Debt Cycles part 2. Long term debt cycle

A warning: This text is long and takes a while to read.

The majority of the long-term debt cycle is largely based on changes in interest rates regulated by the central bank, which make the above-mentioned processes work. Most of it is the sum of changes in short debt cycles. They are mainly based on changes in interest rates regulated by central banks, which reflect the willingness of people and businesses to borrow or borrow money. The short debt cycle will be discussed later. At the end of the cycle, the role of interest rate changes diminishes and the focus is on printing money with the central bank's key interest rates close to zero.

At the beginning of a long debt cycle, the parts of the above equation are much smaller than when the debt bubble bursts in the end. The money supply is often tied to fixed assets held by the central bank. In practice, the amount of debt cannot grow significantly faster than the amount of real assets. This affects the right side of the equation, reducing the amounts on that side. The growth rate of money in circulation and debt remain limiting factors as the money supply is linked to the central bank's fixed assets.

At some point, policymakers will be pressured to increase money supply to improve economic development. This is done by breaking the link between the money supply and the fixed assets. In other words, the amount of money is growing faster than before. The central bank can tighten or loosen monetary policy by regulating interest rates and money supply. The latter is rarely a significant factor. This mostly happens at the end of the cycle.

The long-term debt cycle lasts 60-100 years. In the initial phase, debt and consumption are roughly in balance with money and income. The increase in the money supply allows for an increase in debt, which enables increases in consumption and an increase in wealth. The former allows additional liabilities. Creditors provide additional debt as borrowers ’income, cash flows, and collateral values increase. These increase the willingness of creditors to borrow. Development strengthens itself and the economy grows.

The growth phase lasts most of the cycle. It progresses variably according to short debt cycles. Through the key interest rate, central banks regulate the willingness of creditors and debtors to lend or pay the debt. Total debt is slowly increasing. The peak of the cycle is manifested by high debt levels and / or the failure of monetary policy to generate economic growth. One of the signs of the peak is found in the granting of debt, which focuses more on collateral values than on debtors’ income. Interest rates are close to zero or at zero. Debt service costs are higher than the borrowers' ability to borrow. This reduces consumption. Debt ratios are declining. Too many businesses, households and financial institutions are becoming insolvent. They need to reduce consumption which increases unemployment, reduces people's incomes and increases other problems.

Debt problems are often the sum of many stages. First, the expectations of the general public about large cash flows in the distant future arise. Secondly, expectations arise about the increases in value in the near future and the gains they will bring. Thirdly, the wildest paintings of a glorious future emerge, exploiting the general public and eventually generating the outrageous scams that make money for their developers.

The above development is compounded by the fact that the investments are made by over-indebtedness and future cash flows are not sufficient for debt management costs. The differences between expectations and reality are the greatest when the debt bubble bursts. Prior to this, the positive effects of rising asset prices have been visible and not enough people have understood their unsustainability. Before the bubble bursts, there is usually low inflation and a debt-driven boom. The latter seems more of a boom created by high productivity growth and prudent investment than the absurd euphoria which will be revealed later to the general public. Debt payment begins. Economies can do it in four ways:

1. Austerity
2. Debt reduction
3. Increasing the money supply by lowering interest rates to zero, continuing it with the central bank purchases of bonds as interest rates fall to zero
4. Income transfers

The first two reduce income and consumption. All are necessary, although few are desirable. They also produce less unwanted effects and, when going into excesses, more harm than good. Financial discipline is necessary because there is no extra money. Savings need to be made where they have the least impact on long-term economic growth and quality of life. Excessive savings increase problems. Some economic actors must save. They can be either public or private actors. Without saving, there can be no needed investments in the long run. Some of them can be financed with the central bank´s bond purchases, but not all of them. The reason is that the government usually has too much debt.

Debt write-downs take place through insolvency, debt restructuring and forced asset sales. The latter have the greatest negative effects. Debt restructuring reduces creditors' income because at the same time the prices of assets also decrease, which also means the decreased debt collateral. The ratio of debt to asset values and income is increasing as a result. This leads to forced sales of debts as they are diminishing assets of creditors.

Forced sales lead to the sale of other assets and the payment of bank loans, which reduces the rate of money circulation, which accelerates forced sales, which leads to deflation, i.e. an increase in the value of money if the printing of money does not prevent it. At the same time, paying off debts adds to the problem of paying off debts as they increase as the value of money increases. The value of the business decreases, reducing corporate returns, which in turn reduces production and employment and increases bankruptcies. They lead to pessimism and a lack of confidence which lead to hoarding which reduces the speed of money circulation. The negative spiral feeds itself, shrinking the economy if nothing is done about it. During it, it is difficult to produce sensible indebtedness.

The worst thing that can follow from forced sales is a lack of trust between creditors and debtors. This means that no companies or governments can borrow money. Payment transactions cease to operate and society is paralyzed for hours, days or weeks. Nothing can be bought in stores and people depend on others. At the same time, financial markets are likely to close for longer than regular payments. The former do not happen suddenly but e.g. the stock market is likely to have fallen for weeks or months. The situation has been close before. The lack of confidence was caught up in the days or hours of the previous financial crisis. The situation is recognized by the fact that the prices of all asset classes are falling at the same time. It may not last more than hours and offers the opportunity to buy cheaply when the risks are high.

For this situation, I recommend buying quick-to-eat foods first and taking tap water where it is possible for several days or buy large amounts of water from somewhere. You can then follow which direction the investment prices are going. At the same time, it is worth following the news about the decisions of central banks to put money on the market. If it works, the prices of asset classes will start to rise. The length of the situation depends on how faith returns to the markets.

Printing money is a necessary evil so that the financial system does not collapse and there is no depression. It is needed to break the deflationary cycle, but too much printing can produce bad problems. It is not automatically a good or bad thing. As overshoot, it can cause additional amounts of money to be transferred to other currencies, which will increase the prices of imported products. In addition, it can transfer too much money to inflation-hedged investments. It can produce hyperinflation when the value of money falls sharply. Its risk is greatest when the debts are in other currencies and owned by foreigners, but the income of people and businesses are not. Large economies with their own currencies have the lowest risks, but they can also experience hyperinflation.

The end user and uses of printed money mean a lot. Saving the economic system and increasing the growth of economic activity are the main reasons for the pressure on money printing. The end user can be the state, other public actors, companies and citizens. There are many possible uses: investing in tangible and intangible capital such as infrastructure and know-how, maintaining bankrupt companies by buying their loans, buying other assets, direct consumption, savings, etc. The first use is usually to buy loans, without which the economic system becomes too likely to collapse. Economic activity will increase as asset prices rise and the potential for growth-generating investments will increase as the availability of money improves. The rationality of the state and public actors determines the usefulness of the investment.

Ultimately, the question is whether the benefits of printing money outweigh its less desirable effects. In the beginning, it produces the greatest benefits. The more the operation is utilized, the lower the relative benefit. The result is ever-increasing bond purchases. In the end, the situation may be that the disadvantages outweigh the benefits. The relationship between the disadvantages and the benefits of printing money is impossible to determine no matter what central banks or other financial experts say. One common denominator for central bankers deciding on printing is that they have no idea of the undesirable effects of their actions. They are missing from the models they use. The following list tells about possible side effects:

• New massive revaluations of bonds and other asset classes

• Non-functioning price formation in various assets

• The emergence of an interdependence between priting and the financial markets

• Decreased long-term productivity growth

• The growth of zombie-companies and the favoring of large companies at the expense of small ones

• Moral hazard

• Negative side-effect of rewarding fools

• Increased wealth disparities leading to internal conflicts

Money going into government and corporate bonds naturally raises their prices. They can become insane. Market participants buy bonds so that they can sell them to central banks at a higher price. This will raise prices even further. If central banks buy too many bonds, there will be absurd self-sustaining price increases. In the end, prices are so absurd that bonds are mostly bought only by central banks. This means increasing negative real yields on bonds. At the same time, the prices of other asset classes are rising as some of the printed money flows into their prices. Although the intention is to put money into the real economy, the biggest benefits flow elsewhere, to the wealthy.

Excessive monetary pressure means that the prices of bonds are not determined by the market, but the real price makers are in the central banks. It leads to the markets´ dependence on them. They start making their biggest moves depending on how central banks signal the amounts of printed money or bond sales. The latter is a rarer phenomenon, but it happens when central banks believe they have gone too far. The market may crash if this dependency exists. In that case, the catastrophe is ready to happen if the central banks do not stop selling. It might happen anyway.

When most of the money goes to rising asset class prices, the real economy suffers in the long run. There will be no productivity growth because no sensible investment is made and the money goes to other uses. In the worst case, they go into the survival of companies that should go bankrupt. These companies are unable to make investments but keep themselves alive. Maintaining them is the same as peeing on the leg in the winter frost.

