In Part 1 of this three part series, John Jagerson discussed a classic example of a credit crisis that occurred approximately 10 years ago in Japan. Read part 1 of “Did the solutions to the last credit crisis work?”
Credit or liquidity crises have many aspects and causes but they all share surprising similarities to each other.
In this article we need to do a little background on the real danger of a liquidity crisis which is deflation. Deflation is a natural result of a shift down in aggregate demand. To make this more clear I am going to illustrate it with supply and demand curves. These curves are not complicated.
When an asset bubble pops and the value of those assets decline, precipitously such as the real estate bubbles in the U.S. and Japan, it is usually being driven by a decline in demand. If the decline in prices of the assets in the bubble is significant enough , it may lead to an aggregate decline in demand across the economy.
That is what we are seeing in the U.S. today and what we saw in Japan earlier. Declines in demand leads to a decline in supply as suppliers cut production. This is deflation.
The end result of falling production and falling prices is that there is no incentive or need for investment. Without investment there is limited or no economic growth. We all know what a lack of growth can do to stock prices, and therein lies part of the opportunity for traders.
The similarities between the U.S. and Japan don’t end there. The subsequent strategies employed by the governments to combat deflation is important as is a discussion of the opportunities that arise for savvy investors. We will discuss these topics in the concluding article of this series.
John Jagerson is the author of many investing books and is a co-founder of LearningMarkets.com and ProfitingWithForex.com. His articles are regularly featured on online investing publications across the web.