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The Next Great Financial Crash – Part 1: The Credit Cycle

Jul 08, 2018 | Peter Christensen |

The Next Great Financial Crash – Part 1: The Credit Cycle

There seems to be consensus among economists that a major correction in the stock market is coming. Some say this will occur in 2018, while others predict 2019 or 2020. However, unless you’re an active stock market trader, the timing of the crash is not the important issue. If you hold your stock portfolio is part of your retirement strategy, you will be exposed to the results of a crash, so you must understand the underlying reasons for the next crash, and where it where we will see the most severe impact.

The traditional business cycle has retired

Traditionally, economies develop like this: First, the economy will peak. Then, it will go into recession followed by a recovery period leading to another, higher peak, and the process will repeat itself. In other words, the economy, up until today, is either expanding or contracting.

This “tradition” no longer applies, however. Over the past decade, we experienced a record-breaking recession, which was followed by historically weak expansion: while GDP growth should reach 5% during recovery and prosperity periods, it only averaged at 2%. According to economist Peter Brockvar, the Federal Reserve’s artificially low interest rates are to blame:

“To me, it is a very simple message being sent. We must understand that we no longer have economic cycles. We have credit cycles that ebb and flow with monetary policy. After all, when the Fed cuts rates to extremes, its only function is to encourage the rest of us to borrow a lot of money, and we seem to have been very good at that. Thus, in reverse, when rates are being raised, when liquidity rolls away, it discourages us from taking on more debt. We don’t save enough.”

During the Alan Greenspan years, in the late ’90s the Fed kept interest rates extraordinarily low despite the fact that the booming economy was in no need of further stimuli. The Fed did so to provide liquidity to a Y2K-wary public and as a response to the 1998 market turmoil. However, they didn’t withdraw the extra cash fast enough and the dot.com bubble burst in a great stock market crash. Following this crash, the Fed was again generous to borrowers, which contributed to the housing crisis and the Great Recession. As we stand now, we’ve been teaching people and businesses for two decades that accumulating debt is not only OK but also fun and easy. And we haven’t failed to respond.

Debt does indeed stimulate growth, but over time it’s effect evaporates; this is evident in the flat to mild “recovery” years. Debt-fueled growth simply uses up future spending—spending that the economy will then be missing out on. And now, we’re entering a dangerous period—the reversal phase—where the Fed will attempt to break our debt addiction. That never ends well.

Say welcome to the credit cycle

What Peter Brockvar points out is that the Fed-driven credit cycle is replacing the traditional business cycle. Debt is a significant factor for GDP growth, so its cost (interest rates) is the main determiner for where we are in the cycle. This cost is controlled largely by the Fed, so investors keep a close eye on monetary policy.

As we have been witnessing for some time now, stocks and real estate are performing quite well. This is because debt boosts asset prices. However, the Fed is now increasing interest rates and unloading its assets purchased after after 2008 to help the banks. Assets are only worth as much as investors want to pay, so when financing costs increase, asset prices must drop. We expect this to happen next year.

The next “Minsky Moment”

In the traditional cycle, a recession will trigger a bear market—resulting in lowered consumer spending, falling corporate earnings, and plummeting stock prices. With today’s credit cycle taking charge, however, lower stock prices aren’t caused by recession: they trigger recessions. Consumer spending and business investment are driven by access to credit, and when that access is hindered or removed, consumer spending will decline, and recession will occur.

This may sound like the Hyman Minsky financial instability hypothesis. According to Minsky, when over-optimistic firms take on too much debt, it paralyzes them, and bad things start happening. We are convinced we’re that point is right around the corner. The last “Minsky Moment” was caused by subprime mortgages and its derivatives. The next one will be a result of corporate debt. More about that in Part 2 to this series..