Currents through an Economic Crisis

Five indicators that make an economic crisis

Aug 11, 2020 by ma_adam

Do you have any idea what you just did? You just bet against the American economy. Which means, if we’re right, people lose homes, people lose jobs, people lose retirement savings, people lose pensions. You know what I hate about banking? It reduces people to fucking numbers.

The Big Short

Brad Pitt’s character in the movie adaptation of Martin Lewis’ The Big Short spews out the above jeremiad in one of the most sobering scenes of the movie (if you haven’t watched it already, then watch it as soon as you finish reading this article).

In the scene, novice investors Charlie and Jamie have just made the deal of their lifetimes shorting AA tranches of CDOs of MBS using CDS. What that alphabet soup means is simply that they bet against people being able to pay their mortgages since banks indulged in predatory lending and gave out mortgages to people they knew couldn’t afford them. Ratings agencies then slapped good ratings on these debts which were, in fact, risky.

Whilst basking in their newfound investing prowess and celebrating their imminent multi-millionaire status, Brad Pitt’s character reminds them that if they’re right about impending doom on the global financial stage, a lot of people will suffer.

Let’s explore what makes an economic crisis and how we can tell through five specific economic indicators, especially in light of the two crises that my generation has now lived through early on in their lives: the Global Financial Crisis of 2007-2008 and the current Covid Crash.

Let us not forget that behind all this abstract talk and data lies the visceral experience of living, breathing humans. When we see the statistic of unemployment rising X%, what that information doesn’t convey is the uncertainty, anxiety, and hardship a lot of people will face just having lost their jobs and not being able to sufficiently provide for themselves and their families.

I hope if there are some good things that come out of this site and my financial career in the long-term that it is allowing people to take control of their financial lives to fully live a life of their choosing, making us all a bit more antifragile to financial madness, and for us to be able to funnel capital for the net positive of human society and create productive people, assets, and businesses for the betterment of life.

What is an economic crisis?

Economics isn’t a science,1 and so there is no objective measure as to what technically constitutes an ‘economic crisis’.

The word ‘recession’ has now become synonymous with the word armageddon, where we have a conditioned response to think of doom any time we hear the word. There is no technical consensus on what constitutes a recession or an economic crisis (these terms are used at times interchangeably, and at times separately, with ‘recession’ relating more to GDP), with definitions ranging from the deterioration in specific key indicators such as GDP, unemployment, living standards, and income for a specific timeframe, to more straightforward definitions such as a decline in GDP for two consecutive quarters which is used by many British economists.

There are certain popular and reasonable indicators that we can use to ascertain the health of the economy and the finances of the people within that economy. Since the economy is fractal, organic, and complex (of the Mandelbrot kind) no two economic crises are alike, and indicators can only tell us so much. Indicators in a complex system like the economy can interact on different scales of the economy, causing larger and compounded effects to emerge in the macroeconomy. The economist Jan Tinbergen, who was one of the founders of econometrics, recognised this by suggesting multicausal theories born from an interplay of causes.

A Mandelbrot set, showcasing the nature of fractals.

Economic crises, recessions, and depressions2 can differ in geography, sectors, length, and depth. However, the more interconnected the world becomes through hyperglobalization, the more uniform these effects become, to the extent that in response to the crash of 2008 countries had to co-ordinate economic policy together because of how integrated the global economy is. This hyperglobalized world has many advantages for businesses and consumers, but also leads to extreme fragility, since an economic contagion3 in one node of the system can more easily bring other nodes down. In other words, we are more exposed to systemic risk.

When looking at economic data and indicators, it is necessary to think about the second order effects of an event. If unemployment rises, your mind should then immediately begin to think what effect that will have on businesses which will sell less since people are not earning money, and so on.

Let’s take a look at five widely used indicators here as a starting point to thinking about economic crises.

1. GDP

Gross domestic product (GDP) is the de facto measurement of the state of an economy and can loosely be considered the total production of an economy. Economic activity naturally fluctuates, but a declining growth rate means there is a storm coming. The combination of the length and depth of a recession, as well as its reach and cause, will determine the sharpness of that recession.

Recessions matter because they usually signal underlying problems within the economy. The production, consumption, and income within an economy only decrease if other indicators are deteriorating. Implicit within GDP as a measure is the recognition of the interdependence of production, consumption, and income. As consumers spend more of the money they earn, businesses and producers sell more, resulting in an expansion of the economy and GDP growth.

On the other hand, unemployment increasing results in incomes decreasing, which results in consumption decreasing, meaning businesses and producers cannot produce and sell. In this case, GDP would decline, causing the economy to shrink. These circular flows are central to economic models. This is why GDP in some senses can be considered a sort of core indicator.

Source: ONS – GDP in the UK from 1955 to 2020

The above chart showcases GDP growth in the UK from 1955 to 2020. The 1970s and 1980s saw severe and frequent recessions, whilst the 1990s saw a shallow recession. Then there was a period infamously called ‘The Great Moderation’ where British Chancellor and later Prime Minister Gordon Brown extemporaneously declared the end of the boom and bust cycle, until it all came crashing down in 2008.

