Sunday, August 17, 2008

Sunday Essay - Kondratiev cycles, economic change and the ICT revolution


Photo: Joseph Schumpeter (1883-1950).

This Sunday essay fulfils my now long standing committment to Bob Q to respond to the comments he made in our earlier discussion on Kondratiev Cycles. For the benefit of new readers, I have listed previous posts at the end.

By way of background first, the term Kondratiev Cycles or Waves has been used to describe what its proponents see as long growth waves associated with technological change. They argue that such waves come to an end as the gains from the technology exhausts itself, leading to extended periods of slow growth - Kondratiev winters - before another cycle begins. I mused that we might be coming to the end of the latest wave, the IT and communications wave.

Bob Q challenged this. To his mind Kondratiev Cycles are rubbish, concepts imposed on the historical record without either historical validity or predictive power. In essence, GIGO, garbage in, garbage out. He also disagreed that we were at the end of the ICT revolution, suggesting in passing that I had overstated the importance of the revolution in the first place.

To extend the discussion, let's start by clearing a little undergrowth first.

Kondratiev proponents suggest that the first Kondratiev Wave began with the industrial revolution in the second half of the eighteenth century. If true, this makes them a relatively new phenomena in historical terms.

The significance of the industrial revolution is that it marked a break in the previous pattern of economic activity. This was partly a matter of new technologies, partly of new organisational forms. In turn, this led to the development of new economic theories including marxism. Kondratiev himself was a marxist.

Kondratiev's ideas were taken up by Joseph Schumpeter, one of the most famous economists of the first half on the twentieth century. Concerned to explain the nature of economic fluctuations within an overall pattern of economic growth, decline and renewed growth, Schumpeter developed the idea of a hierarchy of economic cycles of varying lengths driven by different economic variables. The Kondratiev Wave became the long cycle within which the others operated.

Economics, like all human thought, is a creature of its own place and time.

Schumpeter and his views were effectively sidelined by the rise of Keynesianism because this seemed to explain the nature of economic fluctuations more effectively and indeed offered hope of controlling those fluctuations. When I first studied economics at what was, in retrospect, the high water mark of Keynesianism, I found Schumpeter's economic cycle material mechanistic and un-satisfying. By contrast, Keynes seemed to explain both the why and the how.

While Keynesianism seemed to deal effectively with the nature of economic fluctuation, it had little to say about the dynamics of growth. This was equally true of microeconomics with its focus on value and distribution. Growth was effectively side-lined to development economics or economic history.

The failure of Keynesian economics during the 1970s opened the way for new ideas. Among others, Schumpeter came back into fashion because of his focus on innovation and entrepreneurship.

The point of this short history is that intellectual frameworks affect not just the way we analyse things, but the very questions we ask in the first place.

When I first came to look at industry development issues in the 1970s, I found a dearth of conceptual material outside the narrow bounds of the tariff and free trade debate. Further, the very questions I wanted to ask were seen as heretical, invalid, by some of my Treasury colleagues because they suggested that Government intervention might support economic development. After all, it was less than ten years since the Department had effectively killed the Vernon Committee report.

I do not think that Kondratiev Cycles as expressed have necessary historical validity. I certainly do not think that they have predictive ability. Indeed, I think that long term economic prediction is highly suspect, although I am not above chancing my arm at it!

To my mind, the interesting point about Kondratiev Cycles is that they incorporate a model that I find interesting and intuitively plausible: the way in which technological change moves in waves, leading to a period of expansion followed by potential stagnation or even contraction as the wave ends.

Economic growth is not simply a matter of adding additional resources of labor or capital as would be implied by the simple production function model. This model is deeply imbued in thinking.

Faced with economic growth faster than could be explained by an increase in capital, economists suggested that the additional increment might be explained by improvements in human capital flowing from the spread of education. I have no doubt that this is correct. However, it is still a production function model.

Beyond these explanations, there are discontinuities - change points - where the application of new technology has led to fundamental shifts in economic activity. The invention and application of the steam engine is one such example, the internal combustion engine another.

In each case, the application of the technology has resulted in expanded economic activity. In the Australian case, the spread of the railways allowed expansion of wheat farming, wheat whose entry to the international marketplace was aided by faster shipping.

In each case, the gains from the technology declined with time. Using the same example, the cost of horse drawn transport limited agricultural production to a relatively short distance from the railway line. There were substantial economic gains as railways spread, but these then tailed away. The next big change came with the development of the internal combustion engine, the car and lorry since this allowed a further spread of cropping.

In conventional economic terms, the first effect of changes such as these is a shift in the production function. The second effect is an expansion in markets as new and cheaper goods increase demand.

These two changes are linked. Mass production meant that more people could afford industrial goods. In turn, this expanded market created jobs, leading to further market expansion.

This type of process does not make Kondratiev or Schumpeter right. My point is that their approach suggests fruitful questions and possible answers that fall outside the domain of some of the current economic orthodoxies.

In my Kondratiev posts I suggested that we had come to the end of the ICT revolution and that this might lead to a Kondratiev winter. Before going on, I should make it clear that in saying this I was talking about the economic growth effects. Other effects will continue.

In economic terms, the ICT revolution affected both production and markets.

As an input to other production, ICT shifted production functions to the right. It also created major new industries and markets. Both encouraged growth.

Importantly, the ICT revolution combined with three other changes that also encouraged growth.

The first was a change to work processes. The big fall in employment in certain sectors - the utilities are an example - may have been supported by ICT, but began in advance of the full impact of the ICT revolution. Here we have changes brought about by process and job redesign. In turn, this freed resources for other activities.

The second was the freeing up in world trade, creating bigger market places while facilitating more efficient production.

