Ppt Slides Chapter Seven

7/31/2019 Ppt Slides Chapter Seven

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Global Risk / Global OpportunityTen Essential Tools for Tracking

Minds, Markets & Money

Shlomo Maital and D.V.R. Seshadri

RISK OPPORTUNITY 1


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Chapter Seven

Tracking Booms and Busts

This chapter explains the forces that drive business cycles (periods

of boom and bust), the link between demand components and

recession and the role played by two key deficits -- the trade deficit

and the budget deficit and how they interact. It explains the 2007-

9 global downturn, and the link between prices of common stockwith changes in the real economy.

.

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Toolbox: Tool #7 "Twin Deficits": Budget and Trade Deficits

Supplemental Tool:

"Real" (inflation-adjusted) Common Stock Prices

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Definitions:

Common stock: a document giving its owner a share of the

ownership of the company, a share in its profits, and a share in

the voting rights.

Preferred stock: stock to which dividends are paid before they

are paid to owners of common stock.Shareholders' equity: On the company's balance sheet, the

difference between what the company owns (assets) and what the

company owes (liabilities). It is the 'book value' (i.e. value as

listed on the balance sheet) of the company's net assets, or whatshareholders own after paying off the debts.

Market capitalization: The total market value of a company's

shares, at agiven point in time.


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Definitions: Business cycles are short-term fluctuations in GDP and

unemploymentcycles of recession, recovery, growth and again recession, around a long-

term growth trend, over periods of about four to eight years. They involve shifts

between periods of relatively rapid growth (expansion, or boom) and periods of relative

stagnation or decline (contraction, recession, or bust).Trends are long-term movements in GDP, prices, income and employment, with

consistent direction and nature, over the course of a decade or more.

Recession: Once defined as "two consecutive quarters of decline in real GDP", the

most recent authoritative definition is: "a significant decline in economic activity spread

across the economy, lasting more than a few months, normally visible in real GDP, real

income, employment, industrial production, and wholesale-retail sales".Source: National Bureau of Economic Research, www.nber.org

Downturn: Loosely-used phrase referring to the contraction phase of the boom-bust

cycle. A downturn can mean either an actual decline in real GDP (as occurred in the U.S.,

Europe and Japan, in 2009) or a significant slowdown in the rate of growth of GDP (as

occurred in China, in 2009).

Depression: A prolonged severe economic contraction that lasts longer than a typicalrecession and that afflicts economies in many parts of the world; a global economic

contraction.

Inflation: a general and progressive increase in prices, often occurring during the

'boom' part of the business cycle.

Deflation: a general and progressive decrease in prices, often occurring during the'bust' part of the cycle. 6


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Figure 7.1. World Stock Markets, 2008- and 1929-

Source: "A Tale of Two Depressions", Barry Eichengreen and Kevin H. O'Rourke,

www.voxeu.org

Months from Peak

1929

2008 -

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Table 7.1. Number and Duration of U.S. Business Cycles, 1854-2007

Period Number of Business Cycles Average Duration (months) *

1854-1919 16 49

1919-1945 6 53

1945-2001 10 67

March '01 - Dec. '07 81

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1854-2001 32 55

* Duration: Number of months to peak of economic activity from the previous peak. Source:National Bureau of Economic Research, www.nber.org/cycles.html

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It is worthwhile to remark that a product is no sooner created than it,from that instant, affords a market for other products to the full extent

of its own value. When the producer has put the finishing hand to hisproduct, he is most anxious to sell it immediately, lest its value shoulddiminish in his hands. Nor is he less anxious to dispose of the money hemay get for it; for the value of money is also perishable. But the onlyway of getting rid of money is in the purchase of some product orother. Thusthe mere circumstance of creation of one productimmediately opens a vent for other products.

J.B. Say, 1803. A Treatise on Political Economy, or the production,

distribution and consumption of wealth, 1803 (Engl. transl.) p.138-9)

J.B. Says Law of Markets

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Business cycle TheoriesGovernment policy: It is sometimes argued that government policy itself

exacerbates, or even causes, rather than mitigates, business cycles.

Politics: Related to stop-go is the so-called 'political cycle'. Democracies haveelections every four years or so. In the two years prior to the election governments

stimulate the economy, creating a boom, in order to be elected or re-elected. In the two

years after it, they brake the economy, creating a bust, to resolve the problems createdduring the boom.

Cyclical responses to initial shocks: This theory, due to J.M. Keynes and expanded

by M.I.T. Professor Paul Samuelson, shows how the complex interaction between

consumers (personal consumption) and businesses (investment) can create cycles.

"Real business cycles": External 'innovation' shocks occur, as new technologies

replace old ones, and economies decline, then boom, as investment pauses and then

accelerates. In this theory, business cycles are not a sign of inefficiency or market

failure but rather a sign of rejuvenation, implying that governments should not try tointervene or 'smooth' the cycle.

Marx: Capital accumulation causes profit rates to fall, leading businesses to

merge and create monopolies, to reduce wages, leading to economic crisis.

Credit cycles: In boom times, banks overlend, businesses and people overborrow, as

interest rates fall and real (inflation-adjusted) rates may become negative. When

borrowing halts, as a result of over-leverage, investment slows, asset prices decline andthe economy dives into recession.10


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Four Question Framework

* Do people have money and are they optimistic and keen to

spend it? Or are they concerned about debt and pessimistic

about losing their jobs?

* Are businesses making profits and are they keen to reinvest

them, in creating new assets (buildings, machineries, equipment,software)?

