Fear During a Recession

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January is
a hangover month, in every sense. In January, the holiday bills
start coming due.

Recessions
are the hangovers of economic booms fueled by central banks’ fiat
money.

After a long
boom, almost no one remembers the degree of fear that strikes non-government
employees during a major recession, when they see their investments
shrink in value, their career opportunities shrink, and their commissions
— for those people on commission — cut by half. They pay their monthly
bills by withdrawing savings or by borrowing.

Today, at the
tail end of a five-year recovery, Americans are already paying their
monthly bills by drawing down their savings or by borrowing.

BAD MEMORIES

Bad memories
fade. We remember the good times. This is one of humanity’s greatest
blessings.

When it comes
to recessions, this is a liability. Senior-level decision-makers
today in every field have no memory of how terrifying a recession
is for senior business managers: falling sales, enormous payrolls
to meet, and enormous corporate debts that must be funded. Red ink
is everywhere. Stock options become worthless. Senior managers are
paid mostly by stock options.

Senior managers
did remember back in 1981. There had been three recessions: in 1970—71,
1975, and 1980. Recessions were a common occurrence in that ten-year
period. Managers had experience with them.

So had investors.
The Dow Jones Industrial Average had peaked in early February, 1966,
at just under 1,000. It had briefly gone above 1,000 inter-day.
The Dow had yet to reach that 1966 level again in 1981. It fell
to 777 the next year.

Then, for almost
a decade, it was boom time. The Reagan boom began in 1982. Not until
1991 did the nation suffer a recession. That was 16 years ago.

An even longer
boom began in 1991, but not strong enough to save Bush’s Presidency.

You don’t remember
the details, do you?

Neither does
your boss if you work for a Fortune 500 company. Your boss was just
a hot prospect in 1991 — a comer. He may have been in a different
company, even a different industry, in 1991.

The 2001 recession
is also barely remembered. It inflicted too little pain. This is
because Greenspan’s Federal Reserve had been pumping in money and
cutting interest rates for at least seven months when the recession
began in March. It was over by November.

The Nasdaq
had been in freefall for over a year by March, 2001, the month the
recession began, as we were told officially in 2002. The S&P
500 was at 1100, down from 1550 in early 2000. It recovered that
summer; then it fell to 950 later in the year. It recovered again;
then it fell below 800 in the second half of 2002.

That was bad
news for owners of individual stocks, but their numbers were small:
about 20% of American families.

It was bad
news for pension fund managers, but most pension fund investors
keep contributing.

It was bad
news for senior managers in American companies. Their companies’
pension fund obligations continued to rise. The 15% to 17% per year
gains in their funds’ stock holdings had reversed, but the day of
reckoning for most corporate pensions was at least a decade away.
Senior managers would be in retirement by then.

In February,
1991, the United States won a war in Iraq in one month. The army
did not stick around. The voters trusted President Bush in March,
1991. His popularity ratings were sky high, scaring off Mario Cuomo
and other big-name Democrat contenders, leaving only some guy from
Arkansas at the head of the pack. Yet Bush lost his bid for re-election
in 1992. That’s how fast things changed. "It’s the economy,
stupid," was the Clinton camp’s slogan.

It surely was.

Today, we are
losing a war in Iraq. It is clear that there is no way out with
honor. It is a quagmire. Iraq is moving into a civil war. The Republicans
don’t know what to do. The Democrats don’t know what to do. The
public has lost confidence in Bush, yet the economy seems to be
booming. What will happen to public confidence in his leadership
during a recession? We have a new Federal Reserve Chairman, who
has yet to be tested under fire. Congress has just changed hands.

There is no
recession-tested leadership. Yet a recession looms.

The U.S. trade
deficit (current account) is approaching $850 billion a year. Nothing
in man’s history rivals this level of deficit. The largest economy
on earth can no longer compete with the rest of the world except
in one area: the issuing of IOUs. Here, we are the grand masters.
This has been the pattern since the 1991 recession.

The savings
rate of private households in some recent fiscal quarters has gone
negative. We have the lowest personal savings rate of any large
economy.

We are dependent
on Chinese imports for our goods on shelves in Wal-Mart, Target,
and the other large retailers of consumer goods. These imports have
kept down the rate of price inflation. We are being subsidized by
the mercantilistic export policies of Asian nations, whose central
banks fund the operation by expanding their currencies. When they
stop inflating, they will have a recession like nothing seen in
Asia in history. The last time it happened — the 1930s — Asia was
agricultural.

