The greatest book that I have read so far is Economics in One Lesson
by Henry Hazlitt (published 1946). It was written to expose the popular fallacies in economics and the lessons are as applicable today as they were over 60 years ago.
I received a direct message on Twitter asking if I could explain what causes bubbles. Taking cue from Hazlitt, I said that I could do that in less than a dozen Tweets.
In this post I have reproduced the same (with a few edits to increase readability).
- Bubble Tip: There is no boom-bust theory in Micro Economics - ergo free markets are stable. The destabilization factor must come from... outside.
- Bubble Tip: Look for the fuel for speculation... check if real inflation adjusted interest rates are negative!
- Bubble Tip: The fuel for speculation comes when the Central Bank prints "mickey mouse" money out of thin air. [Hint: Printing = Quantitative Easing].
- Bubble Tip: "Mickey mouse" money has to go somewhere... and it fuels a speculative bubble where it does. First movers have an advantage.
- Bubble Tip: With the aid of leverages asset prices can be inflated beyond the wildest imagination. [Hint: Japan in the 80's].
- Bubble Tip: Monetary injections are like a steroid. It turbo-charges activity in interest rate sensitive sectors. [Hint: Nasdaq & Housing].
- Bubble Tip: Look if externally created incentives provide support for the bubble i.e. government policy. [Hint: Freddie & Fannie, The Community Reinvestment Act, Tax beaks on Capital Gains].
- Bubble Tip: Finally look for other tell tale signs - poor economic data, inflation, health of banks, inflation, mania, valuations...
- Bubble Tip: The music has to stop. It will when interest rates start to rise to pre-boom levels. Once it does the bubbles pop.
Believe I managed to explain the anatomy of bubbles in less than a dozen tweets. Credits go to Austrian School Economics – notably the work of Ludwig von Mises, Friedrich Hayek, and Murray Rothbard.
Were you able to spot the previous economic bubble? What about the one before that? And the one before that?
Unfortunately for most people tend to come out of no-where and take the world by surprise. They are usually rationalized with the benefit of hindsight, but over 99.99% of people completely fail to spot it. Most feel that these events are virtually impossible to spot and the ones who did manage to spot them in advance were just plain lucky.
However the reality is quite different. According to the economist Freidrich August Hayek, the role of the economist is precisely to identify the aspects of the situation that are “hidden from the untrained eye.” The one reason why most people are unable to spot an impending financial crisis is because they only see the visible immediate effects of economic policy and miss out on the unseen. This is a failure of understanding or a failure to connect causes with effects.
In fact the study of economics has a far greater impact in our lives than most would care to understand. Ludwig von Mises, one of the greatest economists ever, once said:
"Economics deals with society’s fundamental problems; it concerns everyone and belongs to all. It is the main and proper study of every citizen."
And ironically the ones most ignorant of it have the most vociferous opinion about economics. The only reason people do not see the looming danger is because they miss out on the unseen. This is hardly surprising given that most people lack sound economic education… and sound economic education is more necessary today than it has ever been before in history.
The world has still not recovered from the mayhem of the US housing collapse of 2008, and the situation in Europe is getting grimmer. In an attempt to fix the economic problems of today, the governments across the world over have thrown everything at their economy but the kitchen sink (the kitchen sink in itself should follow very soon). They have attempted to take the tiger by the tail. And yet there has been little by way of recovery. Almost every morning the financial dailies report more bad data. Inflation is rising. Incomes are falling. Governments across the world think that their economic policies can fix the problems in the world today. They are wrong... but they don't understand that they are wrong. And what is worse is that they don't understand that their actions are creating a far bigger problem for tomorrow. Of late busts and bubbles are becoming more frequent than they have ever been before in history. Such collapses have one common theme – which is that the “little guy” is the one who is hurt the most. For those with proper training in sound economics it is not so difficult to spot what is coming. Busts take place because of real reasons triggered by the actions of the “elephant in the living room” (the Central Bank). People cannot understand what is coming because they have failed to notice this elephant. The writing is clearly on the wall. The warning bells are getting louder. The financial crisis that is on its way is much bigger than what we have ever seen. Never before in our lifetime has our money, wealth, savings, and our entire financial future been in greater danger. The coming crisis is going to be like what we see in Europe today… but only much worse. The next decade or so would bring with it massive cycles of wealth destruction with most people losing more than half their wealth.
This is one of the reasons I have started this blog. This won’t stop the impending financial disaster that is coming by our way… but can surely help you to avoid getting trapped in the cycles of wealth destruction that are coming by our way.
Do watch this space.