Bond purchases favor large companies because small ones are unable to obtain financing by selling bonds. They finance their growth either with the owner’s assets or with bank loans. Smaller companies are better able to adapt to change, but the benefits to the overall economy diminish when purchases favor the large companies. Few of them are as productive as more efficient small businesses paying more for their loans.

Printing money rewards the wrong kind of risk-taking because fools who buy too expensive assets don’t suffer so easily from their mistakes. They get the reward even if they make mistakes paid for by others. In this case, the others are taxpayers who receive the invoice e.g. as rising costs of living. At the same time, executives who have used the cash flows of their companies either for excessive dividends or to buy their own shares are rewarded. When companies are bankrupt because of these acts, the purchase of bonds in cash will save them. At the same time, company executives will be able to increase their share-based bonuses.

Wealth disparities will increase if money is not distributed to citizens. The printed money is then mostly transferred to the prices of the assets, which can cause internal conflicts. The feeling of injustice is growing, although the majority of the population does not understand why wealth disparities are growing. Printing enriches the already rich more than the ordinary people. The latter relieve their pain through violence or hatred towards the former. If the situation persists, politicians may begin to feel tempted to distribute money directly to citizens. This is one sign that indebtedness is escaping central bank control. As an isolated case, the situation is not bad, but the transition to a continuous distribution of money will destroy the currency.

When citizens receive free money, they can put it for consumption, investment, debt repayment or savings. The desired destination for money is private consumption. In this case, some of the money is forced to be saved because it is the result of a bad economic situation. There is little to reserve for extra consumption. Where the money mostly goes depends on the needs and wants of a large section of the population. Different nations can consume, save, and invest in different ways. In the United States, money is more likely to go to investment than, for example, in Europe. This, too, produces undesirable effects, as unemployment can be a prerequisite for access to money. Not everyone wants to go to work because they can get almost the same money for free. Again, an excessive distribution of money does not make sense.

Over-indebtedness generates deficits in the economies and smaller public actors, regardless of whether money is printed. It can also produce currency escape. Capital can look for better returns abroad. The state can create mechanisms to reduce it. One way may be to restrict or prohibit the transfer of currency by imposing high taxes on currency transfers. Smart money always finds a way to circumvent these restrictions. On the other hand, ordinary citizens cannot do it. This increases wealth disparities and tensions between the rich and the poor.

Tax increases are one way to raise more money for the administration to distribute. They are less popular with the public than printing money because they are better understood. The lower amount transferred from salary to personal account is a signal of higher taxes. The same applies to the taxation of consumption. It is easy to read the tax rate on trade receipts. The same is true when higher taxes are passed on to product prices. If the withdrawals are large, they will lead to tax planning for large capital. Ordinary citizens cannot do it as effectively. People can move out of the country or move to places with lower tax rates. The latter applies to countries that do not have common national taxes. There are numerous tools for tax planning, but the former are perhaps the most important.

Debt Cycles part 1. Introduction and Short term cycle

 Debt is, at its simplest, a promise to repay a sum of money borrowed later. It may involve interest and other debt service charges. Payment of interest usually means an extra portion of the amount borrowed that is payable over a period of time. The creditor wants the interest rate to be higher than the cost of borrowing and the rate of inflation. It wants the value of the money to be depreciated in excess of the total amount of money repaid and interest over the loan period. In other words, real returns must be positive. A sensible debtor wants a used debt to bring a positive real return. Sometimes it makes sense to take on debt with a negative real return to avoid complete economic collapse. In other words, the debtor buys time to get his finances in order.

The debtor becomes insolvent if he is unable to pay the debt. To do this, he has to provide collateral. The creditor must make a probability assessment of how well the debtor can pay his money back, either directly from the debtor or by redeeming the collateral. The more uncertain the repayment and the lower the security, the higher the interest the debtor will have to pay. This happens when the creditor understands the situation of the debtor. At the peak of debt cycles, creditors’ lack of understanding of debtors’ ability to repay is at its greatest.

The best understanding of the role of debt in the economy is obtained by looking at remittances in the big picture of the economy. In the following equation, the sources of money are on the left and the uses are on the right:

Money + Liabilities + Income = Consumption + Assets + Savings

The equation is bidirectional. For example, consumption is the income of the counterparty. Some of the increased money supply from the left side can be consumed, some can be used to buy assets or put into savings. When the central bank tightens its monetary policy and interest rates rise, debt is often reduced. This reduces consumption and / or the purchase of assets which reduces revenue. The opposite phenomenon occurs when the interest rate decreases. It will increase the amount of debt which is likely to increase consumption which will increase revenue. Both are self-reinforcing series of events. By looking at the varying amounts of the parts of the equation, you can see how the debt cycles are progressing.

Short debt cycle

Short debt cycles normally last 3-8 years. The length depends on the previous cycle and some other factors like changes in central banks´ interest rate policies. The further it progresses and / or or the deeper the economy goes down the longer the next one will last. What I mean is how much excesses people, companies and central banks have made. The worse the over-indebtedness, the longer the damage will be repaired. The short debt cycle is also called the general economic cycle. As I mentioned earlier, central banks regulate short debt cycles mostly by either tightening or loosening monetary policy. This is mostly done by raising or lowering interest rates. Exceptions arise mainly from the bursting of a debt bubble at the end of the long debt cycle.

Short debt cycles can be divided into four parts: growth, peak, decline and recession. Growth starts at the beginning. Interest rates are low and borrowing is easier. Demand for interest-sensitive products such as housing and cars is growing first. Growth is initially rapid. Unemployment is falling and the average working week is lengthening through rising demand and output growth. Inflation remains low despite debt increases and economic growth. The best investment targets can be found in equities. The situation for commodities and inflation-hedges is deteriorating. Later, economic growth will slow temporarily. Inflation will remain low, interest rates will fall and stock prices will calm down. The decline in the prices of commodities and inflation-protecting assets is slowing down.

At the end of the growth, the pace accelerates. Wages are rising faster and production capacity is coming back. Inflation is accelerating, consumption is peaking and interest rates are rising. Equities make their last rise in the cycle before falling, and inflation-hedged investments perform best. The peak is coming because the economy has overheated. The latter will lead to tightening of the central bank's monetary policy. Liquidity is declining and interest rates are rising. Economic growth is starting to decline. The amount of money is shrinking and the growth rate of debt is declining. The stock market will start to decline before economic growth goes into the red. Eventually the recession will hit.

Economies are in recession on average 10-12% of the time. During them, economic growth will average -3%. At the beginning of the recession, the economy is shrinking. At the same time, the prices of shares and inflation-hedged investments are falling. The central bank is not loosening its monetary policy and inflation is falling. In the end, the central bank fears recession and deflation, so it loosens its monetary policy. Interest rates fall and stocks rise. Commodity prices are low, as are inflation-hedged investments. With low interest rates and rising stock prices, we are moving from a recession to the beginning of a new cycle.

The operation of short cycles depends much more on external factors such as major natural disasters like pandemics and wars. The latter are wars between great powers and neighboring states. Less often, export bans like OPEC`s regulation of oil production have effects on cycles. Utilizing short debt cycles in investing requires skill which most of us do not have. I cannot recommend anyone to take advantage of them. It is easier to understand longer cycles.

One of the best signs of a recession is the shift of the yield curve to negative. It refers to a situation where the interest rates on longer government bonds are lower than those on their short-term bonds. This usually occurs about 12 to 18 months before the recession. The exact timing of interest rates does not tell the future recession. This indicator is not easy for an investor to take advantage of. It may be used as a signal to increase cash position for future investments. It can be seen as an indication that the leverage should not be increased. Stock prices can also predict a future recession 6-12 months before that, but they are a more uncertain indicator. They can be used more to invest in other asset classes.

Recessions are poorly predicted. This is true for both amateurs and professionals. The latter manages to predict a recession when it is underway. According to an IMF research paper, between 1992 and 2014, economists out of 153 recessions in 63 different countries managed to predict only 5 in April of the previous year. Instead, in October of the recession, economists correctly predicted 118 times out of 153 recessions. It can be said that economists ’predictions of a recession are not worth reading or listening to.

World leading economy cycle part 3 Dropping from the top and brief overview of the whole cycle

 Reaching the peak probably includes a double-digit number of short debt cycles and usually at least one long debt cycle. I will discuss the peak and fall in more detail later, in a long debt cycle. The road to the top leads to the sowing of the seeds of the fall. Prosperous times increase people’s incomes which makes the cost of labor more expensive. The competitiveness of labor is declining. The smartest, disadvantaged nations know how to select the ways that work best for them from the ways produced by the top nation, which further reduces its competitiveness. Copying is easier and faster than developing anything new which improves their competitiveness at a lower cost.

Newer generations will replace those who have raised the nation to the top of the world. They are accustomed to wealth without as much effort as previous generations. They have not experienced time without wealth. They demand more of their free time which reduces work ethic. More money and less work will lower the nation’s productivity compared to its competitors. If it lasts long enough, the country's relative situation will deteriorate too much.