Our current economic predicament is very clearly visible on the right-most edge of the chart with a sharp downturn.

There are many differences between 2008 and now. This isn’t a financial crisis like the subprime mortgage crisis of 2008. A pandemic is an entirely different beast and a more ‘natural’ cause than an intrinsically financial crisis. The economy was essentially quarantined and kept in an almost comatose state due to government intervention and quantitative easing.

Even in the US, it is turning out to be a very unique recession and the predictions of a Great Depresion-esque crisis don’t seem to be manifesting with many parts of the economy doing better than expected, whilst some indicators, such as unemployment, deteriorating.

The 2008 crisis changed the way governments react to crises and broke the taboo of pumping colossal amounts of money into the system. The UK and US governments, both currently more free market in bent, didn’t hesitate in swiftly creating a financial backstop in the economy and exacting precise stimulus packages.

We are living through a very weird recession where the property market is booming, the stock market is roaring, large businesses are profiting, whilst small businesses are breaking and millions of people are losing jobs.

2. Unemployment

Unemployment is one of the nastier effects of economic crises on a human scale. As I mentioned in my introductory post, we are in a game of survival, and in the modern era survival for most people is facilitated through wage labour. Losing your job puts the survival of some of your more primal needs at risk.

In economics, unemployment specifically refers to someone who isn’t working but is actively looking for work. The aggregate of those employed and those unemployed are the labour force of a country.

Those who have looked for a job in the past year but are now discouraged are called marginally attached workers. Those not looking at all are simply not counted in any of these categories and are considered ‘economically inactive’.

These categories and distinctions are not merely academic, currently in the UK the unemployment rate is at one of the lowest it’s ever been. Taking unemployment data in isolation, you wouldn’t be able to tell that we’re living through a crisis.

The number of people that have become economically inactive or marginally attached has increased, since the job market has been shattered and there aren’t enough vacancies for many to even be classed as unemployed. It’s important to take a holistic view of data and encompass the full narrative.

In economic crises, not only does the number of unemployed people increase, but so does the number of ‘underemployed’, which refers to involuntary part time workers who want to work full time, or those with skills having to work in unskilled jobs.

All these figures point to the reality that there is a lot of inefficiency in the economy, and parts of it are broken, especially during a crisis. The available resources and skills are not being allocated as efficiently as they could be, and the shrinking economy in a crisis leaves more and more people without a means of income as businesses make cuts.

The circular flow of income also means that less people being paid means less is being consumed and therefore produced, which will result in even fewer people being paid. Understanding this is key to understanding how grave the downward spiral of rising unemployment can be. For businesses, wages have a dual nature: they are a cost of production, but also a source of income since people with wages will purchase what they produce.

Rising unemployment can cause serious social ills and instability, which is why governments take unemployment and falling production very seriously since they have a ripple effect on the rest of the economy.

The UK faces an impending unemployment crisis as the government stops pumping money into the system and stops paying the wages of workers. Businesses will be making the hard choice of making swathes of the work force redundant.

Unfortunately, as with a lot of economic indicators, it can take time for markets to recover. And a fundamentally important point is that the opportunity costs of a crisis are devastating. For example, if a person who was advancing in their career lost their job this year and had to settle for an unskilled job, they may lose an entire year or more of experience in their field, not to mention the reduced income, which will have an acute knock-on effect on their total future income and quality of life, as well as stunting the maximum they could have achieved.

From an investing perspective, earning £10K less due to losing your job and having to settle for a lower paying job means your disposable income decreases. This means you have less money to invest, and you can’t take advantage of compounding effects for this period. This will decrease the total return in your lifetime and there is no way to get this opportunity back, only to make the most of the present and the future, and endeavouring to make your financial position more robust.

3. Inflation

Inflation is a general rise in the price levels in a country, and a fall in the purchasing power of currency.

The effects of inflation and unemployment are distinct in that unemployment is immediate and a shock: you’re working one day, and the next day you don’t have a job. Inflation stealthily creeps up on you, gradually eroding the value of your money and degrading the standard of living. If unemployment is like a sudden acute illness or accident, inflation is like a chronic illness.

In order for standards of living to remain stable, wages and earnings must increase in line with inflation. So the antidote to inflation on an individual level is simply to earn more, and for returns to be above the inflation level. Though this is easier said than done in many cases, especially in an economic crisis.

Deflation can also occur over time. In some cases it can even be positive, for example, due to the digital revolution of the past few decades the price of computing power from the 1980s to 2020 has decreased drastically since it is becoming cheaper to produce computers, and because knowledge has increased and economies of scale have been fully established.

It is also important to note that some types of goods or sectors can face sharp inflation, or even deflation, relative to others. For example, in the current pandemic, the prices of many staple and basic foods increased sharply due to high demand. In fact, some businesses were artificially raising prices because of higher demand.

In an economic crisis, where people are losing jobs and wages are decreasing, where some goods are increasing in price and there is a fear of inflation shock due to high levels of quantitative easing, inflation can be a real worry. Some fear a sharp rise in inflation in a post-covid world due to the sudden increase in demand and pent up activity, and lost opportunity.

