In a previous post I have shown how a recession is a reflection of human behavior. We are in as much control of the recession as our own behavior. That being said it is far from irrational to be scared of a recession. There are multiple events that may cause the next recession. In this post I will explain what will likely cause the next recession.
I want to note that although there is talk about an upcoming recession, this may not happen in the very near future. The purpose of this post is not to scare anyone, but to address issues in which we can try to get under control to prevent the damages that may come from a recession and to let you know what to pay attention to.
Personal Debt And Credit Card Debt Bubble
The US debt increased to over $22 trillion as of the moment this post was published. As of 2019, the total personal debt of the US is almost $20 trillion and has increased by 42% as of last year. Debt can be a useful tool when the increase in debt is lower than the increase in revenue. As of right now, it is not. I will break down the issues.
Despite the fact that millennials are not buying houses as much as previous generations, the total mortgage debt have increased. The reason why is that most houses are larger now and some people feel no choice but to buy them.
Luckily, the only zero down mortgages available are VA housing loans, which is partially backed by the Department of Veteran Affairs. These I do not mind too much because many veterans have broad skills in which make them employable so there is little risk. I also do not mind FHA loans too much. They allow people to put down as little as 3.5%, but there are still hoops to jump through in which prevent loans from going to high risk lenders like low debt to income ratios, and credit scores. These loans use reliable insurers to lower risk for lenders to make these mortgages possible for less fortunate borrowers. I know both of these programs have given people and families houses in situations where they cannot, at least not for a while.
What I do mind is that not everyone who mortgages a home for less than 20% down is in these programs and instead require PMI. I have addressed PMI in a previous post, but essentially if you put down less than the traditional 20% down for a house, the lender will include an annual 0.5-1% average. It is essentially wasted money.
There are some who say that not using PMI will cost you wealth. There are two reasons this is false. First, is that they are assuming that a house is an asset. It is not. The second reason is they say home values will continue rising without fail. Ask some homeowners who owned a house in 2008 and 2009 if that is true.
PMI is an additional cost to your debt. It is like taking out a mortgage with higher interest and homeowners will have to pay as much as hundreds extra each month. This is very similar to a student loan. And since these require money each month that is less money people are investing. This could cause the next recession.
The total student loan debt has now exceeded $1.6 trillion. There are interest rates to pay off just like any loan on top of higher rates of delinquencies, which means there is more money coming out of people’s income to pay off student loans than ever. With less time taken to pay them off, the millennial generation will be spending more to pay them off, will have less spending money for assets and other goods. With less money going into the market, some businesses will lag in growth.
Furthermore, there is an “education bubble” much like a housing bubble. The education bubble is formed very similarly to other economic bubbles. There is a higher demand for college degrees and the cost for getting these degrees became higher. Then the pop happens. If fewer people go to college, there would be fewer clients, I mean students, who can pay for colleges. Some colleges could close down.
However, some say that if more students default and do not pay their loans there would be more colleges that close down. This is not necessarily the case. Many people associate this student loan bubble with a housing bubble. There is a difference between the effects of a housing bubble and an education bubble. When a house is bought, the lender takes a risk in the mortgage. If the borrower defaults and goes in a foreclosure, the lender can and probably will lose money. The lender now has a house with lower value than normal or some liabilities in which the money from the down payment and interest do not make up the difference. Some of these liabilities include legal costs and resale. In some instances the lender can sue the borrower for the difference. If they cannot make it up, they slow down on loaning out money.
With student loans, if the borrower defaults they could be sued. But most of the time that is not necessary. The government could force out wage garnishments, tax refund claims, and retracted social security benefits to pay the debt off. This would be like if you took a mortgage and defaulted. Then the government forces you to keep the house while taking away your income to compensate for the lack of payment. There is a particular reason for this. A physical home could be an asset sold or rented to others. A degree cannot be resold and is only an asset to the receiver. Colleges, universities, and their lenders have considerably less risk since the government could force the borrowers to pay it off one way or the other.
Effect Of The “Education Bubble”
In other words, lenders and colleges will not experience the same crash in the “education bubble” as lenders and real estate would have from their crash. The only economic downside is on the borrowers themselves who will have to almost constantly pay off their student loan, some to the bone, and the lack of investing potential these payments have on the economy. And I wondered why people detest student loans so much.