The reserve currency position of a leading economic country allows for a high debt burden. Consumption and borrowing capacities are growing first, leading management and citizens to believe in a strong economy. The country is growing its army and fighting to maintain its leading position in the world more than is necessary. In the end, the former consumes more government resources than brings benefits. At the same time, citizens are spending more on borrowed money. The former will improve the chances of the country and its citizens to borrow abroad as the reserve currency strengthens. They increase wealth disparities. Citizens' ability to cooperate deteriorates as the wealthy safeguards its interests at the expense of others.

The decline begins as the peak surpluses turn into declines and the interests of the rival nation strengthen. The central bank’s ability to increase debt and economic growth will be lost and at the same time the nation is hit by a recession or depression. This leads to the printing of money which leads to an excessive depreciation of the reserve currency. The relative position of the poor is deteriorating more than the prosperous, increasing the popularity of political extremism. The former require the latter to take action to reduce wealth disparities, i.e. they want income transfers by raising taxes. The wealthiest transfer their wealth to safety with a lower tax rate, which further weakens the position of the poor.

These factors reduce productivity and the wealth distribution is reduced. In the worst case, the result is totalitarianism like Hitler's Germany. At the same time, a rival nation can challenge a leading economic country, which increases the potential for military conflict, which in turn increases the number one country’s spending that it cannot afford. It has to choose between either military conflict or avoiding it. The decline is further in the long debt cycle.

Brief description of the progress of the cycle

The cycle of a leading economic country follows the same formula. It begins with a new world order and ends with the birth of a new one. In the beginning, the leading economic country will determine the creation of new rules. It has the most power. Now such actors are e.g. The IMF and the World Bank. In the end, power is gone. The next leader contributes to the renewal of the rules or orders the creation of new ones. If a new world order emerges through military conflict, then the most likely new leader is its winner.

The economic situation of the leading country is the best at the beginning of the new world order. The country probably doesn’t have much debt. The debts of others to it are much greater. In the coming decades, the country will prosper. It develops as short-term debt cycles fluctuate, so does the economic growth. During fluctuations, economic agents become slightly more indebted on average until a large-scale debt bubble is created, for which the country's main economic operator, usually the central bank, will have to lower interest rates to zero. At the same time, it will have to grow its money supply, otherwise it would result in massive bankruptcies and / or long-term deflation. Excessive monetary pressure leads to hyperinflation and / or other economic catastrophe. A suitable amount of printing is difficult to accomplish in the long run.

Debt bubble management tends to weaken the financial position of taxpayers in relative terms the most because they have been used by the smart money. The latter usually has so much power that it does not have to pay as high a price as it should. Taxpayers become bitter towards the rich which adds to internal contradictions. The bitterness is also compounded by the fact that money supply is increased until its benefits to the national economy go to zero. The purchasing power of the people is declining as the prices of various asset classes rise despite non-existent economic growth. At the same time, income disparities are widening.

Too much bitterness can lead to the division of the people which can lead to a civil war. Another option is for the people to find a common enemy and fight against it. Whatever the conflict, it will eventually lead to debt restructuring and a renewal of the political system. After these, a new world order is born. Although the above-mentioned course of events present themselves mainly as separate events, many take place at the same time as possible wars and political reorganizations.

World leading economy cycle part 2. Reserve currency

 Although the reserve currency is the most important and easiest indicator of a leading economic country, it is one of the laggard indicators. Currencies act as a medium of exchange. Reserve currencies are the largest single components of the world's central banks and other financial institutions in their reserves and the most important individual trading instruments. Now the US dollar is the most important. It accounts for about 60% of the reserve currencies. The second most important reserve currency is the euro, which accounts for about 20%. Others come far behind in single-digit positions. If you count gold as your reserve currency then it is the third most important. The position of the dollar as the main reserve currency is the result of World War II and subsequent international agreements.

There are three requirements for a reserve currency: it must retain its value in the eyes of the people, it must be an accepted trading currency around the world, and it must be accepted by governments, central banks and other financial institutions. Currencies retain their value better as central banks retain them as additional reserves. There should be enough, but not too much, reserve currency in circulation. Its position may be lost if the latter occurs. Mainly a large-scale war or a failed repair of the destruction of a long debt cycle can lead to the loss of the position.

The values of the trading currencies must not fluctuate excessively as they move between the parties. The less the value of a currency fluctuates, the more suitable it is for trading. A currency is only suitable for trading if its value is believed by both parties to the trade. Large fluctuations erode credibility. When credibility is lost, the currency is mainly suitable for wiping the back if it does not have real estate in the back. Confidence can be lost without a warning or little by little. Large fluctuations occur when there is not enough currency in the market.

Regulatory approval is required. This means, among other things, that it is up to the central banks to increase and decrease the money supply. It means that the reserve currency acts as an instrument of power for the authorities that govern it. Therefore, Bitcoin or any other privately managed virtual currency will never achieve reserve currency status. This will never be said out loud by any central bank or government. Cryptocurrencies will be banned if they threaten the status of the former. The reason given is something else such as use as an instrument of crime or environmental damage. The increase in the market share of virtual currencies will lead to bans.

The world's largest economic power is practically always found in the country that dominates the most popular reserve currency. For example, the United States may choose to exclude any actor that uses their dollars in trade. In addition, the country has the most decision-making power, e.g. At the World Bank and the IMF. The reserve currency cycle usually has three stages:

1. Extensive agreement on new reserve currency + coupling to real assets like gold
2. Decoupling and switching to a free currency
3. Depreciation compared to the new reserve currency

The change in the reserve currency requires a global crisis or a massive debt crisis in the country administering it. They may cause the value of the reserve currency to collapse. In most cases, this has been the first situation. In most cases, it requires a massive debt crisis. The global crisis is almost always a major military conflict. It does not always mean a loss of reserve currency. In a war, the ruler of the previous reserve currency goes into war with another major country, causing the new ruling country to become the most powerful country in the world. An agreement on a new reserve currency often allows for the largest share of votes in global economic organizations. For example, the United States has the largest share of votes in the IMF.

An agreement often initially involves tying money to real assets, such as precious metals. A certain amount of money equals a certain amount of them. Money may not be in circulation more than an equivalent amount of precious metal. In the first phase of the current cycle, one ounce of gold was equivalent to 35 US dollars. The good thing about the arrangement was that it was harder to produce inflation because it was difficult to increase the amount of gold and thus the amount of money. The downside, again, was that the amount of gold could not be increased enough compared to the growth rate of working-age people. In other words, more people entered the market than money. The solution is problematic in the long run and may limit economic growth.

The previous solution lacks sufficient flexibility in terms of the value of the currency. Before long, the state managing the reserve currency will move to the second stage, i.e. scrap the link to real assets. The United States did so in 1971. This increases long-term inflation and may cause short-term inflation to accelerate. In addition, the price of real estate pegged to the reserve currency will increase because the price used for pegging is likely to lag behind its real value. Stock prices will also rise, at least in the long run, as the amount of money grows even faster and some of it is transferred to shares.

Inflation rose in the 1970s, but that was not the only reason for it. It was also affected by OPEC's actions. The money supply is based on a decision by a central bank or other financial authority to print the amount it deems necessary for the reserve currency. The price elasticity of the reserve currency is increasing. This is the best way to act in theory. It works for a long time, but not indefinitely. It's easy to go too far. In the end, the result is the loss of reserve currency status.

World leading economy cycle part 1. Rise to the top

A leading economic country dictates the basic rules of the world economy. Others have to follow them if they want to cooperate with it. They are more likely to run into financial difficulties if they try to deviate from the rules it creates. They can also ensure that weaker economies do not catch the lead. The United States has been acting ruthlessly for a long time. The same is expected from the nation that dictates the rules next time. The cycle includes three phases: rising to the top, staying there, and falling. Operating at peak includes a reserve currency cycle. The leading country changes after the country has gone through the cycle. This is as natural an event as the rain in England. The duration with its stages is about a century. The rise and peak are slow, but the decline is fast compared to them.

The more economically developed a state is, the more it is hoping weaker states will follow the rules of the market economy. This means that more developed countries should make sure that weaker countries do not exploit practices that are unfavorable to them. This is especially true for the biggest competitors. The closer the countries are in the development cycle, the more this matters. The United States should not care about Bangladesh, but China is another matter.

The leading economy is in many ways the leader of the world economy. It has the largest share of world trade, is the most competitive, controls the main financial center, is a leading technology developer and industrial country, has the best education, a reserve currency, and has such a strong military power that it cannot be shaken by war. It is also likely to be a ruthless economic actor that will discipline other countries, if necessary militarily, if they threaten its interests.