In a recession,
Asians will cut prices even lower to keep workers at work. The Zorro-masked
yellow smiley face in the Wal-Mart ads will still be slashing prices
and smiling. Meanwhile, American manufacturing will be slashing
payrolls and screaming.

The Institute
for Supply Management on December 1 issued its monthly report on
American manufacturing. The index fell in November to 49.5. Anything
below 50 is a mark of contraction. This was the first time in 41
months that this index had turned negative. For American manufacturing,
the recession is here.

It is time
to start hunkering down. As the radio ads on the kids’ shows said
in my youth, "Be the first on your block!"

THE ONLY
THING WE HAVE TO FEAR. . . .

If you are
male, married, white, and on salary, you probably won’t get fired.
The unemployment rate will rise. It could conceivably double. But
for white, married, salaried men, the unemployment figure will not
go double-digit. You won’t get a raise. You won’t get a promotion.
But you probably won’t get fired. That’s the good news.

The bad news
is that you can’t be sure. People do get fired. If your position
in your department is marginal, you’re not immune to the axe. There
is always some hot shot looking for your job. If he is single and
can work for less, you’re in trouble. He may live in India.

If you provide
a service that involves the production of digits, you’re at risk.
If your company sells into an international market, you’re at risk.
If your division is marginal, you’re at risk.

What gets hammered
in a recession is commodities. They are at the bottom of the supply
chain. They are price competitive. There is usually a cheaper commodity
that can be substituted. In November, 2001, the month in which the
most recent recession ended, the Commodity Research Bureau’s index
bottomed at 180. Today, it’s over 340.

If you are
a commodity, expect trouble. If what you do for a living, others
can do almost as well, and if they are in a position to cut their
price, you’re in trouble.

One thing is
certain: If you are on salary, you will become a net liability for
your company. You are a fixed expense. Meanwhile, corporate revenues
will fall.

If you are
on commission, the 16 fat years are about to end. For you, the news
is bad . . . unless you work for an auction firm specializing in
liquidating bankrupt companies.

The worst thing
about a recession for most Americans is the ticking of the debt
meter. It doesn’t stop ticking just because the economy is in recession.
It ticks louder.

People freeze
up when they get scared. They put off making purchases. They cut
expenses. But there are limits to what they can do. They live so
close to the edge of their budgets that there is not much fat to
cut in relation to disposable, after-tax income. The debt meter
ticks.

This is why
the auto industry is always hit hard in recessions. People can forego
buying a new car.

Consider the
American-owned car industry today. Ford and GM are experiencing
huge losses. Chrysler joined with Daimler. We are in a boom.

The housing
market has turned people’s homes into ATMs. People borrow their
homes’ equity. But this process has begun to slow down. When equity
begins to shrink in the next recession because of falling home prices,
it will dawn on a growing number of Americans that they have been
eating their seed corn.

What is really
scary in the housing market in a recession is the increase in illiquidity.
People refuse to face reality: Their real estate is worth less than
before. When they decide to sell, they hold out for last year’s
price. They sit. They grow fearful. They still sit. Then they grow
panicky. Eventually, they are forced to move: a lost job, a transfer,
a foreclosure, or something that leaves them without recourse. They
may walk away from the house.

They lose their
credit rating when they do.

I bought my
home in a foreclosure in 2005. I got a very good price.

The number
of foreclosures is already over a million a year, up from 650,000
a year ago.

The "wealth
effect" — spending more when you feel richer — has been fueled
by rising prices on housing. This is about to end, all over the
country, but especially in coastal cities.

I feel sorry
for people in the early years of their careers. They have just bought
their first homes. They have not faced a recession. They think that
household budgets, while tight, will get looser as they get older.
Ah, youth! They will soon have a rendezvous with reality.

WHEN
NOTHING SEEMS TO WORK

In recessions,
fear grips consumers. They start looking for ways to cut back on
spending. If your services are marginal in their budgets, you’re
in trouble. If consumers say, "I can do without this,"
you’re in big trouble.

Not everything
marginal gets cut. Some things are seen as cheap luxuries. People
may buy a candy bar instead of going out to lunch. Warren Buffett
bought See’s Candies. He knew what he was doing. People may rent
a video instead of going to a movie. Nobody moves from three-martini
lunches to brown bag lunches in one fell swoop. People should, but
they don’t. They resist being perceived as failures, as being desperate.
They have their status to maintain.

Anything addictive
or near-addictive tends to hold its market in a recession. Alcohol,
cigarettes, and sugar products don’t face collapsing markets. Bad
habits are hard to break.

