I've given much thought lately to the phenomenon of economic bubbles. There are many kinds of bubbles and it appears that we humans are very fond of creating them but we don't have a lot of knowledge about them. A couple of bubbles that stand out are the bubbles in the stock market, housing market, consumer prices and credit. It is my firm belief that bubbles burst, which often comes as a shock to those that thought the end could never come. We Americans haven't seen a lot of bubbles bursting because we've been riding up the side of huge bubbles in the four areas I just mentioned. When the bubbles burst money becomes tight, layoffs occur, small businesses go under, home owners find that their mortgage rates, which they thought were low, have actually increased in terms of real interest rates (the money they are paying back is more valuable than the money they borrowed). When the U.s. experiences its next recession, it will probably cause much of the world to fall into a recession as well since the U.S. fuels the world economy (we're the ones buying everything).
Back in 2001-2003 we saw the stock market fall. As this happened people started using the "D" and "R" words, deflation and recession. The Fed then lowered interest rates and that sparked a credit and housing bubble and the stock market rebounded. The Dow Jones is right back where it was in 2000. I remember what it was like in my city, San Francisco, in 2003. It was different. Nobody went to restaurants, cabbies complained of lack of fares, it seemed like the streets were more deserted and many of the artists and musicians left because they were no longer being supported in their craft. The party was over and all that were left were the people cleaning up.
Now the city has rebounded and restaurants are doing fine, cabs zoom around full of passengers and the arts are back (although not as powerfully as in 2000). But we're still in a bubble, just an extension of the first one or another wing of it but it's still the same bubble. The stock market because it is more liquid than the housing and credit market will be the first to drop. It'll happen suddenly and will catch us all off guard. This is what happened to the market in 1929, Black Monday. Everything was fine until the market dropped 300 points over two days. This time the market will drop and keep dropping, credit will be next as businesses cannot pay back their loans, banks will stop lending money. If businesses cannot get loans, they'll stop hiring and stop inventing and that will lead to an unemployment rise. The same will be true for housing: defaults on home loans will rise and banks will stop lending.
When the Fed sees this, they will do two things, drop interest rates and start printing more money. If the situation gets bad enough interest rates will drop to near zero. When this happens printing more money has no effect and we are in what is called a liquity trap which is the catalyst for a deflationary death spiral. The deflationary death spiral is a condition where prices are dropping. This sounds like a good thing and if you don't have a lot of money it is, sort of. The problem is that prices are falling for a reason. The reason is that people don't have money to spend. They don't have money to spend because: a) they've been laid off b) their assets (stocks, house, etc.) are worth less then they thought they would be c) dollars become the most valuable investment therefore it pays to hang on to them. People also begin to expect to pay less as time goes on so they'll hang on to their money, it becomes a self fullfilling prophecy. Small businesses cannot compete in this atmosphere where they are not getting paid enough to cover development of new products. Low cost retailers are the only ones doing business. Expect Wal-Marts, Costcos, Goodwill, etc. to do the bulk of the business.
The only thing worse that a deflationary recession is an inflationary recession, that's where you're paying more and more and getting paid less and less. I don't think this is what is going to happen. I think we're in for deflation and I don't think there is anything the Fed can do about it. I've heard that the only thing they can do is increase the money supply early on and keep promising that the supply will keep increasing in the future. The reason they will not do this is two-fold: 1.) they have to do it early on and therefore have to do come forecasting. At the time, it would seem irrational and will destabilize prices, which is something that central banks loathe to do 2.) If the fed increases the money supply it will be a temporary fix. Because it is a temporary fix investors will not be convinced that dollars today is more valuable than dollars tomorrow so no investing will occur. The new Fed Chairman, Bob Bernanke, is someone who is accutely aware of deflation. He once said that if necessary the Fed would "drop dollar bills from helicopters" to make sure it doesn't happen. But as I just pointed out he would have to start that process early (when it seems irrational) and keep doing it into the long term, two things that I don't think are going to happen.
I'll leave you with three charts which I think illustrate my point about bubbles. The first is the Dow. We are in the apex of the second wing of a very large bubble. The next is the Consumer Price Index since 1913. This is index of what consumers pay for a host of items. It's been skyrocketing and notice that every time it pulls back a recession occurs (the shaded area). The CPI is also a pretty good measure of inflation (the opposite of deflation). The last one is the credit bubble. What goes up does go down, we just haven't seen it in a long time.
Dow Jones Industrial Average
