History's engine and the great bear wave

I had the good fortune to attend a lecture given by Robert Prechter this weekend. Prechter is the originator of the fascinating neo-science of socionomics, about which I have previously written, and the purpose of his lecture was to update the Elliott Wave interpretations provided in his 2002 book entitled "Conquer the Crash." His fundamental thesis is that the U.S. economy is now several years into a depression that will be an order of magnitude larger than the Great Depression of 1929.

Prechter's socionomic views are of particular interest to me at this time because the conclusions he reaches are virtually identical to those predicted by Austrian economic theory. Whereas Prechter's identification of a larger contraction stems from the forms of the Elliott Waves in the financial markets, Austrian theory guides one to examine the extent of bank credit expansion and the vigor with which the financial and monetary authorities are attempting to fight the subsequent contraction. While there is not sufficient space here to explain precisely why a Grand Supercycle wave is larger than a Supercycle wave (I presume the nomenclature will suffice), the evidence in support of the Austrian position is easily summarized.

The extent of the credit expansion is significantly greater. The level of total U.S. credit market debt is now 375 percent of GDP, 44 percent higher than its 1933 peak. The amount of Japanese, European and Chinese debt also exceeds their historic levels. In 1930, it was the U.S. that launched a determined, seven-year counter-cyclical fiscal program in 1930, thus deepening and dragging out the liquidation process that took rather less time in Europe and Japan. Unfortunately, all of the major economies are now following the U.S. historical model. In terms of GDP, Europe's collective stimulus package is a little less than half the size of the $939 billion Bush-Obama stimuli, while Japan's is approximately the same size, and China's is more than twice as big. Moreover, if banks continue to fail at the same rate in the second half of 2009 that they did in the first, the percentage of failed bank deposits to total bank deposits in 2008-2009 will be precisely twice as high as it was in 1930-1931.

Prechter's lecture went into great detail, exploring some of the more impressive successes of Elliott Wave Theory as well as its most costly disappointments. An interesting justification of one of the more notorious of the latter, the failure to predict the 2003-2008 stock market rally and coincidental housing boom, was a chart showing the divergence between the Dow Jones Industrial Average priced in nominal dollar terms and the same index priced in gold. His conclusion is that the current stock rally from March is likely in corrective wave B and will see one more wave upward into the fall before collapsing dramatically in a powerful third wave down. In contrast to nearly every economist and financial analyst who pays attention to the currency markets, Prechter also forecasts U.S. dollar strength in the medium term.

But the most fascinating aspect of Prechter's lecture was his formulation of the Socionomic Theory of Finance, which asserts that finance must be an entirely separate discipline from economics. I found this idea to be intriguing since I had independently determined that none of the major economic theories, including Austrian Business Cycle theory, appear to accurately describe the observed behavior of the financial markets. Prechter's brilliant insight is to note that the laws of supply and demand cannot be properly applied to financial markets because there are no producers to provide the supply curve required for establishing price equilibrium.

In a paper titled "The Financial/Economic Dichotomy in Social Behavioral Dynamics: The Socionomic Perspective" published in the Journal of Behavioral Finance, Prechter and Wayne Parker write: "But even to a casual observer, price equilibrium is obviously absent from financial markets. ... If the law of supply and demand were regulating financial markets, prices and relative values for investments would be as stable as those for shoes and bread." Like many significant concepts, this idea is so retroactively obvious it borders on embarrassing. To make his case, Prechter showed a series of graphs demonstrating, in the case of the financial markets, an increase in price does not lead to a decrease in demand even though supply remains constant.

Neither prophets nor intellectual iconoclasts are often honored in their own time. It's clear that Prechter knows this, just as he recognizes the difficulty in overturning decades of scientific sclerosis even when the existing theoretical models have been repeatedly shown to be fundamentally flawed. Fortunately, as befits a man focused upon the future, Prechter has responded to this challenge by laying a solid, methodological foundation which can readily be built upon by others interested in following in his footsteps. Additional notes from the lecture and my comments on them are available at my blog.