A new Kondratiev transition ?

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This article is the first in series of white papers on the global hypotheses that I accept when analysing economic and technological patterns and behaviours. This first article is dedicated to Kondratiev cycles and their implication in the current economic turmoil.

For those who do not know the story, Kondratiev was a communist economist born in Russia in 1892. In the 1920s he was the Director of the Institute for Economic Forecasts in the Soviet MOF and elaborated his theory on long term cycles. Since this theory was not really in line with Marxist dogma that capitalism was going to its grave, he was sent to gulag by Stalin in 1931 and executed seven years later.

Kondratiev’s cycles theory predicts that the economy follows long term patterns or “waves” of expansion and recession. The cycle begins with the "upwave" during which prices start to rise slowly along with a new economic expansion. At about half the cycle, inflation is running very high. Its peak sets the stage for a deep recession which begins about the time commodity prices break from their highs. Eventually, though, prices stabilize and the economy recovers, beginning a period of selective expansion that normally lasts nearly a decade. Referred to as the secondary plateau, the expansion persists, giving the impression that "things are like they used to be”, while in the meantime, business model are refined to minimize costs and maintain profits. This secondary plateau ends with a sudden shock (financial panic/stock market crash) and the economy rolls over into the next contractionary phase, which is characterized by deflation and the start of an economic depression. At this stage, there is massive debt repudiation either through default, recognition of bad debt or inflation (or a mix of the three) as well as a period of major political instability, riots and wars.

The cycle begins anew with a major technological change, usually in the area of energy or transportation (or both). It is important to note that this technology may have been invented long before but its generalization and its new status as the next way of doing business render the previous business infrastructure largely obsolete. Early adopters of the new technology suddenly have a tremendous competitive advantage, which triggers the adoption of the new technology on a global scale. The need to build a new infrastructure fuels the expansion phase. This is usually a time when major companies of the previous cycle finally collapse due their incapacity to adapt to their new environment and this largely explains why the average life expectancy of a corporation is lower than 100 years.

Looking at history, several cycles can be identified. Georges Modelski et William Thomson say they have identified fourteen cycles before 1680 in various geographies, the first one in 930 AD in China. (here for more details). With the colonization, the various local economies got synchronized and since 1680, one can identify three cycles, each with a major technological innovation and a significant change in the organization of labour.

• Cycle 1: 1800-1870: Dominant technology: steam engine (invented in the 1760s) Impact on business: Industrial revolution. Impact on Society: creation of major cities, Politics: Unification of USA, Germany and Italy (among others) and creation of major colonial empires.
• Cycle 2: 1870-1940: Dominant technologies: Electricity and Internal combustion engine. Impact on business: Easy energy, new materials, aerospace. Impact on society: Considerably improved lifestyle, development of tourism, Aviation, Apparition of suburbs and megacities. Politics: Apparition of communism in the down phase, two world wars, Europe dominates the world. Recording of sound and images becomes possible.
• Cycle 3: 1940-2010?: Dominant technologies : Jet engine and new electronics. Impact on business : Multinational corporations become the norm and computer becomes the basic tool. Impact on society: cultural unification (same music, same movies, same food all around the world), convergence of lifestyles, end of the communist experience who benefited from the expansion phase but could not manage the down phase, dependence on oil, importance of image and communication in politics and business. Politics: USA sole prime power, Dollar de facto international currency, end of colonial empires, war gets subcontracted to local conflicts.

There is currently much debate about whether Kondratieff theory is still valid in the modern world. The main argument of the cons is that, historically Kondratiev cycles have lasted around 50 years. The end date would thus have been passed in the 1990s with no noticeable change. Apart from the fact that, as a finance person, we are very uncomfortable with the “this time it’s different” sentence, one can note that in fact, the period of the cycle is approximately two generations and as such, as life expectancy increases and women get their first child later, the period of the cycle can be expected to have lengthened. A 70 year period looks extremely credible considering the current average life expectancy.

On the pro side, the economic context looks very much like the end of a Kondratev cycle. We are in a deep economic trouble and in the middle of a big phase of debt repudiation (between 10 and 15 thousand billion dollars according to our estimates. Thanks to our better understanding of economic mechanism, the impact has been largely softened by the nationalization of this bad debt, but nobody can seriously imagine that the US (or the others debtors) will ever destroy their standard of living to pay it back (especially considering that creditors are far away Asian countries nobody really cares of in the Midwest). Plain default is unlikely but inflation is just around the corner and it is no surprise that many corporations are issuing bonds as much as they can.

At the same time, several new technologies currently await their generalization on a wide scale. In the energy field, Nuclear power remains relatively marginal (only a handful of countries have a significant nuclear base) while clean power remains in the early adoption stage. 2008 may have brought a major change on that front as consumers realized that their dependence on oil was too big. The other big major change is the emergence of Web 2.0 which remains absent from the corporate world. Here again, 2008 marked the emergence of the shift to digital business with TV and press losing ground to new digital media like this blog.

Things thus look very much like Kondratiev theory is to be proven right once again. Let us try to see what the brave new world will look like when our current business infrastructure finally becomes obsolete again. The Y generation is now coming in with a completely different mindset based on social networks, sharing of resources and ad hoc task forces. This will probably significantly alter the corporate structure and we think this is the greatest challenge facing HR departments in the coming decade. We know several emerging companies which have minimal corporate structure and rely largely on free lances and at home workers, all tightly connected through a corporate network. Such companies enjoy a tremendous cost advantage and a comparable model could probably be deployed in all services industries from audit to media as long as in many corporate back offices and R&D departments. The next generation of corporations will be highly networked and probably divided in much smaller units than today. We expect the downtown office property markets to suffer badly in the coming years.

On the society side, the benefits of living in a big city are eroding as new networks bring services, jobs and entertainment everywhere. Cities may reached their population peak in a few years, especially in European countries as people go back to smaller towns where traffic is easier and life conditions are better.

Overall, the good side of things is that we may be facing a new golden thirties expansion period, with the nuclear/renewable energy sector leading the way as long as the instalment of a global always connected ubiquitous fixed/mobile network. Debt will have been largely defaulted/inflated away and business conditions should be brisk. On the bad side of things, history shows that Kondratiev transitions are long and painful. We are probably not through the current turmoil and a few more years will be necessary for the transition to be over. In the meantime, political vigilance is key if we don’t want to experience what happened at the end of the 1930s again.