The Economy Is a Two Stroke Engine

Epistemic status: qualitative speculation. Effect may be real but dominated by other factors and therefore irrelevant. Or we’re robbing our children of 1% per year in GDP growth, i.e. trillions of dollars.

Economic activity can be thought of along a spectrum, from the completely Ineffective (or even negative) to the very Productive, with some overlapping Uncertain — we don’t always know if something will eventually pan out or not.

With this in mind, we can do a qualitative analysis of the business cycle:

Up-Stroke: The Economy Grows

Growth: Productive Activity Growth Dominates

The wheels are starting to turn, hiring is coming back up, and new business opportunities are starting to show.

Economic activity grows, but Productive is growing faster than Ineffective as people pursue the best new projects first, and there are plenty of good people to hire.

Operations scale out, focusing on delivering to a hungry market, so Uncertain activity contracts on a relative basis.

Bubble: Ineffective Activity Growth Dominates

Opportunity is everywhere, there’s full employment, your cocktail napkin sketch gets immediate VC funding, asset prices are skyrocketing, conspicuous consumption is cool again, it’s a New Economy and the old rules are for suckers!

Growth in Ineffective activity is starting to outpace growth in Productive activity. Irrelevant products and services are developed and produced inefficiently as firms hire even unsuitable workers, and pursue projects with poor odds of success.

Even the most outlandish project ideas are pursued, and as such Uncertain activity grows drastically on a relative basis.

Down-stroke: The Economy Contracts / Grows Sub-Trend

Restructuring: Ineffective Activity Contraction Dominates

It’s grim out there, the forecast is looking gloomy, the market is softening, there are some layoffs, and projects that no longer measure up get cancelled.

Economic activity contracts, but Ineffective is contracting faster than Productive as firms shed under-performing workers and cancel irrelevant projects first.

While contrarians invest in the downturn, the herd gets cautious and restricts Uncertain activity, which contracts on a relative basis.

Depression: Productive Activity Contraction Dominates

It’s a hangover, the bottom has fallen out of the market, even “we never fire people” companies are letting 10% of their workforce go, everyone is hunkering down, concerned they’re not going to make it through the next round of layoffs, everyone wants to switch jobs but no-one dares to leave and there are no jobs to switch to anyway, once high-flying assets are a dime on the dollar, forget about starting a new business, this is the End Of The World As We Know It and I don’t feel even a little bit fine.

Economic activity contracts, but Productive is contracting faster than Ineffective as there’s less Ineffective left to contract, and firms have to shed even their performing workers and cancel even promising projects in order to survive, and many firms go out of business.

As desperation sets in, individuals start exploring very Uncertain activities — necessity is the mother of all invention. Companies exposed to the downturn restrict anything that’s Uncertain, whereas more shielded organizations may take a more contrarian approach.

The Business Cycle And GDP

The Bubbles provide both the capital and the insanity that enable us to go where we haven’t gone before. Many of these new places will be dead ends, but some will not. And after these new opportunities and new ways of doing things have been discovered, they will percolate through society over the next cycle, allowing productivity and GDP to reach new heights.

The Bubbles are where we find out what we can be, but they don’t make us become it. GDP expands.

The inevitable crash brings fear, sanity, and a popped asset bubble, ending the period of free money. This is the period where we tighten the belt. The previous expansion has inevitably brought with it a ton of inefficiencies, ranging from excessive compensation, the wrong people in the wrong roles, to entire business units that should never have been started. These have to go, not because anyone wants the party to stop, but because of simple economic reality: we can’t afford it.

The Restructuring rids society of the unsustainable, and forces us to live within our means. The money-saving discoveries from previous cycles get implemented. GDP contracts, at least relative to trend.

A successful Restructuring sets the stage for Growth. However, things don’t always work out that well, and we face a Depression. Depression is the cardiac arrest of the economy. This is where even businesses that “should” continue operating go out of business. It should be avoided if at all possible — this is where the down-stroke goes too far.

At some point, Growth starts to set in again. This is where we pursue and implement the money-making discoveries from previous cycles. GDP expands.

So it’s two steps forward, one step back, and hopefully we don’t stumble into Depression.

The Need For Restructuring To Fuel Growth

Organizations and individuals tend to stagnate over time —we lower bars and expectations, get stuck in a rut, “we’ve tried that before and it didn’t work”, ambitious workers move on while the complacent stay and accumulate in the organization, the world moves on but we stay right where we were.

Activity that was once Productive tends to become Ineffective over time.

It can be hard to appreciate just how difficult it is to change until you have to. Try changing your diet, to lose weight or stop smoking — most people find it extremely difficult, and many simply can’t. Now compound that by the size of an organization and it’s not hard to see why they don’t change without significant external motivation: you have to work hard and it’s really hard work.

Improvement takes great effort, and is mostly done under pressure.

While every organization and situation is unique, there are two broad sources of external pressure to improve: competition and downturns.

Large parts of the economy are more shielded from competition than we may realize. Monopolies, Oligopolies, Government Organizations, and Nonprofits are all at least partially shielded from traditional competitive pressures, but usually subject to at least some pressure in downturns.

Restructurings drive the economy to become more efficient by putting pressure on us to shed Ineffective activity. They provide across the board, cultural level buy-in for change that would otherwise not happen.

Without Restructurings we accumulate excess Ineffective activity in the economy.

This chokes off future growth.

Testable Hypotheses

1. A business cycle with small swings should produce modest GDP growth, as Ineffective activity is allowed to accumulate and weighs down on future growth.
2. Large swings should produce modest GDP growth, as the depression-part of the cycle sheds too much Productive activity.
3. Medium swings should produce good GDP growth, optimizing the trade-off between accumulation of Ineffective activity and excess loss of Productive activity.

I.e. there should be a sweet spot for the size of the business cycle swings. This should be observable in the GDP records across countries, though the ideal swing may differ across countries and over time.

Policy Recommendations

The broad policy recommendation coming out of this analysis would be to let the Growth, Bubble, and Restructuring phases play out, but try hard to stave off Depression if possible, so a partial Laissez-faire / selective Keynesianism.

Key difference with Laissez-faire: try to intervene against Depressions.

Key difference with Keynesianism: allow Restructurings.