Companies cut
back on advertising because revenues fail to pay for the ads. This
leaves undefended territory in the market which can be exploited
by companies that have deep pockets. For those few firms that remain
aggressive, a recession allows them an opportunity to increase market
share.

If you think
Wal-Mart is a tough competitor today, wait until the recession is
six months old.

It is the feeling
of having hit a brick wall that is so discouraging in a recession.
People refuse to buy from you, no matter what you do. If you are
marginal in their present situation, you can’t lower your price
low enough to get them to buy. You and your product are no longer
in their budget.

If you are
a brain surgeon, you will do fine. People don’t schedule brain surgery
based on the business cycle. If you are a dentist, you are in trouble.
People can put off getting their teeth cleaned.

Because recessions
have been infrequent for so long, and because business owners who
are not facing Asian competition are not familiar with the effects
of consumer resistance, the next recession will come as a shock
to business decision-makers. They will see red ink flow because
of fixed expenses and falling revenues.

Businesses
that do not have a line of credit, guaranteed in writing, from a
local bank may not survive. That is what happened two decades ago
in Texas during the savings & loan crisis, which piggy-backed
on the oil patch crisis that began in 1980. Small businesses that
had enjoyed informal lines of credit saw these lines severed when
their local banks were bought out by national banks, and new managers
took over locally. "Never heard of you," was the refrain.
"Your rolling credit is not being renewed. Pay up." They
couldn’t.

You may think
your employer is solid. Yet we have just been through a period of
rising corporate debt like no other in history. The borrowed money
was used to fund mergers and acquisitions, as is common at the tail
end of every boom. The money was also used to buy back corporate
shares, thereby raising share prices, thereby making senior executives
rich through their stock options. The debt meter will keep ticking.

WHAT
IS YOUR FALL-BACK POSITION?

You probably
will not be fired. You received a Christmas bonus — maybe. Don’t
expect a big one next Christmas.

What major
moves are you planning over the next two years? Re-think them.

If you have
your capital invested in equities, re-think your position.

If you plan
to retire, re-think this decision.

If you plan
to expand your business, wait. Put the expansion money in reserve
in a near-cash asset. You will get more bang for your buck a year
into the recession.

The old rule
of having enough money in the bank to cover payments for six months’
bills is a very good rule. Extend this to 12 months.

The problem
is, almost no business can afford to do this. The bills are many,
profit margins are low, and reserves are minimal. If your business
requires a rolling line of credit, lock it in now. Get this in writing.
Pay an interest premium if you must.

My next-door
neighbor is an independent contractor. He does cement work. He does
very nice work. He has no marketing plan that I can see. I offered
to help him develop an advertising program a year ago, for free.
He never contacted me about this. He is a typical small businessman.
He is uninterested in advertising. That is why most small businesses
remain small.

His services
are marginal. Nobody really needs them. He is not a plumber. When
people are feeling no pain, they upgrade their yards. A few of them
call him. But when people are feeling pain, they won’t call him.
Nobody needs a new patio.

My guess is
that a year from now, he will be forced to put his home up for sale.
I could be wrong. Maybe he has marketing skills I don’t recognize.
Or maybe he can liquidate his business and get a job as a laborer.
Or maybe the town I live in will continue to boom. A lot of people
are moving in. But for people like him in most regions, a recession
is a disaster, not an annoyance.

Have you made
an honest assessment of your position in a falling economy? Have
you got some sense of how marginal you are in today’s economy? If
this economy heads as far south as it did in 1991, what will your
income/outgo position be?

If you work
for the government, you’re safe. If you are in a business that helps
people deal with emergencies that cannot be postponed, you’re safe.
But most people are not in this position.

CONCLUSION

Recessions
are hard times for businesses. People in good times think they have
done all they can when they hedge their investment portfolio against
falling demand. But the fact is, what threatens most people is not
a fall in their investments, since they have so few investments.
What threatens them most is the loss of a job or the sidetracking
of a career.

You may need
reserves to draw down in a recession. This means that you will need
ready cash. If you have to sell something in order to get access
to cash, you’re in big trouble if that is your only reserve. Others
will be selling, too.

High liquidity
requires three things: (1) a rapid sale without offering a discount;
(2) a rapid sale without advertising expenses; (3) rapid sale without
offering a commission to a middleman.

Could
you live for six months on your liquid reserves? If not, it’s time
to sell some less liquid assets in order to increase your liquidity.

January
3, 2007

Gary
North [send him mail] is the
author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible
.

Gary
North Archives

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