Rise to the top

There are several roads to the top, but together they are the most efficient way to get there. Wealth can be created by harnessing domestic intellectual capital to develop the products and services that others want. It can be created by finding natural resources within its borders that can be resold to other nations at a higher price than the cost of exploiting them. In addition, there is a third way.

Imagine a country where tariffs on industrial products have averaged 40 to 55 percent for decades, the majority of the population is not allowed to vote, votes are bought, elections are cheated, and the government does not hire workers without the permission of those who bought the votes. In addition, the state economy is on the edge, the country has gone bankrupt and foreign investors are being discriminated against, especially in the banking sector, and shareholders cannot vote if they are not citizens of the country. It also has no competition law. It allows cartels and monopolies and does not care about foreigners' intellectual rights. What is this country? The answer is the United States in the late 19th century.

Lie, steal, and cheat. These three commandments of striving for the position of a ruling state in the world economy run counter to those who believe in Western values ​​and the rules of the game in a market economy. These are often necessities for those aspiring to become dominant economies. The three commandments have also been China’s means as it strives to become a leading economy. Warfare requires a bit of explanation because people perceive it mainly as a military conflict. In this context, it means e.g. a currency war, one way of which is to manipulate the exchange rate to create. In addition, it means protectionism, etc.

Getting to the top doesn’t just mean breaking the rules. It means improving the factors that are important for the economy at home. The journey to the top requires e.g. a large workload, a people whose vast majority adhere to common rules of the game, cooperation between citizens and government, high-quality education, finding new ideas from abroad, importing top foreign professionals when needed and investing heavily in the necessary infrastructure and high quality of leadership.

The above will lead to a prudent investment of capital, high productivity and the creation and the use of new competitive technologies. These will increase the country’s share of world trade which will require a strong army so that trade is not jeopardized. The above factors attract large amounts of foreign capital, which reaches the country's stock markets, foreign exchange and credit markets. Eventually, they will become more attractive than in other countries, so in the end, the reserve currency will also be held by a leading economic country. The reserve currency has its cycles.

National economic development cycle and investors

The significance of the economic cycle for the investor depends on few things. Index investors are in a particular need to understand that in addition to price. The stage and direction of the development cycle tell about the potential for long-term returns. The duration of the phases can be decades or centuries. In such a long run, the investor is often dead. The nation´s internal direction of the phase indicates about the return opportunities. A downward-going state is rarely able to change direction before moving on to the next development phase. Changes in direction require radical changes in social systems and citizens' thought patterns. Here are some examples of my estimates for countries at different stages of development:

1. Ethiopia, South Africa, Bangladesh, India, Ukraine, Bulgaria, Brazil, Bolivia, Cuba
2. Malta, Czech Republic, Slovenia, Cyprus, Puerto Rico, China mostly
3. Luxembourg, Singapore, Switzerland, Norway, Denmark, the Netherlands, Sweden, Canada, Germany, Australia, major cities on and around the east coast of China
4. United States
5. Portugal, Japan, Spain, Italy, Finland, Belgium, France, United Kingdom

My thought process was not entirely clear in which category any country should be placed. Instead, the direction of development was easier to notice. It is clear that many impoverished countries that are clearly going downhill have been rich, but whether they are impoverished or still rich is more difficult to assess. Such countries, I think, include at least Japan, Britain, Finland, and France. It is clear that the direction is downwards. The location of the countries in the second phase can also be difficult to see. As an outsider, it’s hard to see if people really feel poor. China is a difficult country to evaluate because the countryside is poor, but big cities are more prosperous. The United States is an exception because of its reserve currency status. It will allow it to become more indebted than other countries without moving to the fifth stage.

The importance of a direction to stock index investors often depends on the state. For example, the direction in Finland is downwards, but most of the large companies on the Helsinki Stock Exchange are export companies, whose results and turnover mostly come from elsewhere. The same does not apply to all other countries, such as the United States and all its indices. The Russell 2000 Small Business Index is more dependent on the direction of the state. Equity investments, mainly in companies operating in the internal market, are subject to the same rules as for equity index funds.

One of the main factors behind the change in direction is the taxation of investors. A downward trend often means tightening taxation and an upward trend. Investors in export-dependent countries need to monitor tax developments. Bond investors also need to understand where countries are and in what direction they are going. On average, the debt of improving countries is falling and that of backward moving countries is rising. Debt securities of a leading economic country are generally considered to be the best asset hedges. Their attractiveness only diminishes when the position begins to look precarious. It may then be too late to respond to maintain status.

National economic development cycle, a short introduction

Ray Dalio has divided national economies into four different stages of development. I will use his assessment, but I will add more to the phase of the country that dominates the world economy. This position encounters few countries and even less often the same country reaches it more than once. Every economy has started from the first or lowest level of development which means that the country is poor and its citizens feel poor. Few countries reach the top level, the dominant economy in the world.

Most third-stage nations do not reach this stage. They jump straight to the fifth. The paths contain similarities and the same cause-and-effect relationships, but no country follows exactly the same path as the others. The levels will remain for decades and their changes will not happen fast. Each phase includes both ups and downs and booms and busts. Psychology contributes to the rise and destruction of nations or to their own level of development. It has five levels:

1. A poor nation that feels poor
2. A rich nation that feels poor
3. A rich nation that feels rich
4. A country that dominates the world economy
5. An impoverished country that feels rich

Stages are estimates of how the government and citizens, on average, see things. In many countries, individual provinces, geographies, cities, and residents do not feel that their state is at the same stage as the majority. Often the capitals of countries are richer than others which can be due to many things like corruption in poorer countries. The definitions are not clear. They are based on the opinions of the person making the assessment, with the exception of the country that dominates the world economy, which is self-evident to almost everyone.

The foreign investor needs to look at the transitions between stages. They last for years or decades. The functioning of a market economy increases as nations develop. The opposite trend is likely on the downside. The cause-and-effect relationships of transitions are not simple. Their effects often last for decades. Moving from a lower level to a higher one can mean a long period of favorable economic development. It is reflected in increased returns for investors. Dropping to a lower level weakens the expected returns. Changes are difficult to detect without visiting the country. This is especially true for lower tier countries. Reality and the outward image are not always close.

A long psychological / socioeconomic cycle part 3. Investing and the cycle

 Why are different phases and archetypes important for the investor? They tell about the rhythms of the past and the future. The time periods are not duplicates, but they have similarities. Phase identification increases the likelihood of estimating what may happen in the coming years or decades. This applies to both life and investing. At the same time, it increases the likelihood of better understanding and better responding to world events. In addition, the outcome of the Crisis indicates that most of the next cycle will follow the outcome. The emergence or non-emergence of totalitarianism determines the opportunities for people, companies and financial markets to produce prosperity.

In the following sections, I review the financial characteristics of different phases that are important to investors, price changes in different asset classes, etc. It is difficult to find historical prices for asset classes beyond a hundred years, so statistical significance is low. Careful interpretation of the historical prices of asset classes must be taken, in order to make better conclusions.

High

The economic characteristics of the High that reflect the Crisis are favorable productivity growth if the Crisis has not led to leftist rule, high taxes on individuals and companies, large infrastructure projects, a new leading economic nation, an emphasis on a unified culture, mostly positive economic growth, and a reduction in stock market volatility. The latter most likely apply to the first decade of the High. In addition, during the High, the largest age groups in the new cycle are likely to emerge, replacing the largest age group in the previous cycle. The departure of the latter will significantly reduce pension liabilities.

During the High, the highest personal tax rates inherited from the Crisis are insane compared to today’s world. They are likely to be well over 50%. The percentages depend mostly on the magnitude of the destruction of the Crisis and the people rising to power. Depending on the nation, corporate taxation of profits can also be more than 50%. High taxes will remain through the phase and the change will then be in a lighter direction until the end of the Crisis. Change may not be slow. High taxation is needed for massive infrastructure projects, such as the possible modernization of energy production and the construction of new roads. Investor tax planning is important during the High. The long-term investment horizon is the most preferred because of taxes.

As the economic winner of the Crisis is allowed to create new rules for the world economy, it will have the greatest influence on the possible change in the reserve currency and the creation of the new worldwide economic organizations. This applies to Crises with global implications. The new reserve currency is most often pegged to precious metals in this phase, which can mean, for example, a fixed price for gold for decades. It can also lead to the decline of precious metals. These can happen during a Crisis, so it is uncertain whether any individual will keep it in storage. Gold may not be eligible for investment.

Of the asset classes, commodities may be more expensive than historical averages in the wake of the Crisis, but their price trends during the High will move downward. In the beginning, interest rates on bonds are usually lower than average, but they are rising. Property prices are special in that they don’t depend much on the stage of the cycle. They are on a sharp rise at some point during almost every phase. The intervals between their peaks are 15-30 years. In a market economy, stock prices rise more evenly than in other stages of the cycle. This is one of the best times for a long-term equity investor. The most favorable development will take place a decade after the beginning of the phase and the average price fluctuations will be smaller than in other phases. This is partly because the memories of the Crisis are strong in the nation and collective insecurity is present.

