Human knowledge is the assimilation of a vast range of experiences. The incorporation of new ideas from other disciplines allows scholars to incrementally expand the frontier of knowledge. Otherwise, we become trapped in an obsolete paradigm, like the medieval scholars who argued incessantly about how many angels could dance on a pinhead. The adoption of mathematical techniques, for example, allowed economists to model and test new ideas. Likewise, the use of engineering principals can provide interesting insights into cyclical properties. The oscillation of objects creates sinusoidal patterns, with defined amplitudes and frequencies. This phenomenon is repeated throughout nature. Scientists, during the 19th century, established the basic laws of thermodynamics, which today provide the basis for many modern machines—including air conditioners, steam turbines and jet engines. The foundation rests with the thermodynamic cycle, whereby heat chases cold. The way an air conditioner works is by pumping a cooled gas through metal coils, drawing in the room’s warm air and expelling it out again. As the warm air passes over the coils, the heat is absorbed into the gas and the colder air is pumped back into the room. However, as the warmed gas is re-cooled, the energy must flow into another zone that is relatively cooler. That is why the back of an air conditioner is always blowing hot air. An air conditioner is actually a heat exchanger that moves energy from one place to another. Nevertheless, every engineer knows that the differential in temperature is what makes the process works. The allowance of only one phase of the sinusoidal progression stalls the operation. By applying this concept to economics, it can be inferred that there can be no expansion without contraction.
The inherent qualities of human beings largely define their behaviour. The frailties of the human body help explain herd tendencies. There is safety in crowds. This is one of the characteristics exploited by marketers and fashion designers. They create brands to attend these insecurities by generating a common sense of identity. The same goes with finance. Fear of the unknown and fear of failure produce crowded trades. Several years ago, for example, emerging markets were only for the strong at heart. They were reserved for a small band of exotic investors, who had local knowledge and skills. Emerging market corporate bonds were a subset of emerging market instruments left for a narrower band of experts. Yet, they are now main stream. Fund managers from across the planet are rushing headlong into corporate bond deals. As a result, valuations are becoming misaligned. Since the rush started, little has changed in most of these emerging market countries. They still tend to be mono-product exporters, with weak institutions and rampant corruption. Yet, they are now the most sought after assets in the financial world. This crowding of trades is what creates manias and bubbles. It is what leads to over-investment in sectors, such as technology, housing and tulips. It is also what triggers the oscillation between booms and busts.
However, policymakers fail to understand that by dampening the amplitude of the most unsavoury part of the business cycle, they are preventing the formation of the expansion phase. Just as in thermodynamics, where energy cannot flow unless there is a differential in temperature, there can be no recovery unless there is a recession. The Obama Administration’s rapid move to limit the effects of the 2008 credit collapse is the reason why the economy is not getting any traction. The banks are walking zombies, loaded with trillions of dollars in bad loans, mortgages and properties. Households are swimming with their heads deep underwater. Therefore, all of the quantitative easing (QE2) in the world will not solve anything. The financial system will take the additional money and push it back into the securities markets to lock in a quick profit. Except for a handful of bankers and traders, QE2 will not generate any new employment. However, a massive restructuring of bank and household balance sheets would allow the financial system to create the space to start anew. Otherwise, we are headed into a prolonged Japanese-styled downturn. As the amplitude of the sinusoidal curve decreases, it morphs into a flat line. Moreover, the sinusoidal curve is naturally symmetrical. Altering the shape of the phases only destabilizes the cycle. Therefore, in the same way that its namesake lies rusting at some Arabian pier, QE2 will not be anything new. Had the Obama Administration allowed the economic cycle to run its course, the U.S. economy would have been in the midst of a powerful rebound by the start of his re-election campaign. However, it is now moribund in an obsolete paradigm, and President Obama is on his way to becoming another one-term wonder. As in the words of a famous Spanish film director, there can be no pleasure without sorrow. The same goes with economics. There is no gain without pain.