Did the Solutions to the Last Credit Crisis Work? (Part 2)
10/21/2008 12:01 am EST
Credit or liquidity crises have many aspects and causes, but they all share surprising similarities to each other. In this video 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 clearer, I am going to illustrate it with supply and demand curves. These curves are not complicated but reviewing the video a couple times may help if you are new to this subject.
When an asset bubble pops, and the value of those assets decline precipitously such as the real estate bubbles in the US 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 US today and saw in Japan earlier. Declines in demand lead 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 US and Japan don't end there. The subsequent strategies employed by the governments to combat deflation are important, as is a discussion of the opportunities that arise for savvy investors. We will discuss those topics in the concluding section of this series.
Watch the accompanying video now: