Data Point To Probable Market Crash in 2010

A fundamental premise of my viewpoints relies upon the “Austrian” view of economics. As a former Keynesian, I realize how easy it is hold onto misguided views, either because of ignorance or sheer ideological support. Keynesians and their supporters (which could come from other schools of thought) believe that government intervention in the economy is necessary and beneficial. They have built theories and beliefs based on this observation. F.A. Hayek, a champion of the “Austrian” school of thought, wrote a masterpiece, Prices and Production, explaining how prices influence the capital structure of production. Prices are determined by supply and demand. The price of money, which is the interest rate, is controlled by the central bank. If the price is low (low interest rates) then there is a lot of money flooding the economy. This excess money has to find a home somewhere, typically asset markets. When the price of money increases, the reverse is true. What is important to ascertain in this brief missive is that the policy measures of the central bank determine economic recessions. Despite the belief these days, recessions are not a byproduct of the capitalistic system. On the contrary, recessions are the result of government intervention in the form of the central bank.

After the Lehman Brother collapse in 2008, the Federal Reserve Board (FED) engaged in the expansion of its balance sheet (i.e. its monetary base) in an unprecedented manner. The FED’s balance sheet represents money that is in the economy. Through fractional reserve banking, this money is multiplied many times over, consequentially causing prices to rise. When the FED withdraws money or slows the pace of its creation, its balance sheet’s must inevitably contract. Against this backdrop, prices will fall. Consider the following graph (see clear view here):


This graph illustrates the behavior of the “percent change from a year ago” (aka year-over-year or YOY) for the adjusted monetary base from 1984 to April 2001. We can easily see that the contraction in economic activity (synonymous with market crash) almost always preceded the trough of the most recent credit expansion. In other words, when the YOY figure dropped sharply, a market crash is probable. The graph should contain another shaded rectangles to demonstrate the bond market crash in 1994 and the Asian and Russian crisis in 1997.

Notice this next graph, which illustrates data for the first decade of 2000 (see clearer view here).

The gyrations in the YOY change of the monetary base were less pronounced. In fact, the downward trend was relatively smooth in comparison to prior periods. This allowed the appearance of stability to extend longer than it should have. Ultimately, however, the market ran out of steam by 2008 and the previous bull market subsequently turned bear and severely crashed. All of the FED’s liquidity facilities (TALF, TAF, etc.) have now expired; therefore I don’t expect the monetary base to continue to increase (this means rates will go up). Notice the sharp fall, hitting (what appears to be) the low in January 2010. Indeed the trend can continue lower to a YOY change between 5-10%, a percentage consistent with what was seen in the early parts of the 2000s. In light of the massive expansion of monetary policy, this is inconsequential. If history is any guide, a market crash is in the works for sometime later this year.