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What will be the cause of the next financial crisis?

I have been studying markets and long term macroeconomic trends as both a hobby and a work related venture for quite a few years now. As an employee of the railroad industry, our traffic levels are heavily affected by market downturns. I can personally describe the effects of the 2008 market crash when traffic levels fell drastically enough to put me out of work. Whenever a market downturn begins, the railroads are one of the first industries to suffer, and the effects last longer and hit harder than those seen in the consumer goods industries such as retail. Therefore, I will cite the railroad and our traffic patterns in answering your question.

What will be the cause of the next financial crash? Well, that’s simple. The cause hasn’t changed substantially since 1913 when the Federal Reserve System came into existence and fundamentally changed the American economy from a mostly free market system to a mixed economy in which members of the board of governors exercised substantial control over the money supply. Each and every meltdown from the Great Depression of the 1930s to the housing crisis in 2008 can ultimately be laid at the foot of the Federal Reserve System and its economic policy of the time. Each crash had a unique catalyst which the history books have reflected as the “cause” but the Federal Reserve and its monetary policy have always created the market conditions which start the catalyst moving.

In an attempt to keep this response short and concise, I wont dig too deep into the history of the Federal Reserve or why it was created. Just know that the Fed was created in 1913 under questionable legislative and constitutional conditions. The Fed serves as a lender of last resort, allowing the federal government to create literally endless sums of money, passing the inflation on to the taxpayer as a hidden and “stealth” inflation tax. The Fed regulates the interest rates throughout the broader economy by adjusting the “discount rate,” or the fund rate that the federal government pays interest back to the Fed. When the Fed lowers the fund rate, the result is ultimately lower interest rates on the consumers. When the Fed raises the fund rate, the opposite is the result. See in the following table the historical Fed interest rate policy from the 1970s to the present.

With this chart in mind, lets answer the question a bit more directly. Low interest rates will cause the next financial crash, just as it has caused every other crash. Interest rates which are artificially held below their natural market equilibrium by the Fed will cause our next crash. Markets are a powerful force which cannot be truly manipulated or understood by economic policy makers and central planning boards. The true drivers of markets are you as the consumer and the entrepreneurs which run the various enterprises that makeup our economy. When interest rates are manipulated lower, the unintended side effects have always proven to be a chronic and debilitating disease which results in a boom in markets followed by a crash. The next crash will be no different.

Next I have included a chart to show the relative movement of the Dow Jones Industrial Average (blue) and the S&P 500 (green) over the last few decades. These averages are comprised of hundreds of stocks from nearly all sectors of the economy and generally tend to show the average health of the economy. These companies are vastly different from one another and are constantly undergoing mergers, splits, buy backs, dividend adjustments, capital investment, changes in management and boards of directors, changes in market conditions, changes in products and countless other microeconomics factors. Why then do they generally tend to follow one another when placed on a graph covering decades? Why would a trucking company have similar stock price trends as a retail store or a restaurant chain? Clearly there is a major macroeconomic trend which runs like a red thread throughout the entire economy. This red thread is the interest rate.

Until the 2000s, interest rates had never dropped to near zero rates. Rates rarely dipped below 6%, let alone the extended period of 0% interest rates which has lasted throughout the entire Obama administration and the Fed chairmanship of Ben Bernanke and Janet Yellen. Moderate rates meant that a reasonable rate of return could be attained through savings accounts and low risk “safe” investments such as US treasury bonds and long term notes. Regular contributions and accumulation of compound interest on retirement accounts were the smart and responsible thing to do and parents taught their children to be frugal and smart with their money and savings for retirement.

Following the more than 20% market drop in 1987 on a day now referred to as black Monday, the Fed lowered interest rates to prop up the failing economy. By the beginning of the Clinton administration, rates had fallen to 3% and remained very low, between 3 and 5% during nearly the entirety of his administration. The effects of this policy act as a drug, which stimulates the purchase of stock. When the bank lowers the rate of interest that you will earn in your savings account, you’re tempted to look for a better investment. Its natural to want to maximize your return. So, you may have been content to stay in bonds before and now you are entering into the more risky stock markets to pursue returns. When the ENTIRE economy comes to this conclusion, the stock markets rise as more and more people decide to leave savings accounts to buy stocks instead. Also during this time, the internet and home computers began to be widely used, allowing internet trades and stock monitoring in real time, which had previously required calling a broker. New investors entered the markets in droves, buying penny stock technology companies in the hopes of getting rich quick. Due to the Fed induced low interest rates, the 90s were a boom time for new investors which much of the undeserved credit still going to President Clinton, who had little to do with the inflated market rally. The real man behind the prosperity of the 90s was Alan Greenspan, the Federal Reserve Chairman.

