The short answer is yes. The nature of economics is cycles because expectations and price information is imperfect and there is a difference between real and nominal value. The question is when is the next economic collapse and what sector will be the impetus? The purpose here is to clarify the cause of economic boom and bust cycles and try to identify which sectors at this time could potentially cause an economic crisis. Prognosticators and book writes perpetually forecast doom and gloom to make the news. However, lets look at the real economics of a business cycle. It is cause by price and value divergence, that is a malfunction in the pricing mechanism.
What causes an economic crisis, collapse or panic?
The cause of a crisis is simple, it is because financial assets in a particular sector are valued above their natural value. This means some part of the financial sector is mis-priced. The jargon is a bubble. What this really means is a set of prices in a particular market have departed from the trend or their natural intrinsic value.
After this divergence between the aggregate nominal price and the natural price, eventually that sector tries to adjust itself, because investors see the difference. When the financial correction of price or valuation comes, it subsequently sends a shock wave that affects the real economy, that is factors like production and employment.
Therefore, the cause of a crisis is a wrong aggregate market prices in a particular financial sector. It could be technology stocks or mortgage backed securities or it could be the bank interest rate (the price borrowing money). However, some aggregate price in the financial markets is incorrect. The entire financial sector is not always mis-priced, but usually one particular sector. The reason people do not see the next crisis is the sector out of equilibrium is usually different in every crisis, further, information is imperfect.
What is a natural price?
If the nominal price is what you see quoted in the market, determined by supply and demand. The natural price is some valuation of what the financial asset should be priced at. This is a theoretical price and it is open for debate and have been debated by the great economics from Hayek to Keynes. Even if there is not perfect determinate model for natural value, It is a theoretical concept that provides a framework for understanding cycles. I am only giving examples to illustrate.
For example in a Wicksellian or Austrian economic model of business cycles, the natural rate of interest might be equated to the marginal productivity of capital. While the nominal price is the interest rate you see at the bank. If you are looking at real estate prices, the Case-Shiller Home Price Indices is a good index to follow in relation to the 200 year trend in real estate prices. For stock market valuations some people use book value as the long run indicator of where a stock should be priced. Again the natural or true valuation is purely theoretical, because the marginal revolution in economics correctly model prices as subjective.
Why do prices get valued wrong?
The issue is the economic world is always changing and factors like expectations weighs heavy into the equation. It is really expectations which causes the divergence. Expectations are based on imperfect information about the future, and social trends. Prices are the equilibrium clearing point, but they have expectations about the future embedded into them. This is what makes economics a social science.
No person can predict the actions of another – Mr. Spock
- Therefore – A crisis or panic is caused by an expectational price bubble in the financial sector, playing out when prices are inflated in relation natural value. When this becomes manifest to the majority of investors the spark is ignites a collapse. Rarely is real sector disequilibrium a factor in a crisis.
This is in contrast to long-term structural problems that come gradually, crashes are swift because there is a temporary disequilibrium between supply and demand. Disequilibrium between supply and demand are caused by financial disequilibriums that spread to the real sector.
Think about it, a farmer is less likely to miss-price a bushel of wheat when he brings it to market than people who speculate on MBS securities or stocks in the financial world because the values of these financial assets derive their value from another underlying set of asset in a complex, convoluted relationship that even the rating agencies miss.
Warren Buffet was wrong when he said:
The stock market is the perfect weighing machine.
In reality it is an imperfect weighing machine based on imperfect information.
My premise is every financial market is imperfect. When the imperfections grow there becomes a metaphorical crack in the system that spreads and damages the structure of the economy.
- Therefore, it is when price departs from natural value, then an imperfection is caused. If price and natural value are too large in aggregate, there will be a correction. if the correction is large there is a displacement of money that spreads to the real sector.
So how can we predict where and when the next crisis will be?
Do not listen to Economist who are looking at large demographic tends, politically motivated or are selling a book writing about baby Boomers and Millennials. Rather always focus on prices of financial assets that deviated from the long run trend in an unnatural way. If do not have the time analysis balance sheets or like Dr. Micheal Bury did in predicting the housing market crash, however, you can look at trend lines.
What are the main markets to watch that trigger an economic collapse:
- Interest rate market – The federal reserve bank interest rank to the marginal productivity of capital.
- Stock market by sector – historical valuations of a particular sector and deviations from the long term trend.