The third has been called the demographic dividend. The sharp fall in the birth rate in many countries from the sixties meant that the proportion of national resources devoted to things such as basic education declined at a time when the work force was increasing in absolute terms.

We now face a quadruple whammy.

The easiest efficiency gains from ICT are past us. Many of the new products and markets have entered the mature stage. There is still potential for growth in particular markets, but in aggregate terms market growth has peaked.

Gains from changes to work processes have, I think, come to an end at least in developed economies. In Australia at least, and I do not think that Australia is unique, people are now demanding different life styles.

Liberalisation of world trade appears to have ended, at least for the present.

Finally, the demographic dividend that has supported growth has turned into demographic deficit in many countries as they start to come to grips with an aging population.

Within all this, we can debate the relative role of ITC itself. Clearly many variables are involved. However, one of the points made by many Krondratiev exponents is that waves come to an end because of an accretion of factors that slow and then stop growth. This is, I think, true.

Postscript

I forgot to add previous posts. Will do so later.

4 comments:

Bob Q said...

Jim,

I'm currently in Fiji with limited internet access. I will ..er.. come bak to this this later.

Jim Belshaw said...

Take your time, Bob. Smile! Fiji eh. That's interesting.

Bob Q said...

I have a bit of time here now, Jim.

You said "I do not think that Kondratiev Cycles as expressed have necessary historical validity. I certainly do not think that they have predictive ability."

I am in total agreement. My problem with Kondratiev cycles is that I think they are a false framework, leading to the asking of wrong questions. You look and see a slowdown especially in the industries and areas that most concern you, and wonder if the cycle is coming to an end and that we are now facing a Kondratiev winter. In short, you are using the model for predictive purposes despite your reservations.

I find the model simplistic and mechanistic. It is a good story, but like Wagner's Ring Cycle, ultimately leads nowhere.

I would also question your analysis of where the economies are heading. Economies plural because I think you are mentally separating either the Australian or the developed world economy from developing country economies.

The world is not going through a demographic decline. We are riding on the back of a resources boom precisely because we are seeing the rise of a consumer class in China. We even plan to take minimal advantage of this with a guest worker scheme for South Pacific nations who have increased, rather than slowed their population growth.

I made oblique mention of it before, but in terms of new products and services, these are coming onto the market all the time. Google and Yahoo provide their main product free, develop more free services all the time and charge commercial advertisers a minimal amount, but make it up on volume of a delivered service (click through) which is better than traditional advertising in the sense that the advertiser KNOWS someone looked at his/her product page and who sent them there.

While process refinement has certainly slowed in developed nations it has a long way to go in other nations, leading to an increase in the export of managerial, educational and other services. Sensible developed nations are retooling to become leading service providers in technical and specialised niches.

I agree to an extent about trade liberalisation, although bilateral and limited multilateral free trade/freer trade agreements are still being negotiated all the time.

With product growth, population growth and the rise of some developing countries, I don't believe, in short, that market growth has peaked.

I'm far more concerned about economies like Australia that sometimes seem to actively hobble themselves, using the gains from enabling technologie such as ICT to allow government bureacrats to impose needless brakes on progress. Some regulatory supervision is good, but your later post about Government excesses had me cheering in agreement.

I suspect we won't agree on this one, but in summary, I think Kondratiev, by working from a false/unprovable assumption, leads to wrong questions being asked and I think you aren't looking widely enough at the sources of our future development.

For your interest, the Asian meltdown in 1997 was held up by some as proof of an oncoming Kondratiev winter. Except in Australia where we were barely affected. :)

Jim Belshaw said...

As a general comment, Bob, it may be that I am too bound in by industries and countries that I know, although I actually challenge that.

Focusing just on demography for a moment, we are dealing with aggregate and distributional effects.

At aggregate level, the world population is still growing. This plus economic growth especially in China has driven growth in demand.

However, this slowing world population growth is an aggregate.

The sharp decline in the birthrate in developed countries to below, in some cases well below, replacement level has now set in place long term population decline in, among other places, Europe including Russia and Japan.

Then there is a second group where the fall in the birth rate began later. We can take China here.

The combination of a slowing birth rate with internal migration delived China a demographic dividend. The Chinese population is now aging. India, where the fall in the birth rate began later, will far exceed China's population before the same aging effect occurs.

Then there is another group, Africa in particular, where the birth rate is very high. Nigeria will easily pass 300 million people.

What is very unclear to me is just how these demographic changes will play out. What is clear is that they provide a longer term framework for shorter term trends.

There seems to be a pre-supposition around that China's growth can somehow continue independent of trends elsewhere in the world and that that growth can continue at a very fast rate. Again we have short and long term.

In the shorter term, the Chinese economy is already slowing in part because of weakening export demand. There also appear to be significant bottlenecks and inflationary pressure points.

In the longer term, growth is likely to slow very significantly. That growth has been supported by a very high domestic savings rate combined with a ready supply of cheap labour. Arguably, the cheap labour is coming to an end for the reasons already outlined, while the savings rate is likely to be eroded by higher consumption.

China's export growth has been driven by its capacity to supply high volume, low cost, exports. This, too, is ending. As part of this, and as we saw years before with Japan or Taiwan (Taiwan began to phase out textiles in the sixties), some activities will shift to lower cost countries.

Of itself, this is no bad thing. However, it is going to create adjustment pressures within China.

Without trying to trace through the full chain of effects, one of my core concerns is that the distributional effects (the impact of change on specific countries)may be of sufficient size to outweigh aggregate effects.

Countries do not accept actual or relative decline gracefully. Mr Putin is a case in point.

Bob, I seem to have come a long way from K. cycles and my starting point, and I have not even begun to address some of your other points! But I am out of time this morning.