Companies have good opportunities to succeed in at least the following industries: infrastructure construction, all industries related to children, and all products and services that emphasize coherence. For example, market leaders are likely to increase market share because people want to consume the same products and services as others. The position of monopolies or oligopolies is hardly challenged during the phase. Finding them on the stock market can guarantee higher than average probable returns for a couple of decades. These can be state-owned companies. Equity investments should be considered as long-term investments if it is possible for the age of the investor.

Awakening

The investments and returns of the Awakening will be affected by the events of the High and its progress. One major change is the entry of the largest age groups into the labor market. In this case, the real estate market requires additional investments and at the same time prices may rise. With larger families, larger apartments can be traded better. Infrastructure inputs investments will decline compared to the High. At the same time, prices for construction-related raw materials may rise.

The steady growth that began during the High decline badly at least once during awakening. This has been the case in the United States during the last four Awakenings. Inflationary pressures are rising as large age groups consume more consumer goods and services. Although the last time it was hit by high inflation, it is not the only possible outcome. Deflation can strike. Coupling between the reserve currency and real assets may break. In that case, investing in the latter is a viable option. At the same time, government bond yields are likely to soar for a long time to come.

The Awakening is not the golden age of the stock investor but vice versa. Real dividend income can go into the red. Companies are not seen as an important part of the economy. During that time, companies related to culture, spirituality and drugs are doing well. Mass events can be good investment targets. Intoxicants, both legal and illegal, are more popular than in other periods. It is worth putting your money in the companies that sell them legally. Financial market developments fluctuate.

Unraveling

During the Unraveling, the probability of the economic boom or bubble in a person’s lifetime is the greatest. There may be several, but one of them is larger than others. The largest one is not always related to stocks, although it was during the previous two Unravelings. The stock bubble is not always the most destructive. The absurd consumption of external signs of wealth is the most significant feature of the phase. Consumption binges are visible everywhere. They appear as expensive consumables, expensive individual products, etc. At the same time, the nation can become indebted.

Even in a Crisis, it will take a long time to find out the devastation of the boom or its eruption. The period has far-reaching implications. They appear e.g. as the largest inequality. The devastation can only be solved after the end of the Crisis. Belief in new, life-changing consumer technologies is high and the public can buy them massively. The number of companies related to the boom is the highest. Most new technology companies crash, but the best ones remain. The prices of their shares will fall after the crash of the stock market bubble. Some will return to pre-crash or higher prices, but it will take a long time.

The phase may be the golden age of the banks as individuals become indebted when they participate in the boom. This can be reflected in high property prices. Bank bubbles are possible. They normally burst at the end of the deleveraging, so care must be taken when investing in banks. Bond interest rates may be high at first, but will go down thereafter. When this happens, bonds will be a great investment for a long time. Any asset class can experience a bubble.

Crisis

The whole Crisis may go into the aftermath of the economic problems caused by the boom of the Unraveling. It is accompanied by gloomy economic developments such as collapsing financial markets, high unemployment, deflation or hyperinflation, state insolvency and over-indebtedness of other economic actors, a maximum of economic inequality reflected at its worst in violence, protectionism, poverty and mass unemployment. The problems are great and require significant change. Towards the end, investor tax planning becomes important. Society realizes that economic equilibrium between incomes and costs cannot be achieved without higher taxes. This is especially true during wartime.

Techno-oligarchs are one hallmark. A possible technology bubble has burst and the winners will be able to enjoy the fruits of their labor. Domestic companies are doing better in the internal market thanks to protectionism. This means an increase in market shares in consumer-driven societies. On the other hand, consumption is declining compared to the Unraveling, as the largest and most prosperous age groups are retired and their consumption is lower than during the previous phase.

The regulation of financial institutions will increase through this phase in the event of a banking crisis in the deleveraging. Regulation follows decades of development. Companies with significant tax-deductible losses may be better-than-normal investment targets if taxes start to rise. Healthcare and other industries related to large numbers of elderly people are likely to be a good investment.

The outcome of the Crisis is reflected in the social system of the new cycle. It is one of the most important parts of the success of the national economy, as it affects both productivity and the number of people in the working age groups over the next cycle. Economic growth is, in effect, the sum of the former, although it may be affected by indebtedness in the medium term. In developed countries, the long-term development of productivity growth in an economically viable system is about 2% per year. Productivity growth in less prosperous countries will be bigger than that figure in market economies. The number of workers is affected by both the birth rates and the migration to or from the country. For the index investor, these are the most important pieces of information.

A long psychological / socioeconomic cycle part 2. Phases

The phases of the cycle last 15-30 years. During the Civil War, the crisis lasted only five. The change of phase can be either a clear and eventful event or a gradual and ambiguous event. Each phase leads society towards the next. A new cycle begins after the Crisis. The previous cycle ended at the corners of 1945 and the current cycle then began at the High which ended during 1963. The subsequent Awakening ended around 1983 and the subsequent Unraveling most likely ended in the great financial crisis of 2007-2008. Since then, society has lived through a time of Crisis that is likely to end in the corners of 2030.

The High will begin once the main problems of the crisis have been resolved. The damage caused by the Crisis will be repaired for a long time during it. Society is slowly rebuilding itself. At the start of the High, the majority does not believe in the future. The mood is slowly rising. Faith in the future will improve to the end. The majority despises individuals they consider selfish. Self-confidence is low and group pressure influences decisions more than at other stages. The role of institutions is growing and they are expected to guide society. Birth rates are usually highest during the Peak. Family values are strong and the number of differences is low.

Awakenings are the times of the Cultural Revolution and the spiritual rebirth. People invest the most effort in developing their values. The role of institutions is diminishing and social disorder is growing. Crime statistics do the same. Demonstrations are becoming more common and some of them are causing riots. Children feel insecure and family values are declining. People are the most creative and creativity focuses on spirituality. At the end of awakenings, social orders disappear and individuals believe their inner values have improved. New values have replaced old ones.

At the start of the Unraveling, people are happy. Belief in the future is high, but at the end of the phase it will darken. The rhythm of life is fast and people think about the present. This is a time of abundance and selfishness. Confidence in governance and common institutions is low, as is morality. Spirituality is diminished, but the people are prosperous or feel that way. During Unraveling, the probability of the largest economic bubble in a lifetime is greatest. Often its consequences are corrected throughout the Crisis.

The Crisis often begins with a rumble. The mental state of society is changing rapidly. Inequality peaks. As the Crisis begins, People are divided, but it will not last indefinitely. Unity and peer pressure are intensifying towards the end of the Crisis. People see themselves as a continuation of a group more than as an individual. Institutions are changed and directed against a common enemy. Xenophobia is at its strongest and wars are likely. They are either against an external or internal threat. Civil wars hardly occur at other stages.

During Crises, responses to threats are often extreme, whether external or internal. Every effort is being directed against a common enemy. This creates tremendous destructive power and an extreme end result. The Crisis is the most important stage of the cycle. Its outcome determines the next cycle, creating a new personality for society. The end result is either freedom, totalitarianism or dictatorship. It is difficult to predict. The Crisis is closely linked to both the long debt cycle and the cycle of the leading economic country. The winner of the crisis sets the rules. This applies to internal and external relations, social relations and the economy.

National economic cycles

 Cycles related to national economies include the long socioeconomic / psychological cycle, the cycle of economic development, the cycle of the leading economic country, the long debt cycle and the short debt cycle. The first four cycles may be strongly interlinked, as is now the case in the United States. The situation is exceptional and happens about once a century in a maximum of two individual countries. Now it only happens in the United States. A short debt cycle works within a long debt cycle. Economic cycles are most important for index and long-term government bond investors. The more an investor focuses on the activities of individual companies, the less he needs to take care of the national economy and its development.

There are four components to economic growth in advanced economies: productivity, the long debt cycle, the short debt cycle, and politics. In the long run, economic growth is based on changes in productivity and the number of working age population. Policies generally do not play a major role in the short-term productivity of advanced economies. Most political agents do the same things, even if they sell it under a different name. Politics has only a meaning when there are significant forces of change in the social system. This happens on average once in a person’s lifetime. Major changes in the social system follow the socioeconomic / psychological cycle. Birth rates are also wrapped around it.

The long debt cycle is also wrapped around the socioeconomic / psychological cycle, but short debt cycles have little to do with it. They mainly produce fluctuations around average economic growth. This is mainly reflected in productivity. It is impossible for people of working age to be cloned, for now. The policy influences fluctuations mainly by regulating the state and municipal loan taps, but there are no long-term changes in productivity. The main reason why politics doesn’t matter is the basic features of man-made systems. The outputs of political systems rarely change.

