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April 5, 2017

Looming Threats: Hope and Prepare

“Irrational exuberance” was first uttered by Federal Reserve Board Chairman, Alan Greenspan, in 1996. The tech bubble didn’t burst until 2000.

NYU professor, Nouriel Roubini, warned of the looming credit and housing crisis as early as 2006. The recession didn’t begin until December 2007 and the real collapse didn’t start until the fall of 2008.

What are the big, looming threats we are hearing about today? Here are a few that have remained at the top of the heap for months, if not years:

·         Global warming and climate change

·         Military conflict in South China Seas, which could potentially trigger a world war

·         Massive credit bubble in China

·         Huge housing bubble in Canada

All four of these potential calamities could have massive, life-changing effects. Yet, people have become immune to the threat.

The problem with massive threats is that they take a long time to happen. The seeds of destruction are sown long before the first shots are fired. Civilizations end, not because nobody saw it coming, but because nobody thought it would actually happen. It’s not that people don’t understand the logic behind such warnings. They simply construct a rational argument for the status quo.

People have a tendency to draw straight-line forecasts based on near-term history. In July of 2007, Ben Bernanke (then Chairman of the Federal Reserve) did just that, commenting on the housing market:

“The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening in lending standards, and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment, as well as by mortgage rates that, despite the recent increase, remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further, as builders work down the stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth in coming quarters, although the magnitude of the drag on growth should diminish over time. The global economy continues to be strong, supported by solid economic growth abroad. U.S. exports should expand further in coming quarters. Overall, the U.S. economy seems likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend.”

Meanwhile, very smart people were arguing that systemic risk was massive and the financial system could collapse, which it did about a year later. Of course, by the time these folks were proven correct it is too late to do anything about it.

For a giant oak tree to fall onto and destroy a nearby house it first needs a lot of time to grow. The earlier it falls, the less damage it does. Again, one can only prove the tree will fall after it falls…when it’s too late to prepare.

The same is true for many crises today. For example, people have been calling for the collapse of the Chinese credit bubble for years. The fact that it hasn’t happened yet doesn’t mean it won’t happen. Indeed, it could mean the systemic risk within the Chinese financial system is still growing and the eventual collapse will be worse.

Pretending these potential threats don’t exist - by arguing time has proven the doomsayers wrong and by projecting the status quo into the future - won’t make them disappear. Hope the threats never materialize, but prepare as if they will.

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