Source: Bank of England

It is too early to say what inflation looks like in a post-covid world. Decreasing global economic activity, falling demand and falling incomes can all have downward pressures. Some predict that deflation may be an issue, due to a longer term time horizon for recovery as well as lost opportunity and a massive build up of debt.

4. Inequality

Steve Eisman of The Big Short fame proposed the inequality of income distribution as one of the causes of the 2008 Global Financial Crisis. His reasoning is that income distribution started to become more imbalanced in the 1990s, and instead of focusing on that problem, the US let ‘credit get democratized’ which essentially allowed people to lever themselves by taking out loans on their homes. This is the predatory lending I mentioned.

The 2009 edition of The State of Working America, published by The Economic Policy Institute in the USA put it quite succinctly: ‘the economy did well, except for the people in it.’

Income inequality means that most people do not benefit proportionately from increases in the economy. The pie is getting bigger, but not everyone is getting a taste, or at least not enough of a taste. Inequality is impossible to avoid and has been inherent in every human society. However, when most people earn their living through wages, a lack of significant increase in those wages whilst other parts of the economy expand is a huge problem.

The GDP of a country is representative of the income of that country. The income of a country can be roughly divided here into wages/salaries, profits, rent, and interest.

Source: LSE: Percentage share of wages in UK GDP

Percentage share of wages in UK GDP

Living standards of a lot of people (up to around 60%) have become decoupled from the growth of the economy, and as in the chart above, people that are not rich are not benefitting as much from the growth of GDP. Richer people are more likely not only to earn a salary, but also benefit from rents and profits, and so they are benefitting more from the increase in GDP. Whilst the average person has the sole income stream of wages/salary, to which GDP is not being trickled down to, and so the average person doesn’t benefit from that growth in GDP.

Another aspect of inequality being experienced in the current Covid Crash is between small and big business. As big business has more cash, avenues, and resources to stay afloat, many small businesses are drowning, which is going to have acute economic and policy effects for the next few years.

The UK government has done remarkably well in providing loans to many small businesses. While in the US, however, big business is receiving much more favourable terms. The stock market shows that the US mega-caps are eating up more and more market share. This is another perspective on inequality.

When the indicators of economic inequality are deteriorating, it can lead to second order effects that can cause devastation in the future. 2008 showed us that the hedonic treadmill is ever present. People wanted to have a lot more money so badly that they borrowed their way into a crisis.

5. Debt

Source: Bank of England: Total value of sterling lending secured on dwellings

The above chart is fascinating for two reasons. Firstly, the left side shows that as Steve Eisman rightly surmised, people took out loans on their homes at record amounts before the financial crisis of 2008. We borrowed our way into a crisis. This fell sharply after the crisis began unfolding.

Secondly, as soon as the Covid Crash started, banks and lenders stopped giving out mortgages and loans. One major benefit of the 2008 crisis is that it led the way to critical financial reform which has made financial institutions a lot more responsible and even risk averse in many ways.

Too much debt in the economic system leads to fragility that eventually cascades into a financial meltdown. As Nassim Taleb warns us, too much debt is evil. In a hyperglobalized system we face volatility like never before, leaving us highly exposed to black swan events.

On an individual level, high debt and high interest reduce optionality. Debt becomes a shackle that follows you like a financial shadow. It promises you more, and in return gives you less.

Our ancestors understood that debt, especially high levels of it, is not respectable in a civilization.

The context of debt as an indicator in the wake of the 2008 Global Financial Crisis is that there was a wage squeeze as we explored, and real wages were not really increasing in line with GDP. Lifestyle creep, media, and keeping up with the Joneses get to us as social animals. We constantly compare our lives to others and are dragged into envy of material things.

So what did we do? We simply borrowed, using a silent but lethal option that was a ticking time bomb. Predatory lending meant that banks practically handed it to us. Rising debt is probably the most lethal indicator of these five since it gives the illusion of prosperity but eventually asks for everything and more in return.

All these indicators are connected and are in a constant commingle. One indicator will eventually cause a deterioration in the next. Complexity dictates multicausal theories where you must look at events from different perspectives and with multiple indicators to achieve a holistic appreciation of the narrative. History never repeats itself, but it has a tendency to rhyme.

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  1. Fields of studies, such as economics, will want to claim scientific status because of the material benefits and the (relatively) precise nature of natural sciences. This has popularly been dubbed physics envy in this case. Economics is not a science, and an overwhelming amount of economic theory bears no relation to reality. See discussions in the philosophy of science as well as critiques of economic theory and models. []
  2. The terms crisis and depression are not precisely defined in economics. Some economists and policy institutes do not distinguish between them, seeing the events after 2008 as merely a bad recession (National Bureau of Economic Research (NBER), 2012). Others demarcate between crises and depressions by identifying the latter with more severe economic costs, and, more importantly, with large scale economic restructuring and policy change (Perez, 2002). []
  3. Contagions of all kinds can spread more easily in a world that is increasingly hyperconnected. From actual viral contagions, the likes of which we are living through right now, or economic contagions as in the subprime mortgage crisis in the Global Financial Crisis of 2008. []

By ma_adam

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