By spring of 2000 the markets had begun to decline and the first signs of a collapsing bubble in the market were being seen by savvy investors. Despite a decline in markets in May, the Fed raised interest rates to 6.6%, the highest that they had been since 1990. Look back at the Dow Jones/S&P chart and you can see that the markets tanked immediately following this rise and the dot com bubble was over. The drug of low interest rates, more dangerous than heroin or methamphetamine had run its course and now the tweaker needed to go to rehab.

It was about this time that George Bush took office and shortly after the attacks on September 11th 2001. Instead of sending our economy to rehab and allowing the markets to naturally correct to a reasonable rate of growth the Fed gave more drugs to the addict and lowered rates to a new historic low of 1.75% in December. This was followed by more reductions to as low as 1%, and the markets reacted accordingly. It was nearly impossible to make any money in a savings account at these rates so the stock market rallied in response to an influx of buyers. With interest rates so low one would be crazy not to buy a house and thus the housing bubble, which took the blame for the 2008 crash was sewn.

Many factors lead to the crash of 2008 including banks which made risky loans to unqualified buyers and other irresponsible lending practices. The true criminals, however, were the Federal Reserve board of governors, which tricked the markets into adjusting to artificially low rates. “Teaser” adjustable rate mortgages were given to ignorant people that did not realize the ramifications of a rate increase. They were told that rates would never rise and the demand for homes skyrocketed. Not just one home, but two or three or four homes with zero money down. Rates were so low that these buyers used their homes like a credit card, taking out huge lines of credit in anticipation of selling the home for a higher price. Prices jumped hundreds of percent in some markets, an obvious sign of an unsustainable rate of growth. Banks used these unstable mortgages to sell mortgage backed securities, given a AAA rating and backed by the US government. Investors, businesses, municipal agencies, colleges, governments……everyone bought mortgage backed securities loaded with horrible sub prime mortgage loans. This is why the entire world nearly came apart in 2008.

By 2005, rates had risen 8 times and by the time Ben Bernanke became the new Fed Chairman in 2006 the rates sat at 5.25%. Adjustable rate mortgages went up to adjust for these higher rates and the markets began to unravel. The entire crash can be placed at the foot of the Fed which willfully and intentionally tampered with the natural rate of interest dictated by the uncontrollable forces of supply and demand. The results were devastating. The 2008 crash was a direct result of LOW INTEREST RATES.

Following the 2008 crash the tweaker should have finally gone to rehab. Instead, we gave him more drugs. By the time Obama took office, Bernanke had lowered interest rates 7 times and the rate sat at near zero percent, creating an un-natural distortion of market signals and leading our economy into uncharted waters. It was official: you could no longer make any reasonable return in a savings account. The only way to try to increase your net worth was to do quite literally anything to not hold onto cash. Interest rates were so low that you would be crazy not to buy a home, car, boat, atv, college or anything else that your heart may desire. Put it on credit and get zero percent financing. Life is good! Meanwhile, those approaching retirement before 2008 had lost their entire 401K’s and there was no way to make a reasonable rate of return on a safe savings account or bonds. This is the Obama/Bernanke/Yellen legacy. Zero percent APR financing!

There is a huge consequence that I’ve haven’t truly covered until now, and that is that prices rise when demand rises for a limited supply of goods. How many times have you been tempted to buy a new vehicle on the premise of “low interest rates?” Or a home? Or anything for that matter? This is only counting you……imagine the effect across every city, town, county, state, municipality and suburb in the entire United States when average people decide to buy a new whatever, simply because they got cheap financing. The result is that prices RISE rapidly. As of today, the average american pays far more for average goods than they did in the year 2000 and this increase has risen far faster than inflation in many cases. Vehicle prices alone are up on average between 30 and 40 percent since the year 2000 and some goods and services have risen hundreds of percent.

Next lets compare the Dow/S&P Chart to the rail transportation industry.

Above is a chart showing the stock prices movements of most of the major railroads in the United States. This includes Union Pacific, Norfolk Southern, CSX, CN, CP, and Genesee & Wyoming. BNSF is not included as it’s shares are now included in the parent company Berkshire Hathaway after Warren Buffet’s acquisition several years ago. Notice that there is a distinctive trend in all of these railroads. You can clearly distinguish the dot com bubble, the housing bubble and the present bubble, which I like to call the “Bubble of Everything.” Clearly, there is a driving macroeconomic trend. A red thread that weaves its way through this industry: Interest rates.