The current situation requires further reflection. Therefore, there is also a part in a book which describes how the long-term cycles intertwine. In it, I discuss the similarity between the long-term debt cycle of the United States, the psychological / socioeconomic cycle, and the cycle of a leading economic country. They intertwine in a way that affects the world. It is a pity that no one knows the exact effects in advance. That’s why I focus heavily on the current situation and guess what might happen. I have a better view of the first one. With regard to the latter, it can be said that my crystal ball is fuzzy.

Bubbles, Booms and Crashes part 7. I found one, what should I do?

When a bubble or boom is found, it is clear that most investments are too expensive. It is difficult to recommend any investment. Using leverage is even less recommendable. Extremes can last longer and grow higher or decline lower than anyone thinks. They are unpredictable and not easy to predict. The peaks and crashes of bubbles and booms may seem clear in retrospect, but few succeed in predicting them. Don’t try to time peaks and crashes.

It does not mean that you should not do anything. Bubbles and booms are good moments to consider selling investments that are too expensive. Not everything is worth selling at once. It may make sense to diversify your sales of the most expensive investments. This makes sense because prices are rising higher than expected. Tax consequences should be taken into account. At the same time, people can sell their loss-making investments to reduce taxes.

Uniform proposals cannot be made for all asset classes. For example, more time should be set aside when selling houses. They are not worth buying unless you get them really cheap. The same applies to other real estate. Easy-to-sell assets such as securities require a more individual approach. Short selling, i.e. the sale of other people´s securities, is difficult to recommend because of their negative risk / reward ratio. The profit can be 100%, but the loss can be several hundred percent. Options that take advantage of price reductions are another matter, but my expertise is not enough to make any suggestions.

Once a bubble or boom is identified, the investor´s cash reserve increases, because it makes sense to start selling little by little. The buying should not be rushed. As cash reserves grow, you have to be patient as temptations to participate in the boom increase as prices continue to rise further than expected. You can pay off your debts if you have them. At the same time, it is worth increasing cash position, because sooner or later prices will crash. Then you get good investments with low prices. Lack of cash in a collapse lowers long-term investment returns. Everyone should match their money supply to their needs. For example, the age of the investor matters. The older the investor, the smaller the portion of the assets is worth investing in. There are plenty of other reasons, but I won't go into them in more detail.

The crash is a good time to buy. It may take a long time for the bubble to move from the top to the bottom. Smart money makes sure it gets to sell as much of its bubble-priced assets as possible to others. It can take years to profit from being right. Prices are also falling lower than anyone expects. Crash of more than ten percent or more than fifty percent are normal in equities and in alternative investments such as commodities and currently popular cryptocurrencies. I do not recommend the latter to anyone as they may become worthless.

In crashes, it makes sense not to sell everything fast and it is not worth trying to predict the bottoms either. They can take years or decades before prices return to the previous peak. There is no hurry. Although the rise may be rapid at first, prices will remain far from previous peaks for longer after the bubble. Tax consequences can also be considered during collapses if possible. Cash reserves during crashes are useful, because you might have to sell your best assets during them. Nobody will buy your worst investments during them.

Bubbles, Booms and Crashes part 6. Indicators

 Previously, I listed a few signs of booms such as reflexivity, money supply growth, psychological phenomena, and political factors without their more specific signs or indicators. It should be clarified how the indicators are reflected in national economies and in the prices of investment products. In numerical signals, the rate of change is important. In them, a longer-term decelerating pace of change anticipates a slowdown in bubbles, booms, which lead to crashes. There is no single sign or indicator that predicts the progression. The more characteristics you can find the better you know what you see.

Reflexivity has signs. One is to move further and further away from the average historical return. For example, stocks can be examined in comparison to the trend of ten-year average earnings per share, which has been around 17. The farther one moves from that figure, the more reflexivity is affected. As growth slows, reflexivity decreases. The interest rate of government bonds must be scrutinized because it makes more sense to pay higher prices for shares when it is low. The prices of houses or other share classes can be compared to the average trend growth for the reasons mentioned earlier.

The former is not the only sign. Declining interest rates and the fact that borrowing is based more on collateral values ​​than income are indicative of reflexivity. The first increases the chances of reflexivity and the higher leverage it requires. Higher prices combined with higher leverage increase the likelihood of reflexivity. The latter is an early signal that anticipates reflexivity. Lower collateral requirements and increases in collateral values ​​increase the probability of reflexivity and strengthen it.

In smaller countries, a significant rise in the amount of external money flows and the strengthening of the local currency signal reflexivity. So do loans to locals in foreign currencies. When foreign money notices the higher-than-normal returns offered by the local country, it rushes to the local market. Local incomes are rising and the currency is strengthening further, making the local market more attractive.

Reflexivity works in both directions. The previous phenomena also work in crashes, but they increase the decline in prices. They fall below average trends, increasing the decline, as interest rates rise, prices fall, and declining collateral levels increase borrowers’ willingness to increase collateral requirements. The transition from collateral requirements to income requirements will lower prices as revenue declines. The transfer of foreign currency away from local markets lowers prices, lowering the value of the currency, reducing the value of collateral previously issued, which also affects prices.

Several figures and indices can be examined to notice reflexivity. Changes in the supply of money tell something about it. Different countries have their own statistics. Not everyone is as reliable, but at least the US and eurozone money supplies can be tracked. There are also indices around the world to describe indebtedness opportunities such as the MBA Mortgage Index in the US, the address of the website can be found in the sources. The longer the maturity of the loans offered, the more certain the reflexivity will affect. Long 100-year mortgages or government bonds are a signal. The historically high volume of loans in the stock market compared to the indices indicates possible reflexivity.

Psychological factors are present in bubbles, booms and crashes. Let’s start with social proof and state that at its highest it applies to almost everyone. Everyone in their immediate circle is starting to have one or more people who are quickly enriched with popular investment products or have invested large sums in them, with at least a large amount of assets on paper. They are also eager to recommend their investments to others and say they are stupid if they don’t do the same. The more close colleagues or friends report on their successes and hundreds of percent returns in the short term, the closer the boom and the end of it is. The collapse has begun when the same people don’t say a word about investing or their losses. Social proof is mostly caused by amateur investors.

The progress of social proof can be monitored in Google Trends. There you can see how popular certain keywords have been at any given time. Peak moments don’t directly correlate with prices, but the highest search volumes are in the vicinity of both peaks and bottoms within a few months. The latter may be even better correlated.

Be fast! Buy before it becomes too expensive! The feeling of scarcity and hurry is one sign of a boom. Quick jumps in housing prices or multiple oversubscriptions of investment products indicate a shortage of supply or a sense of it. Low number of shares available in IPOs may be a conscious choice for listed companies. Two- or three-digit percentage increases in listed products on first trading days indicate scarcity. In the crash the supply of stocks is plentiful. This is reflected in the rapid decline. For example, a broad front before popular stocks lowers its prices in double digits on several days.

The majority of people follow a few authorities that seem credible. The latter may have been in other businesses before the bubble or boom. The general public gets promises from them where prices multiply fast. As the boom progresses, the promises increase. They sound nonsensical to those familiar with things. As the bubbles and booms progress, the warnings of the former follow, the anti-authorities of the booms, increase. At the same time, more people believe they are incomprehensible. In crashes, authorities and their promises are revealed to be either scams or their views wrong. During that time, the “Warren Buffets” will also start to get rich with their foreclosed assets. Their returns exceed averages by significant margins as the collapse progresses.

Excessive regard in one’s own abilities, possessions, and chances of success is reflected in excessive trust in both communities and individuals. The euphoria created by booms and bubbles increases confidence in significant and rapid economic growth. It can be seen e.g. as large-scale, absurd consumption patterns. Record prices are paid at auctions. You can see signs like the construction of the world’s tallest building or record-breaking massive construction projects that exceed their budgets. A sign of bust may be the interruptions in them.

It is particularly evident in individuals who, during the new economy, have earned significant returns, at least on paper, through either their investments or their business. They buy expensive cars and waste their money on status symbols. The phenomenon does not only affect individuals. One sign of the new economy is found in individuals who leave their jobs because they believe they can be investment professionals. They recommend the same to others. This “This time it is different” delusion is big.

The above factors reinforce the illusion of excess availability, but they are not all the causes for its existence. The media is a significant part of the strengthening. They give their followers what they want to hear during a boom. They want to hear that ”now is a good chance to get rich immediately,” etc. They dig up people who suddenly became rich and let them present their advice. It is common that the majority of journalists don’t understand enough to be able to question bad advice. They lift the wrong authorities on pedestals and write negative stories about how those who have invested for decades have lost their grip. They talk about how their investments don’t match short-term successes. The number of things moving from media placement is at its peak at the end of the boom or the start of the collapse. At the same time, their availability and popularity are at their highest.