* Do governments have money and are they keen to spend it,

beyond what they absorb in tax revenues?

* Are businesses selling more abroad to other nations than is

being bought from abroad, i.e. do exports exceed (or fall short

of) imports, and is the gap widening or shrinking?11


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Action Learning:Using the Four Question Framework

For the country in which you live or work,

answer the four boom-bust questions above.

How can you find data that generate accurate

answers? How can you supplement such datawith your own observations, in stores, malls and

workplaces? Do your answers lead you to

conclusions that differ from those of the

forecasting experts? Why? Above all, can you

anticipate major shifts in consumption,investment, public spending and trade?


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Keynes Employment Multiplier

Govt. spends $1 b., accruing to households as added income: Households spend 71 % of it, creating $710 m. in new income..creating $500 m. in additional spendingand so on.

$1 b. + $0.71 b. + .50 b. + 0.36 b. + 0.25 b. ., etc.

The formula for the sum of a geometric series is:

SUM = 1/(1- a)

where a is the constant multiplicative factor in the geometric series. In the

case of the Keynesian multiplier, this factor is the fraction of each dollar

of GDP spent on personal consumption, termed by Keynes the marginal

propensity to consume. For the U.S. it is 0.71, as noted.In the above example, therefore, the $1 b. initial stimulus generates

$3.448 b. in overall GDP growth:

SUM = ($1) [1/(1-0.7)] = $1b. times 3.448 = $ 3.448 b.

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Animal Spirits as a Cause of Business Cycles

In Keynes' landmark 1936 book The General Theory, which

struggled to explain the Great Depression then afflicting the major

economies of the world, there is the following passage:

There is instability due to the characteristic of human

nature that a large proportion of our positive activities depend on

spontaneous optimism rather than mathematical expectations Our

decisions to do something positivecan only be taken as the result

of animal spirits - a spontaneous urge to action rather thaninaction

J.M. Keynes. The General Theory of Employment, Interest and

Money. London: Macmillan, 1936, pp. 161-2.

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Action Learning:Gauging Animal Spirits

Do you regularly engage in informal

conversations? Do you cross-check by matching

survey data with your own observations? Can

you acquire a sense of 'animal spirits' throughthese conversations?

Some excellent sources of such data are:

taxi drivers (taxis are sensitive to the business

cycle, because people walk or take public

transportation when their incomes decline);restaurants (also sensitive to business

conditions); shopping malls (are they crowded,

and are people carrying packages, or simply

window-shopping?).


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Toolbox:

Tool #7 "Twin Deficits":

Tracking the Government Budget Deficit and the Trade Deficit

Disposable Income Personal Consumption +

Gross Capital Formation+ (Public Consumption - Net Taxes)

(budget deficit)

- (Imports - Exports)

(trade deficit)

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Change in Disposal Income

Change in the budget deficitminus the change in the trade deficit


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Figure 7.2. United States, 1987 - 2009: Budget deficit for state, local and federalgovernments; and trade deficit (exports minus imports), $ billions.

$ billion


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Country Market cap GDP Market Cap/GDP

$ b. $ b. %

1 USA 17923 13841 129

2 Japan 4615 4380 105

3

United

Kingdom 3722 2770 134

4 China 3059 3242 94

5 France 2653 2556 104

6 Hong Kong 2180 207 1053

7 Germany 1976 3317 608 Canada 1620 1426 114

9 Switzerland 1207 424 285

10 India 1090 1135 96

Table 7.2. Market capitalization of stocks and GDP,

10 countries, August 2007


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Table 7.3. U.S.: Annual Real Returns, Stocks, Gold, Bonds, 1870-2001

Period Stocks Gold Bonds

1871-2001 6.8 % -0.1% 2.8%

1946-1965 10.0 -2.7 -1.2

1966-1981 -0.4 8.8 -4.2

1982-2001 10.5 -4.8 8.5


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Unadjusted AdjustedFigure 7.4 Dow-Jones 30-Stock Index, 1949 - 2009:

Unadjusted and Adjusted for Inflation ("Real")

Toolbox:Supplementary Tool: Real Dow-Jones.

"Real" Dow-Jones index = Nominal Dow-Jones Index / Price Index


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demandpull

cost push

demand curve

supply curvePRICE

QUANTITY

Figure 7.5. Cost Push vs. Demand Pull Inflation


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Definition:

Price-Earnings Ratio (P-E): the ratio between the price of

common stock (what you pay for one share) and the net after-tax

earnings per share, either for an individual stock or for a group

of stocks (such as the Dow Jones Index or the Standard & Poor

500 Index).

PF PN--- = ---E

FE

N

Where:P is stock price, E is earnings per share, subscript F signifies:

(expected) Future, and subscript N signifies (actual) Now.


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Figure 7.6. Price Earnings Ratio forStandard & Poor 500 Index (U.S.) 1900 - 2009


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Fig. 7.6. Company value (1994 = 100%): Fundamental value andExpectation premium, 1994 and 2000


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Tracking and Managing Boom-Bust Cycles

First, think differently -- identify 'bubbles' and'bubble psychology' while others are still caught up in

them.

Second, assess the timing -- try to gauge when thebubble is likely to burst, and when 'boom' shifts to

'bust'.

Third, catch the tide not only when it goes out, but

also when it comes in -- assess when the 'bust' phase islikely to reach bottom, and the economy begins its

recovery.

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Ppt Slides Chapter Seven