Another Housing Bubble
So enough of my rants about personal debts. On to talk about real estate, that’s better right? (Extreme sarcasm notice). Many people believe that the housing market will crash because of falling prices from an oversupply of houses. There are multiple other factors that may play roles from interest rates to the Trump Tax Reform.
Despite the potential signs, I do not believe that a housing bubble will lead to a recession, if anything the recession will have an effect on the housing market. The reason why is we have much stricter regulations on housing mortgages than before 2008. Despite the fact that borrowers own mortgages with less than 20% down, the risk on lenders is lowered with the PMI.
Furthermore, the largest demographic of homebuyers now is my generation, the millennials. We had an understandably slow start. But now, many in my generation are considering buying houses. The demand for these houses should increase as my generation further establishes their careers.
The risk for lending out mortgages has decreased and the demand is not decreasing anytime soon for all houses. This is the main reason I do not believe that the upcoming recession will be nearly as big as 2008.
Lack Of New Investors
To be completely honest, I believe this one will take some time to fully sink in and have an effect on the economy. It may not affect us in the very near future. Unfortunately, with the increased debt of younger generations, there is less free spending money for other assets including stocks and bonds. I explained before how the stock market needs cash flow to produce revenue. Without cash flow, revenue growth will slow down and so will the growth of the investments.
People can be scared and withdraw there shares, which will lower cash flow and lower revenue further. That, or the growth will be so small that when retirement comes to full fruition for the baby boomers, they may not have enough to live off of. Almost half of the baby boomers are already retired and the other half is close to that age. If revenue is not high enough to provide revenue payoffs in the form of stable dividends or stock growth, more cash flow will be taken in the form of shares to cover the cost of living. This would lead to the same effect of sudden withdrawals. Flow of money will decrease and businesses will grow slower, drop in value, or even close.
Everyone wants something they do not have. When people who are invested in assets and receive massive payments from these assets, inexperienced investors want to try to obtain these assets. Unfortunately, inexperienced investors take unnecessary risks. As soon as there is a dent in their income, the inexperienced investors will try to pull out, even when the assets lost value.
There are two ways to solve this. The first is to make people more financial literate. Unfortunately, America has failed at basic knowledge in financial literacy. This is one the reasons I made Forge Your Wealth, to try to reverse this trend. The second is to make people more confident where they are. To be clear, I am not talking about encouraging stagnation, quite the opposite, I want to encourage making smart investments that will start formation of wealth. Most people want to climb the social ladder, and income inequality can force them to feel greedy and try to make risky investments they cannot or should not take.
What should we do?
We should not redistribute wealth though. Simply put, if we redistribute wealth then there is no ladder to climb people will not try to produce revenue. The problem with wealth inequality is not the inequality itself, but the feelings of inequality.
I read about this in Behave by Robert M. Sapolsky where he tries to explain how almost everything affects behavior, including income and class. Instead projects must be made to improve schools, neighborhoods, and organizations that help people in need. This will help to eliminate the feeling of inequality. This may sound like manipulation, but I think I see how this works. By realizing that others have your interests in mind, people will ease their minds and not take risks that are outside of their current tolerance levels. They will take this to mind and start at their current tolerance level and maybe grow it later when they feel like their income can take more of a risk.
There are many current issues that could lead to the next recession. However, civilians and policy makers can easily solve these issues. Most recessions are self-fulfilled prophecies. If enough people believe a recession will happen the economy will reflect these fears. Many issues may seem large, but there are small ways to help people out to ease their fears. I believe the best way is financial literacy, the more people know about how to handle money, the better people can forge their wealth.
As much as I do not like government interference, I do not believe the government implementing laws to help people with repayment of their debts, finding residences, or even providing education would be considered interference. I do recognize that such changes are a double edged sword.
If the government tries to prevent lenders from giving just anyone a student loan, some people will never receive higher education. When the government controls loans of houses too much, some people will never be able to buy these houses. If the government starts to improve lower income neighborhoods, higher income civilians will be attracted to these neighborhoods. It tends to be a cycle. People love these policies when the economy is doing well, and hate these policies when the economy is not doing too well. There is always a price to forging wealth. The question is do you want yourself to determine what your price is, or a group of higher ups? Are we always going to trust our futures to the people in government?