Introduction by the Blog Author
The Federal government of the United States, having failed to budget for fiscal year 2014, also failed before midnight eastern time to agree to a continuing resolution for any period of time. This is resulting in a partial shutdown of the government.
It is the professional opinion of the blog author (as a certified public accountant suspicious of economic theories) that the prime problems with the American central government are entitlements like Social Security and Medicare, which are woeful overpromises supported by outrageous underfunding (to the tune of tens of trillions of dollars in net unfunded debt), as well as the prime error in 2011 of allowing federal debt to exceed the national gross domestic product (GDP) – for which Standard and Poors properly downgraded the nation’s credit rating -- and a housing bubble between 2002 and 2008 aggravated by a lack of oversight and further irritated by strenuous efforts, especially by the Federal Reserve, to re-inflate that bubble from 2009 to the present.
Therefore there are two critical concepts lurking behind the partial "shutdown" of the US government as of the morning of October 1, 2013: the debt-to-GDP ratio and a rational economic understanding of bubbles.
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In economics, the debt-to-GDP ratio is one of the indicators of the health of an economy. It is the amount of national debt of a country as a percentage of its gross domestic product (GDP). A low debt-to-GDP ratio indicates an economy that produces a large number of goods and services and probably profits that are high enough to pay back debts. Governments aim for low debt-to-GDP ratios and can stand up to the risks involved by increasing debt as their economies have a higher GDP and profit margin. In 2011 United States public debt-to-GDP ratio was about 100%. The level of public debt in Japan in 2011 was 204% of GDP. The level of public debt in Germany in the same year was 85% of GDP. Almost a third of US public debt of USD 16 trillion is held by foreign countries, particularly China and Japan. Conversely, less than 5% of Japanese public debt is held by foreign countries.
http://en.wikipedia.org/wiki/Debt-to-GDP_ratioThe Federal government of the United States, having failed to budget for fiscal year 2014, also failed before midnight eastern time to agree to a continuing resolution for any period of time. This is resulting in a partial shutdown of the government.
It is the professional opinion of the blog author (as a certified public accountant suspicious of economic theories) that the prime problems with the American central government are entitlements like Social Security and Medicare, which are woeful overpromises supported by outrageous underfunding (to the tune of tens of trillions of dollars in net unfunded debt), as well as the prime error in 2011 of allowing federal debt to exceed the national gross domestic product (GDP) – for which Standard and Poors properly downgraded the nation’s credit rating -- and a housing bubble between 2002 and 2008 aggravated by a lack of oversight and further irritated by strenuous efforts, especially by the Federal Reserve, to re-inflate that bubble from 2009 to the present.
Therefore there are two critical concepts lurking behind the partial "shutdown" of the US government as of the morning of October 1, 2013: the debt-to-GDP ratio and a rational economic understanding of bubbles.
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Debt-to-GDP Ratio
In economics, the debt-to-GDP ratio is one of the indicators of the health of an economy. It is the amount of national debt of a country as a percentage of its gross domestic product (GDP). A low debt-to-GDP ratio indicates an economy that produces a large number of goods and services and probably profits that are high enough to pay back debts. Governments aim for low debt-to-GDP ratios and can stand up to the risks involved by increasing debt as their economies have a higher GDP and profit margin. In 2011 United States public debt-to-GDP ratio was about 100%. The level of public debt in Japan in 2011 was 204% of GDP. The level of public debt in Germany in the same year was 85% of GDP. Almost a third of US public debt of USD 16 trillion is held by foreign countries, particularly China and Japan. Conversely, less than 5% of Japanese public debt is held by foreign countries.
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Economic Bubbles
An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is "trade in high volumes at prices that are considerably at variance with intrinsic values". It could also be described as a situation in which asset prices appear to be based on implausible or inconsistent views about the future.
Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, when a sudden drop in prices appears. Such a drop is known as a crash or a bubble burst. Both the boom and the bust phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone.
While some economists deny that bubbles occur, the cause of bubbles remains disputed by those who are convinced that asset prices often deviate strongly from intrinsic values. Many explanations have been suggested, and research has recently shown that bubbles may appear even without uncertainty, speculation, or bounded-rationality. It has also been suggested that bubbles might ultimately be caused by processes of price coordination or emerging social norms.
Impact
The impact of economic bubbles is debated within and between schools of economic thought; they are not generally considered beneficial, but it's debated how harmful their formation and bursting is.
Within mainstream economics, many believe that bubbles cannot be identified in advance, cannot be prevented from forming, that attempts to "prick" the bubble cause financial crisis, and that instead authorities should wait for bubbles to burst of their own accord, dealing with the aftermath via monetary policy and fiscal policy.
Within Austrian economics, economic bubbles are generally considered to have a negative impact on the economy because they tend to cause misallocation of resources into non-optimal uses; this forms the basis of Austrian business cycle theory.
Political economist Robert E. Wright argues that bubbles can be identified ex ante with high confidence.
In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise; this view is particularly associated with the debt-deflation theory of Irving Fisher, and elaborated within Post-Keynesian economics.
A protracted period of low risk premiums can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders.
Possible Causes
In the 1970s, excess monetary expansion after the U.S. came off the gold standard (August 1971) created massive commodities bubbles. These bubbles only ended when the U.S. Central Bank (Federal Reserve) finally reined in the excess money, raising federal funds interest rates to over 14%. The commodities bubble popped and prices of oil and gold, for instance, came down to their proper levels. Similarly, low interest rate policies by the U.S. Federal Reserve in the 2001–2004 are believed to have exacerbated housing and commodities bubbles. The housing bubble popped as subprime mortgages began to default at much higher rates than expected, which also coincided with the rising of the fed funds rate.
It has also been variously suggested that bubbles may be rational, intrinsic, and contagious. To date, there is no widely accepted theory to explain their occurrence. Recent computer-generated agency models suggest excessive leverage could be a key factor in causing financial bubbles.
Puzzlingly for some, bubbles occur even in highly predictable experimental markets, where uncertainty is eliminated and market participants should be able to calculate the intrinsic value of the assets simply by examining the expected stream of dividends. Nevertheless, bubbles have been observed repeatedly in experimental markets, even with participants such as business students, managers, and professional traders. Experimental bubbles have proven robust to a variety of conditions, including short-selling, margin buying, and insider trading.
While there is no clear agreement on what causes bubbles, there is evidence to suggest that they are not caused by bounderd rationality or assumptions about the irrationality of others, as assumed by greater fool theory. It has also been shown that bubbles appear even when market participants are well-capable of pricing assets correctly. Further, it has been shown that bubbles appear even when speculation is not possible or when over-confidence is absent.
Austrians believe that market participants´ decisions are blurred by the wrong price signals given by artificially low interest rates, which explains why many of these are "fooled" during an asset bubble (they call this the cluster of errors).
Other possible causes
Excess liquidity
Social psychology factors including
Greater Fool Theory
Extrapolation
Herding
Moral Hazard
Other causes
Examples of Aftermaths of Bubbles
Great Depression
Panic of 1837
http://en.wikipedia.org/wiki/Credit_bubble