The Inevitable U.S. Financial Crisis

All great empires rise and fall. It is difficult to accept this truth when you are a part of the history. In brief, nobody has a crystal ball. However, in academic circles and in future markets the picture is becoming frighteningly clear.

The Culprit

Five years ago, in 2006, the economic output (goods and services) of the entire world was worth around $48.6 trillion. When we closely examine and measure the stock exchanges in major financial market and at their entire activities, the market capitalization measure shows that is at $55 trillion. (http://www.library.hbs.edu/databases/by_content_type/country_information.html)

The value of the lending market (debt market) domestic and international bonds was and an astounding $67.9 trillion or about 40 percent larger (from 2006-2008). On a monthly basis $5.8 trillion changed hands! Another complex market in  “derivatives”-contracts which involves options and swaps was grew even faster at over $600 trillion by 2009 (http://lawreview.wustl.edu/commentaries/a-proposed-fat-tail-risk-metric-disclosures-derivatives-and-the-measurement-of-financial-risk/ ).

The primary cause of the economic crash in 2008 was financial: more specifically a credit crisis due to in the “subprime mortgage” market. Now consider the historical certainty, which is that so long as banks, bond markets, and stock markets have existed so have financial crises. The question is on the tip of your tongue: so when is the next crisis? Bear the details of the culprit identified above as we look at some facts.

 

Fact No. 1: We live in a financial system that basis its transaction on cashless inter-bank and intra-bank transactions. Consider that gold, coins, precious metals used to be a means of exchange. Debts are settled between account holders without having money physically change hands.  We have in place systems such as fractional-reserve banking, where banks kept only a small proportion of their existing deposits in the vault to satisfy the demands of their depositors (reserve ratios), allowing further transactions (here lies the credit market misgivings) at a profit.

Fact No. 2: In market movements, annual drops of 10 percent or more happen very rarely. Periodic economic Boom and Bust cycles are distinguishable phenomena that occur due to inflation, aggregate demand and supply converging with the velocity of money, interest rates and inventory levels among other contributors.  With respect to market movements of more than 10 percents the Dow Jones Industrial Average has experienced 20 in the last 100 years (http://econweb.rutgers.edu/bordo/WEO.doc) Done the math?… every 5 years.  Looking back at 1929 to the present, stock market crashes have deepened due to severe financial distress and weakness which due to its sheer volume is no longer discordant with the economy.

Fact No. 3:  The world’s best-known crash of 1929 saw a decline 13% on black Monday and a further decline of 89% by 1932. The recovery of the market was not until 1954. From a peak of 14,164, on October 9, 2007, to a level of 8,579, a year later, the Dow fell in this period by 39 percent. By contrast, on a single day just over two decades ago-October 19, 1987-the index fell by 23 percent, one of only four days in history when the index has fallen by more than 10 percent in a single trading session.  Markets are not the best means of measuring economic outcomes and they are fickle. However the debt market and volume of trade in derivatives has forced the economic hand and viewpoint. Given the volume of the derivatives market and the debt market economies are highly subject to the inter-temporal choices of the bond and derivatives market.

The Understanding

This crisis, therefore, is about much more than just the stock market. It needs to be understood as a fundamental breakdown of the entire financial system and the economic system that is hinged to the monetary-and-banking system through the bond market, the stock market, the insurance market, and the real-estate market. It affects not only established financial institutions such as investment banks but also relatively novel ones such as hedge funds. It is global in scope and unprecedented in scale.

We also need to take into consideration that the current US economic data on unemployment and GDP are not politically driven but predetermined by the market. In other words no current US government effort with a deficit ridden $14 trillion economy has the economic leverage to counterbalance a market force of $670 trillion. When the market shift occurs in the US economy the outcome will be irreversible.

As we stand, the general market has not yet made up its mind on the short-term (0-18months) due to the dangers of excessive losses. However in the medium (19mths-5yrs) and long term (5+years) the markets will move to position themselves into a loss-minimizing stance. This is what will be the first signal of the shift.

 

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