There are many signs of political factors reinforcing bubbles and booms. One is tax cuts on certain investment products or real estate. Bubbles and booms may gain significant start-up momentum or accelerate as wealth is diverted to tax-advantageous destinations. Speeches by politicians and central bankers about the merits of a booming economy run rampant. Some of them may warn the public. Unfortunately, they do not lead to actions when they are important.

Promises to save investors are a sign of the moral hazard that has occurred in all booms. Promises ultimately lead to actions. Unfortunately, they are too late. The first capital injections for those who mismanaged their business are a sign of moral hazard and anticipate a boom in artificial respiration for too long. At the same time, the probability of a larger collapse increases.

The increase in the use of “alphabet soup” or other new investment products in language is a sign of a boom. Increasing supply to retail investors also speaks for itself. Their complexity can also tell about it. The more investment products you don’t understand, the more surely the bubble is growing. The deregulation is also a sign of a boom. Increasing them probably indicates the risks that have already materialized. Regulators are often late.

The interference of central bankers or politicians in market price formation are signs of bubbles, booms, and crashes. Purchases or price cuts by central bankers of investment products will increase bubbles and booms. Unexpected sales or price increases can signal or cause a risk of collapse. The boom can also be seen in the lack of supply regulated by politicians. For example, land use restrictions can tell about a real estate bubble. The rapid increase in supply indicates that the crash is approaching.

There are enough signals about the existence of bubbles, booms and crashes. Alone, they don’t tell much. Certain signals have been present in all the booms and collapses of recent decades: the shift from income-based to collateral-based lending, cheap money and the money supply it increases. Other signals are less relevant, but the more of them are found the more likely booms and collapses are present.

Crash signals are less important because they occur afterwards. They don’t help with timing of sales, but they tell about the likelihood of new investments making sense. The most important of these is the extensive and rapid price cuts of tens of percent. After that, you can start to invest carefully. In addition, “just crazy to invest now” and all the other post-panic messages on the psychological profile after the aforementioned collapses are signals of better investment moments.

Bubbles, Booms and Crashes part 5. Their exponential growth and long-term effects

The growth of social epidemics like bubbles is exponential and nothing happens overnight. They can last from days to decades. Unlimited growth has a certain profile to which four parts can be attached: the slow onset of low exponents, the rapid rise of high exponents, the peaking of rising exponents, and the decline. The first profile is clearest when not restricted or regulated. The profile changes with restrictions and regulations. Exponential growth in stock or house prices are difficult to monitor because each has a different impact on epidemics. Therefore, it makes more sense to follow the exponential changes in other figures such as money supply.

Social epidemics rarely grow steadily. They do not follow a normal distribution and their growth cannot be predicted, although claims to the contrary are normal. The exponents vary at different time intervals. They can take a backseat even if the general direction is upwards. There may be variations in the exponents due to the time of measurement. For example, the weekly variations in the current Covid-19 pandemic are so great that it is not worth looking at daily exponents but at weekly readings.

One of the most important things to monitor is the change in exponential growth. In other words, the progression of epidemics can be monitored by observing exponential changes at regular intervals. A significant slowdown in growth is a sign that the epidemic is fading. This cannot be seen from the individual figures. Sometimes epidemics end in single exponential peaks. The following fictional exponents tell of acceleration first and then decline:

1.0, .1.1, 1.3, 1.6, 2.2, 3.2, 3.8, 4.2, 4.3, 4.0, 3.2, 2.4, 1.3, 1.1, 0.9, 0.7...

In the first phase of an epidemic, the exponent is often a little over one for a long time and does not change much before collapsing or moving on to the next phase. Most of the epidemics are not progressing further. The second phase distinguishes the most contagious epidemics from others. Initially, exponential growth accelerates. It is significant and ongoing. At the same time, the critical mass of the epidemic is reached, that is, it becomes unstoppable for a moment. The exponent is often the largest after that moment and may decrease momentarily before turning back up. The trend continues until there is a gradual decrease or a short steep peak with a potentially record exponent. The former is the most likely option when the epidemic is contained and the latter when it is not affected. The peak is followed by a decline, which in most cases is on average steeper than an increase in economic epidemics.

Long-term effects

Bubbles, booms and crashes have long-term effects. The true nature and duration of the resulting collapse is impossible to assess in advance. One significant factor is how banks operate during a bubble and/or a boom. The second is the source of the money. In addition, the actions of central banks and other regulators are significant factors. In the best case, the collapse will be cleared quickly and in the worst, the consequences will be visible for decades. The more bubbles in different asset classes, the longer the footprint. Declines can be short if not all investments instruments are expensive. Therefore, the dot-com boom of the 21st century did not leave large traces in the U.S. economy as bonds and real estate were affordable.

The devastation of the banking crises caused by the big bubbles and/or booms is awful. House prices will fall by an average of 35%, stock prices by an average of 55%, GDP by an average of 9% over the next two years and unemployment will rise by an average of 7% over the next four years. Without banking crises, the devastation will be smaller on a larger scale, although stock markets, for example, may fall more. The problems without the banking crises can be repaired in a few years. The flight of foreign capital exacerbates problems if it has played a significant role. Roughly speaking, the smaller the local market, the greater the devastation that may result from the outflow of foreign capital.

The aftermath of the Japanese boom tells the harsh language of the consequences. Individual investors may never overcome their losses. The Nikkei index has not reached its previous peak of more than 30 years ago. Property prices also peaked decades ago. Even long-term index investing is not worth it when the boom overheats. The aftermath of the Japanese boom is an example of the crash of simultaneous stock and real estate booms. Not all countries will recover even in several decades. The consequences can be complete changes in societal structures such as the transition from market economies to planned ones.

Bubbles, Booms and Crashes part 4. Political factors

Political factors may include more than just politicians. These include e.g. society's attitudes towards property, other regulators and price formation mechanisms. By the first, I mean whether individual citizens or businesses have a right to their property. In socialist states, it is almost impossible for bubbles and booms to occur because the state owns everything. They may have distorted supply and demand imbalances in the form of high prices or shortages. When the state sets prices, no bubbles or booms arise. In other words, the right to private property is essential for bubbles, booms and crashes.

Politicians can decide to socialize or liberalize property rights. They can also decide how much of the revenue generated by private citizens and businesses will receive by deciding on tax rates or seizures and exemptions of property. Increasing ownership or revenue for individuals and businesses can be drivers of bubbles and booms. Reducing them can cause crashes. The former concern not only the rights of domestic operators but also foreign ones. Opportunities for action can be limited e.g. customs duties.

Politicians can decide on other regulations, such as bank solvency requirements. In addition, they decide on government indebtedness which can increase or decrease the likelihood of bubbles, booms, and collapses. More on that later. Politicians are also responsible for managing state-owned companies, facilitating, impeding or closing down private companies. The above reinforces extremes. They are rarely the decisive reasons for their emergence. They are more common as boom reinforcers, but are less used during bubbles.

Law-deciding politicians, central bankers, and other regulators are also responsible for the moral hazard strengthening bubbles and booms, with risk-takers reaping the greatest benefits while taxpayers offsetting much of the losses. The amount of insanity can multiply due to moral hazard. This can be seen e.g. guarantees provided by state-owned companies, compensation for capital required by bank losses, and other business support during collapses.

In addition, central bankers can increase money supply to support businesses or reduce their debt service costs to help businesses survive bankruptcies. For example, it is reasonable to see Alan Greenspan, initiating the current moral hazard in the United States, announcing his readiness to lower the cost of debt management for investors in the 1987 stock market crash. Since then, rescuing investors has been one of the Fed’s most significant ways to keep financial markets working. At the same time, moral decay has been created.

The role of regulators is reflected in the failure to control new investment products in bubbles and booms. New investment products increase the amount of money on the market, hiding risks. They must prevent the risks posed by complex investment products from being passed on from sellers to buyers and kept so small that they do not pose a risk to the financial markets as large losses. Complex products contain thousands of pages of information and figures. Regulators do not always know their content or risks. In other words, regulators should actually make sure that not a lot of them are put on the market. Unfortunately, this does not happen during booms except in exceptional cases.

The role of central banks in setting the price of money through changes in money supply and interest rates is undeniable, although banks can change their margins when lending money forward. There is no cheap money without low central bank interest rates or the “rumble” of the printing press. Controlling the price of money can have surprising consequences, as banks, companies that borrow money from them, and consumers can misinterpret price signals, making bubbles, booms, and crashes more likely to occur. The worst part is that they have no part in the models that central bankers use to decide the price of money.

Bubbles, Booms and Crashes part 3. Psychology

 Bubbles, booms and collapses are social epidemics and follow their principles. Epidemics have three components: the right people, the right message, and the right environment. They are influenced by several psychological factors such as social proof, authorities, scarcity principle, excess self-regard, and the illusion of availability. They increase both the attractiveness of the message and the effects of the environment on bubbles, booms and collapses. Different people have different effects on both individuals and large crowds.

