Monday, March 8, 2010

Maslow’s impact on global financial boom and bust cycles

I love simple explanations. Not because they are accurate, because they are not. Not because they are comprehensive, they are not. I love them because they explain things in way that is easy to grasp, and therefore easy to action. As long we keep an eye out for black swans, and are ready to revise our models, simple explanations trump complex ones in sheer utility.

What’s been top of mind lately is the apparent acceleration of the global financial boom and bust cycles. These cycles seem to be not only more frequent but of higher amplitude as well.

Take the current bust cycle: you can argue whether the Fed’s easy money policy led to unsustainable inflation in housing prices, facilitated by government policies implemented by Freddie and Fannie which purchased questionable notes turned them into mortgage-backed securities, and sold them to investment banks which purchased credit default swaps from AIG as a hedge....

And I haven’t mentioned the money supply issue yet.

But there is a simpler explanation: Maslow is at fault. You see, in the US consumer spending accounts for 70% of economic activities so it follows that consumer behavior becomes a significant driver in the economic equation. If we divide consumer spending into tranches following Maslow's hierarchy of needs an interesting pattern emerges.

Over the last 4 decades, consumer spending has steadily climbed the sides of this pyramid. For example, according to the USDA, in 1929, food consumed 29% of personal income, that measure went to 17% in 1960 and is now less than 9%. Similarly, expenditure on cars dropped from 8% of income in 1984 to 5% today, gasoline expenditures dropped by 10% while women’s apparel is up 25% since 1984. In fact many experts now look at discretionary spending as an early predictor of stock market activity (see this and this).

But what does this trend towards higher Maslow state mean? Well to put it simply: higher volatility and deeper boom and bust cycle. A simple assumption about the ease with which consumers can cut 20% of their spending yields a 50% more decrease in economic activity.

As our society trends richer expect deeper more frequent boom and bust cycles. It’s a fact of life, might as well get used to it.

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