can probably all agree that out of control spending with tax cuts doesn't add up. I believe the old term was 'voodoo economics'.

    On top of this, there has been a growing divide between the have's and the have-not's. Wealth continues to concentrate in America in fewer and fewer pockets.

    While we can look to the Fed to try to do the dirty work that our elected officials have failed to do, to ignore the effects of irresponsible fiscal policy is to blind oneself from the disease and instead to focus merely on the symptoms.

    Our trade deficit is growing, our dollar is declining, and we have elected officials failing us when their leadership is needed.

    Sorry, but this is more than a 'cycle'.


    By Anonymous Robert Freedland, at 11:11 AM  

  • "...Mark, keep posting.."

    Hmmm...i could say the same for you, as it looks like this blog gets a new entry every three months or so ;-)

    Agreed on knowing about what foreign investment is worth investing do you think i make a living :D


    By Anonymous Anonymous, at 6:40 PM  

  • Ootah tootah Solo?

    By Anonymous Anonymous, at 1:05 PM  

  • Dear Bob,

    I share your concerns about the irresponsible fiscal policy of the U.S. It is ridiculous! And to think we call these people leaders! More and more, I think of them as followers - followers of what will get them elected.

    I hope you're not correct, though. I hope this is a cycle, where we return to a point of being more conservative. If not, I'm investing in the wrong stuff. I should be investing in a farm upstate and some fire-arms. I'm negative, but not THAT negative.

    One final point: I believe that the fiscal irresponsibility is chump change compared to the monetary irresponsibility of the Federal Reserve. While the U.S. debt seems enormous, it's not that large historically compared to GDP. I do believe it is manageable, although certainly something needs to be done about Medicare and Social Security.

    The real issue is the Fed's policy of creating more and more and more money supply, which is degrading the value of the dollar and threatening to cause widespread inflation. I can't wait to see all the pundits, politicians, and experts claim "surprise" and "shock" when inflation comes about.

    It will be something akin to the CEO of CountryWide doing a 100% aboutface on the future of the housing market. He went from the most optimistic guy in the market (when he wanted to sell you a loan) to the most pessimistic (when he needed a handout).

    Leadership. It's an interesting thing.

    By Blogger Charlie, at 7:45 AM  

  • "Ootah tootah Solo?"

    Te wanna wanka?

    By Blogger Charlie, at 7:46 AM  

  • your template displayed incorrectly in my browser(chrome)

    By Anonymous Anonymous, at 9:10 AM  

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