What Will be the Most Likely Cause of the Next Big Downturn?

Predicting a tail risk event is just about always a silly thing to do.  The markets are too complex to predict such things.  Of course, this doesn’t mean we can’t be prepared, but you get the point.  So, knowing that we shouldn’t try to predict what the next big black swan will be – let’s try to predict the next big black swan type event…

I don’t fully believe that the markets are so complex and dynamic that they’re entirely unpredictable.  I think that a sound understanding of the macro system, the monetary system and the financial system can help one substantially increase their odds of making high probability decisions about how to approach the financial markets.  A big part of that is identifying where excessive risks are at times.

Over the course of the last 5 years I have repeatedly written about one flawed system in particular – Europe.  We can look at Europe’s monetary system and identify, for a fact, that it has a structural flaw.  That is, with a single currency the countries are all locked into a fixed exchange rate.  This leads to natural trade imbalances within Europe.  So the trade imbalances can’t rebalance via FX markets.  But there’s a bigger problem.  The countries also can’t print their own currency to devalue the currency.  And perhaps most importantly, there is no central Treasury system to redistribute funds to alleviate the debt burdens that inevitably arise from the current account deficit nations.  So you end up with a bunch of bankrupt nations who can’t print money, can’t rebalance via FX and won’t get any outside assistance.  This is PRECISELY what happens in the USA except states like Florida, Louisiana, South Carolina, Hawaii and Virginia receive huge amounts of federal aid which helps alleviate what would otherwise become an unbearable debt burden.

The point is, we can look at Europe and know, for a fact, that the monetary system is deficient.  And the only way to fix it is to implement a rather substantial change.  I’ve proposed moving towards a United States of Europe.  But we could also see a complete break-up of the Euro or even a partial break-up.  But the point is, no matter what happens, it’s likely to be hugely controversial and hugely disruptive to the markets and the economy.  And if and when this does happen it will likely ripple through the entire global economy as uncertainty overtakes markets.

Anyhow, if I had to guess what would cause the next big market downturn that would be my guess.  But it’s only an educated guess….Not terribly useful I know, but a fun thought experiment if nothing else.