The messages from the bubbles and booms are simple and engaging. They say everyone gets rich easily and quickly without much effort as long as they invest in new ideas. The message includes attractive predictions of a rise in the pattern “Bitcoin rises to $ 500,000 (now about $ 40,000)” “This time it’s different” is another message available in large-scale bubbles and booms. They often also contain a message of a carefree tomorrow and the prosperity of the nation. The message often has some truth in it, but its significance is exaggerated. The realization of the message is often far in the future, even though the masses believe in sudden enrichment and rapid change. One message is that those who do not participate in the boom are stupid.

Bubbles, booms, and crashes will not occur without massive social proof in which herd behavior is rampant. During booms, it produces a desire to buy the same investments or consume like large crowds. Crashes create a desire to sell and reduce consumption while others do the same. In them, many have to do so because they do not have enough money to consume. Roughly speaking, the closer and more people produce social proof, the more confident the individual becomes and acts like others.

Even large numbers of people can be made to act like a small number of people as long as the latter has credibility. People have an inherent belief in authority. In bubbles and booms, a small number of lucky fools can make millions while believing in the goodness of nonsensical investments because they have happened to succeed fabulously for a short time. Usually these ”authorities” tell the general public what they want to hear. They can get rewards from people like them or the media. In addition, the masses are demanding so-called anti-authorities who tell them they are wrong. They are most often people who have been enriched by the old rules and have not agreed to pay the prices produced by the bubble or boom. They are considered losers during bubbles and booms.

The scarcity principle means that the less a person has something or the harder it is to obtain it, the higher the value. In addition, it works in the other direction. The bubbles and booms in some investments have a shortage of supply relative to demand. Large-scale bubbles are mainly affected by the other side of the coin, i.e. the fact that money moves fast and enriches a large crowd. The above raises both the prices of investments and increases absurd consumption. At the same time, the real economy is growing strongly which raises the above. Too much money significantly increases stupid investment and consumption decisions.

The excessive self-regard manifests itself as excessive faith to one’s own beliefs, qualities, skills, and possessions. Faith of an increasing mass of investors strengthens with the bubble or boom to the heights rarely seen, which raises the prices of “hot” investments. At the same time, larger and larger sums of money find the above items. Faith is not even shaken by failures or losses. They are explained by bad luck or some other absurd reason, and in the worst case, the ego is further inflated. Losses and failures increase the need for investors to look for sources of information that emphasize their own beliefs and skills. One major factor in the bubbles and booms is that investments become more valuable in price as soon as they are purchased.

The excessive self-regard also increases booms and bubbles, with big money portfolio managers acting as one of the reinforcing factors. One of the truths of their work is this: "It's better to lose money like others than to do something different." Many of them protect their own jobs. This is reflected in the so-called hidden indexation of funds, where the investments of the active portfolio manager resemble the benchmark index, differing slightly from it. This also applies to other moments, but the phenomenon is at its strongest in booms due to reflexivity.

The overemphasis on egos is not limited to investors. It manifests itself in central bankers and other regulators. The majority of central bankers have had a long career believing in the theories they have learned and the models they have used. They work well most of the time while increasing regulators’ confidence in them and themselves. The performance of theories and models in the short term increases the excesses of bubbles and booms as well as the devastation resulting from crashes. It is important to ask whether the actions of central bankers and the models they use have a positive net effect?

The illusion of availability means that people give more value to stimuli that are better available. Availability can be both an external and an internal stimulus. It can be improved by an increase in the number of stimuli, recency, or characteristics. Examples of the latter are surprise, novelty, ambiguity, and threat. The illusion of availability is reinforced by the media reporting on fortunate individuals who quickly enriched and took advantage of the new message. The media is full of half-truths or misunderstandings about the basic principles of investing. The illusion of availability is at its strongest when a bubble or boom reaches euphoria. It is also strengthened by other psychological factors.

Avoiding the negative effects of the psychological factors of bubbles, booms, and collapses is not easy. There are a few good rules of thumb to reduce the effects. When you find that a security or asset class is more popular in your immediate circle than others, it is a likely sign of bubble prices. Combining the former with a new economy or investment vehicle should be seen as a bigger alarm signal. Never believe words that contain the message, “It’s different now,” whoever tells you so.

Don’t listen to people who do not have a proven track-record of investing at least a decade above the market average talking about future returns or losses, or who promise high double-digit returns on investment, even in the medium term. Their numbers in public will increase during booms and bubbles. At the same time, the number of people who are wrong is growing. During booms and bubbles, it is even more important to listen to people who have done better than average for several decades. The same is true during a crash. Also, don’t believe people who predict the “end of the world” during them.

Don’t believe yourself if you do not have a better-than-average return rate, or think you’ll be able to achieve high double-digit returns in the medium term. Don’t let your ego make you believe you are right when the price of an investment collapses well below the amount you paid. This is especially true of the losses caused by the crash. You don’t have to prove you’re right by immediately putting more money into a losing investment. This is a mistake because there is no need to quickly return an erroneous investment with the same investment target. It is safer to take a breather and think about what went wrong.

Do not look at the price of a security before making a cash flow statement. Your subconscious can steer the end result towards it when its availability is high. Do not look at the price you paid when making a new cash flow statement for your investment. Your investment does not know how much you paid. The price you pay may not matter at this time.

Bubbles/Booms and crashes part 2 Their reinforcement, and the effect of the money supply

 

Bubbles, booms and crashes reinforce themselves

The financial markets are seen to return to a so-called equilibrium quickly after they have temporarily left it. Mainstream (neoclassical) economists talk about external shocks or momentary changes created by the news that change the reality markets confront. They have a strong faith for a quick return to equilibrium that real life events do not seem to change their perception in one direction or another. Even the prior booms that offered insane prices, and the crashes that followed, have not shaken this faith. Financial markets have escaped equilibrium too far too often. The farther they escape the worse they recover without major damage. Booms and busts go too far from equilibrium and stay there too long for economists’ claims of quick returns to be true.

Exaggerations in the financial markets produce self-reinforcing prices that are too high or too low. One way to explain their reasons is George Soros’s theory of market reflexivity. In engineering terms, there is self-reinforcing feedback. The actions of market participants can be divided into two distinct parts: a situation where participants perceive a situation where they find themselves or where participants influence the situation. Reflexivity is a two-way feedback mechanism where reality shapes thinking and thinking shapes reality. The former is a chain of events where thought and reality converge but never meet. They create self-fulfilling connections that reinforce misunderstandings. Rising prices increase demand without increasing supply and falling prices increase supply without increasing demand.

Reflexivity occurs from time to time. It is important to understand it because it describes situations where misunderstandings can affect prices. Impact requires a strong two-way interaction between participants and the market, reinforcing misunderstandings that become the prevailing reality. Developments that move beyond the market equilibrium have limits. Eventually, the power of change will prove unsustainable and return the market to equilibrium with a self-reinforcing development. Reflexivity moves prices in both directions. Prices may go far below equilibrium. It rarely happens without exorbitant prices.

Effect of the money supply

It is logical that bubbles and booms require an increase in the supply of money in the market and crashes require a decrease in the supply. The above is easy to see by looking at historical statistics on money supply. There are significant differences between the bubbles and normal market fluctuations. The amount of money can rise by tens of percent in a few years. At best, they do the same thing every year. By monitoring the money supply, you can get a better picture of the magnitude of the boom and the duration of its aftermath. Following it, the outbreak of the boom can only be timed afterwards because it is only one factor in a bubble.

The majority of the increase in supply comes from the increase in debt. The increase in volume is influenced by e.g. the price and the amounts and values ​​of the securities required. As the price decreases, demand increases, increasing the money supply, and as it increases, it decreases, while the supply of money is the same. A reduction in the required collateral increases the amount of debt like increases in value. An increase in collateral reduces the amount of debt, such as write-downs. The amount of debt increases the most as prices fall, the amount of collateral required decreases and values rise. The biggest bubbles and booms arise from the self-reinforcing spiral of the previous interaction.

The worst collapses occur when the combined effect of the above raises the amount of debt to unsustainable levels, causing an inverse, self-reinforcing phenomenon in which the amount of debt decreases, additional collateral is required and the value of collateral decreases. The situation is rapidly getting worse. More on these mechanisms can be found in the chapter on the long debt cycle. By monitoring the supply of money, it is not possible to accurately assess the likelihood of a bubble. By only following it, it is not possible to assess whether a crash will occur. Without a sufficient increase in money supply, there will be no booms and the supply of money will almost never be reduced so much that there would be collapses without bubbles.

The amount of money can grow unmanageable, both on its own and with foreign aid. In the first case, government finances need to be large enough for money to grow without a significant weakening of the currency. Examples of the former are the real estate bubbles of the current century in China and the United States. One of the hallmarks of the latter is the massive cash flows from abroad that strengthen the domestic currency. The Asian economic boom of the 1990s is a good example.