This is an amazing realization when you consider that this chart includes 6 distinctly different rail systems from all corners of the country. How does a class 1 railroad centered in Omaha Nebraska (UP) and focused in the western United States behave nearly in identical fashion to the stock of Genesee & Wyoming, which owns dozens of short lines, many class 3 railroads all over the US, including several railroads internationally? The companies are fundamentally different in management, operation and revenue, and yet the behavior of the share prices has clearly been effected in nearly the exact same way.

The answer, is that the market is fraudulent, effected by interest rates far more than actual market fundamentals which used to be the name of the game for stock trading. No more do we have to worry about those pesky statistics such as Price/Earnings ratios, revenue, profit, dividend rate. We don’t even have to worry about poor management practices as long as the share price is rising every quarter.

When the economy crashed in 2008, traffic levels plummeted as fewer commodities and raw materials hauled by rail were needed across the country. Thousands of employees were furloughed, including myself and many of us lost homes, cars, marriages and our sanity waiting for business to return to the rails. Over the passed few years traffic has increased, but never as substantially as it was before the big crash in ’08 which concurs with the common sentiment around the US that the economy generally sucks right now, regardless of what the government and labor market statistics are.

We have to remember though that the tweaker STILL has not gone to rehab and the underlying problem still persists. Interest rates are still near zero and every few months the markets stumble and attempt to fall as rumors of an interest rate hike circulate the markets. Here are just a couple recent articles that show how shaky our system really is and how reliant on the drug of low interest rates the markets are.

US Treasury yields inch higher after 30-year bond sale

European stocks close at lowest level in 2 weeks, amid U.S. interest-rate worry

Back to the railroads and their relevant ability to predict recessions, an interesting and startling thing happened in December of 2015. The Federal reserve raised interest rates by a mere quarter of a percent to 0.5% which represented a tiny budge upward and surely not enough to effect the general markets. As a matter of fact, traffic plummeted during this time and for the first time in years I was unable to work my regular assignment during the deepest part of the slump. There simply were not enough trains running. As I had predicted a year prior, Union Pacific shares fell from their high of around $120 per share to around $68 per share in a huge slump which screams recession to anyone paying attention. See the railroad stock chart and you will see that we have only partially recovered from this mess and stock prices still remain sharply lower and remember that this was only a mere .25% raise in rates. Imagine the bloodbath that will be felt throughout the entire market if rates rise 2 or 4 or 6 percent as they need to and should to attempt to return us to some financial sanity.

During the same time frame, Union Pacific has engaged in a massive share repurchase program, wasting our working capital repurchasing over 1 billion in shares during the last 3 quarters. This is a bad sign and UNP is not the only company which is participating in this type of practice. Companies such as this are artificially propping up their own shares to prevent the necessary correction and it cannot continue forever. The next financial crash will be huge. The primary cause will be interest rate manipulation by the Fed (as it always is) and the the primary catalysts will in my opinion, be related to businesses which no longer have enough working capital to continue operations after their share prices fall 50 or 60%. Secondary major catalysts will include excessive student loan debt, auto loans, home loans, and pretty much any asset class which has been stimulated by artificially low interest rates. As we have seen before, the government will bail the system out again, further leading us down the path to inflation and destruction of the dollar. As they will say, these companies are just “too big to fail” when the Fed interest rate policy set them up to fail in the first place. The Fed will continue to administer the drug of low interest rates until the patient succumbs from the cancer which infests every part of our economy now.

There were many more topics that I wanted to cover, but I wanted to keep it somewhat short and easy to read. I hope that I have at least contributed some good thoughts to the conversation. If you would like a good read on economic depressions and the “Austrian theory of the business cycle,” which I prescribe to, I would highly recommend:

“Economic Depressions: Their Cause and Cure”——-Murray N. Rothbard

“Economics in One Lesson”——Henry Hazlett

I would also recommend any of the works by Murray Rothbard, Frederick Hayeck and Ludwig Von Misis, and of course, the masterpiece “Atlas Shrugged” by Ayn Rand.

For a good introduction into the Federal Reserve and its history and shenanigans, I would highly recommend “The Creature from Jekyll Island” by G Edward Griffin

Sources:

European stocks close at lowest level in 2 weeks, amid U.S. interest-rate worry

US Treasury yields inch higher after 30-year bond sale

Costs of Everyday Items in 1999 vs. Now

Highest and Lowest Interest Rates and Why They Changed

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