Where are we in the business cycle?

February 9th, 2007

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Yesterday, in our article, The real story behind the phenomena of booms and busts, we asked this question. Today, we will look at the indications of where we may possibly be in the business cycle in Australia (which is applicable to the US as well).First we look at the November 2006 Statement of Monetary Policy from Reserve Bank of Australia (RBA):

What does seem clear, however, from several sources of information, is that the economy is operating with very limited spare capacity.

Clearly, as in the metaphor we gave in What cause booms and busts? Introduction to the Austrian Business Cycle Theory, the bus is running low on fuel i.e. the economy is reaching its limit of productive capacity. This is also the same situation that the United States is facing right now. Further down the statement:

Demand in some sectors has been especially strong over a number of years, reflecting the growth of the domestic and international economies. If firms cannot bring new factories or mines immediately on line when capacity constraints become binding, they may decide to hire more labour to work their existing production processes more intensively. This would lead to strong employment growth, but also a fall in the growth rate of average labour productivity because only relatively modest additional output can be produced by hiring more labour without additional capital.

To cope with the strong demand, businesses are forced to increase output. Unfortunately, the effectiveness of the existing capital stocks in the economy is reaching its limit and the only way to increase production further is to employ more labour and pressure the existing employed workers to produce more. As the statement says, without complementary capital, these extra labours are constrained in its effectiveness in increasing output.

Recently, we read in this news report, Consumer confidence ‘lowest since 2003′, ?dragging sentiment down in the half was a sharp 14 point fall in the quality of life rating to 25.5 points… But (they are) finding it more difficult to achieve due to the demand for longer working hours and more intense competition in the job market.? Anecdotally, many of us are feeling the increasing strain of work. Though Australia may be experiencing the lowest unemployment rate, it comes with a cost at our quality of life. Worse still, according to our personal experience, we can feel that price inflation is more pronounced lately.

With the economy struggling to increase output and the money supply still growing, we can expect price inflation to still remain a threat. But price inflation has been quite benign during the past few years. Why is it so? As in the United States, price inflation has been ?controlled? by importing of goods from China. As we said in The Bubble Economy, the rise of the Chinese economy?s productive capacity has a disinflationary effect on prices worldwide. But such low inflation can only be achieved at the cost of incurring a ballooning trade deficit?our imports exceeding our exports. But make no mistake about it: we cannot always rely on the Chinese to save us from price inflation by blowing out our current account deficit even further. So, the greatest danger to Australia?s economy right now is price inflation. As we said in The real story behind the phenomena of booms and busts, if interest rates persistently remain out of sync from the natural rate of interest for too long, we can run into the danger of hyperinflation.

How can we restore the economy back to equilibrium and ensure that it remains in a firm footing for the future?

The first thing that has to happen is to increase our national savings. As we said in The myth of financial asset ?investments? as savings, we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful. If the consumers do not slow down and get their act together, we can expect the RBA to impose a restraint by raising interest rates.

Thus, we believe that Australia (and the US as well) is at the top of the business cycle. For investors, we have to bear in mind that we are now probably at the cyclical top. If we assume that the current trend of companies? profit growth will extend indefinitely into the future, we will be in for a nasty surprise.

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