The economic system is based on the premises that rising prices and moderate inflation will lead to the growth of institutions which in turn will allow a trickle down of benefits to all. But analytical models suggest that it has inherent assumptions of failure of some individuals at the end of the chain. Financial and economic crises are generally caused by unforeseen weird events or natural disaster or emergencies like war. The financial crisis of 2008, for instance, was due to the bubble of mortgage market that global economies faced as sub-prime crisis.
Indicators to Watch
The economic crisis lies in the mindsets of the people and corporations, risky modes of investing and finally overall economic models. There are three major indicators observed before a crisis – high debt, high capitalization to GDP ratio and high unemployment.
Crises of debt are the first indicator of economic crisis. As debt accumulates, more risk is involved and this reduces the ability of an individual to repay the debt. This creates a very delicate situation where the property is lost from one person without being physically destroyed. This eventually results in loss of financial capital which cannot be settled with any other measures. Besides, physical capital in such cases exists with ownership and without ownership as well.
Over Valuation of Market
The ratio of market capitalization to GDP is the single best measure of market valuations stand in the share market compared to the actual value of the economy. If this indicator is more than 100% of GDP, then the most of the common stocks will show a fall in prices sooner or later. It could be a reliable early indicator of an imminent economic crisis.
Unemployment is a very important indicator of an upcoming recession in the economy. High consumer spending is dependent on high income which in turn results in high employment prospects and rising wages.
The most important indicator is that these crises happen as a result of a change in the mode of thinking. When people spend beyond their means, they accumulate large amounts of debt. It is followed by risky lending practices which further stimulates the spending. Companies may support such consumer behavior as their sales are rising. Such demand based on false income from credits creates inflation with high prices making the cost-of-living too high for everyone.
Forecasting the Crisis
An economic model that can actually generate the crisis needs to be understood for forecasting a financial crisis. Private debt is considered as an indicator of individual economic difficulties in real world. But when it comes to in macroeconomic models it represents simply changes in debt terms. Lending is simply described as the transfer of spending power from one agent to other. Private debt to GDP ratio can be assumed to successfully forecast an upcoming recession, the level of private debt in an economy and its rate of increase must be scrutinized. A sure method would be to note the countries with private-debt to GDP ratio in the range of 120 % to 150 %. A credit to GDP ratio of 10 % to 17 % would also indicate the potential threat to the economy. The consequences of credit-fuelled growth are disastrous; still, it is not a drawback as per the conventional economic theories.
Early Signs and Proposed Solutions
As crises become more common it becomes a necessity to find early signs so that the sudden fall of an economy could be prevented there comes a need to learn to prevent such terrible events. Economic models need to rely and operate on regulations and limits proposed by the state regulators and agencies controlling the macroeconomics. Lack of regulation or deviation from the norms creates an environment for another crisis. Lending by banks to businesses that have sound growth potential and not financing anyone based on asset speculations is the way out. A bank’s business model does not allow this and in order to grow, they are interested in more lending to maximize the profit. The solution proposed in such cases would only postpone the crisis by some more years. Economic regulators cannot hide the ugliness of economy with heavy make-up to look it rosy for long. Furthermore, it also discourages from funding risky entrepreneurs who could innovate for the growth of the economy.