- Housing market – Prices that are well above the long term inflation adjusted long term trend.
How you know a crisis is coming?
Above I gave you the economic explanation. But a common sense way is this, take a look around do people live like they are rich and decedent? Think of the roaring 1920s or the years before 2008 and how people were living and compare this to today. I think people have a subdued caution and many people are scraping by. This in my opinion does not feel like a bubble. Since 2008 was in our recent member we are more diligent and watchful, this adds to a conservative feel about how we conduct our economic lives. We all feel poorer rather than inflated with money.
Forget the news, look around you. Are we booming or trudging along? If we are trudging there is no speculative bubble. Are people eating at McDonald and chain restaurants in your area or spending a lot or gardening more? Where are people going on vacation? Europe or hiking in Asheville? Do people have multiple homes they are renting for investments or barely paying the bills for one?
There are weaknesses in the economy but these are mostly long term structural problems that the next administration may or may not fix, I think Trump will coupled with some favorable supply shocks like the discovery of new Texas oil fields. No one know, but again take the common sense test of looking around you and see if people look and act like they are in the 1920s or just coming out of the 1930s? I tend to think the latter.
Besides the theory of prices, expectations and business cycle, what are the weights on the US economy?
Structural decline is not the same as a crisis and rarely triggers anything but a slow painful relative decline in wealth. A collapse happens in a year or less.
- Other factors that might feed into a crisis are as follows, they cause both structural and potential for cyclical issues
Excess Federal State and local debt – http://www.misgovernment.us/ – The federal debt has exceeded national income. The amount is increasing everyday. Politically motivated writes will tell you that debts and deficients are not an issues because the US can always repay with taxes. Translation, your money. They write this because Obama created the largest deficient in history and they supported the former President. The truth is government debt might not cause a panic yet, but it suppresses the economy to such a level that it eventually will. Government spending crowds out private investment, decreases family income, and will cause an economic crisis unseen before when the US can no longer pay its obligatory payments. The debt has a dampening effect on the US
- Economic factors for an economic collapse rated from biggest factors to least.
- Excess consumer debt
- Low savings rates
- Real wages are are not increasing
- Housing bubble – http://www.jparsons.net/housing bubble/
- Rates are so low for so long that a small increase could affect the economy
- Excess money created through central bank policy could cause inflation
- Banks are unstable – facing the light of regulatory justice has weakened their capital adequacy.
- Socialist polices of Obama administration have cause market distortions
- European problems spread to the US markets
- Unforeseen – Each economic crisis is caused by something that did not cause the last.
- Austrian business cycle – Difference between the marginal productivity of capital (lets say the profit rate) and the bank lending rates causes a cumulative process of disequilibrium.
- Fraud continues – Regulators penalties amounted to a fraction of the perpetrators profits. Few, really only one person responsible for the last crisis, went to prison, thousands of executives who engendered the fraud that caused the last crisis are free. The message from the government regulators is, crime pays if you do a cost benefit analysis. This is unfair and will bring a new generation of greed motivated Wall Street cowboys to who will do the same. The regulators were too easy.
- Big banks know they were bailed out last time and the message is they will be bailed out again. If they were left to fail, a more efficient honest banking system would have developed, even if there was short-term pain.
If you don’t remember anything else I say today, please remember this: Only about 20 financial institutions perpetrated this crisis. These 20 failed in every respect, from business practices to ethics. Greed and malfeasance were their modus operandi. There was no excuse for their behavior, and they should be punished thoroughly, perhaps even criminally. Richard Kovacevich, the former chairman and CEO of Wells Fargo.
- Monetary policy is still being directed by the Federal reserve, rather, than the market. Therefore, the supply and demand for money is not efficiently brought to equilibrium.
- Fear – It is a strong human motivator
- World event – that triggers a shock
- Weather pattern changes causing an economic shock in the primary sector. This theory was populate among economist who tried to explain the Great depression starting with the Dust bowl.
Positive structural fixes to the economy
- Cheap unlimited oil discovered in Texas
- Trump economic reforms on par with Reagan
- Innovation creates a positive supply curve shift.
What if there is an economic collapse?
Do not worry. I lived in Poland much of my life a post communist country. People survived and thrived, educated themselves and had magical lives with literally no money. In fact, in many ways it was a richer life. You will adjust the way you spend your time and money. You might grow you own food and read book and discover there is more to life than slaving away at a career and spend more time with your family.