The 2008 Economic Crisis: How To Protect Yourself (Guest Voice Part III)

This is the last of three special Guest Voice posts on the present Wall Street economic meltdown by Mikkel Fishman, a TMV reader and frequent writer in our comments section who is also an author and computer scientist. Part I is HERE and Part II is HERE. This final part was written right before the House of Representatives defeated the bailout plan.

The 2008 Economic Crisis: How To Protect Yourself

by Mikkel Fishman

In the prior sections of this series I’ve discussed why I believe our current economic crisis is due to long term and fundamental imbalances as well as the two basic choices that our society can make for addressing the problem. In this concluding part, I will talk about the crisis on a more personal level and suggest steps that you should take to protect your own finances, but first a little segue.

A commenter asked if there was a “middle road” solution that had targeted deflation while preserving credit availability and aimed for minimal disruption to economic growth. In fact there is, and the current plans being discussed by Congress are awful if that is the goal.

This plan correctly identifies that the fundamental problem is that there is too much debt that relies on inflated asset values, and that this is preventing banks from lending. It suggests recapitalizing banks directly instead of trying to buy off the assets. This approach is much more efficient because of leverage in the system.

The bailout bill currently being discussed is talking about buying up to $700 billion in assets, but since banks are leveraged approximately 10x, a direct infusion into banks of $70 billion would have the same effect on lending, assuming that it wasn’t directly eaten up by a continued decrease in assets that already exist. This is why the “middle road” is to isolate bad banks and let them fail, letting the massive amount of debt start to deflate and then recapitalizing – even if it means starting up new banks with a fresh balance sheet.

A new study released by the International Monetary Fund that looks at historical precedents concludes that recapitalization is far superior to direct asset purchases, both from an expected government loss stand point and future economic growth.

It’s no wonder that nearly 200 economists have signed a letter opposing the current [recently defeated] bailout as it’s written.

However, while I tentatively support this sort of action, I am more pessimistic about its long term success unless there is a radical change in societal views.

First of all, everyone is talking about spending far too little money. The IMF study suggests about 15% of GDP is necessary to correct these types of problems, but ours is one of the worst in history and we would be lucky to get off that easily. I think that upwards of 30% of GDP is more likely. Even the lower estimate would give a cost of around $2 trillion, and my guess would be about $4 trillion. The consensus amongst several high profile analysts is $5 trillion (e.g. http://www.nakedcapitalism.com/2008/09/marc-faber-us-needs-as-much-as-5.html).

This is a serious chunk of change and calls into question our global dominance. Due to our massive long term liabilities and over extended expenditures on a personal and government level, we will still need to see a large decrease in standard of living for the foreseeable future. Otherwise our slim chance of maintaining our reserve currency status will disappear entirely and really compound our problems. This is already being openly discussed in both China and Europe.

Still, truth be told there is little difference between the views expressed in my prior piece and this middle road solution other than timing. My suggestion is more “conservative” in that it argues that the scope of the problem is so large that it may very well be a large waste of money to try to recapitalize while asset values are still declining rapidly, while this proposal attempts to take the edge off the negative effects of that decline. I should note that during the beginning stages of the Great Depression we tried very similar programs to the recapitalization one and they failed to stem the decline.

In any case, I want to finish the series by discussing how to protect yourself on a personal level once it is clear which direction we are moving in. Unfortunately it may be very difficult to protect your personal wealth if we experience rapid deflation or inflation unless you are in the right asset classes, but it is unclear which path we are headed down now. I would strongly recommend against jumping into any of my suggestions at this point in time, but the more prep work is done beforehand, the more secure you will be when it comes time to make some hard choices.

The first piece of advice is pretty easy and applies no matter what situation we find ourselves in: get out of the stock market almost entirely.

We are still in both a cyclical and secular bear market, meaning that the current price of stocks is not supported by realistic projected earnings over the next couple years, nor expected long term economic growth over the next ten years. Even without Financial Armageddon the market is overvalued by at least 25% and perhaps more, as we are in a period of declining P/E ratios. Everyone is so focused on the credit turmoil that they are all but ignoring how terrible most companies’ earnings reports are.

Also, while it’s true that this will pass in time, it’s not true that buy and hold is the best strategy, as there are very simple strategies that capture nearly all of the gains but require being in the market only about 60% of the time. By selling now and having cash, it will give you more options moving forward, higher expected return if it’s put in a CD or treasuries and will be a cushion if there is an emergency or job loss.

Needless to say, pay down high interest debt if you can, but I would focus on building up several months of cash even if it means carrying balances with moderate (say 10%) interest rates.

Again, having the cash will give you more flexibility to maneuver and respond to unforeseen events, so paying a premium for access to it is probably a wise choice. In fact I’d go one step further and say that if you do not have nine months to a year of cash available, have access to a low interest loan or line of credit and have little existing debt, to take the loan and just park the money in short term CD.

A $50k loan at 7% interest has a carrying cost of $2k a year if invested in a 3% CD. Think of that money has an insurance policy in case you lose your job and it makes sense for most people that have little debt. For people that already have a significant amount of debt I’m not sure it makes sense.

The starting point is to have as little high interest debt as possible and as much cash amassed as possible even if it means a carrying a moderate amount of low interest debt. This will put you in a position to move quickly if deflation or inflation starts to take hold and from here on out my focus will primarily be on preserving your capital if one of those starts and how to spot the beginning of the trend to signal when to start a strategy.

If there is deflation then cash is king. Wages will drop precipitously, as will prices on everything. Assets like houses, cars, etc. will lose a lot of value, and the cost for luxury goods may fall tremendously. If we start seeing deflation then the dollar will start to rise in value a lot against other currencies and it doesn’t make sense to really be invested in any physical asset and you would get “richer” just by having cash lying around. Gold might rise, but that’s a quirk.

The reason why gold would rise is if people are worried about the collapse of fiat currency in general and then it’d only make sense to have physical gold on hand. It’s such a dire situation I’m not sure it’s worth it to bet on it because if it happened then you’d have a lot bigger worries than your bank account.

If deflation happens then the primary concern is maintaining employment and making sure to not have any leverage. In my prior suggestion that it is OK to build up some debt at low interest rates as long as you are also building up cash reserves in a safe account, you aren’t increasing your leverage because you have money to back the debt load. Even if your salary fell by 50%, you could continue to pay off the debt from your reserves.

By contrast, many people have little money in their account and lots of debt so they are leveraged. For these people if their salaries fell then they would have a very hard time paying off debt and monthly costs and would most likely have to declare bankruptcy.

Deflation will be signaled by a very fast increase in the dollar relative to other currencies and government bonds, as well as a sharp decrease in the price of commodities and luxury goods. Bonds for private companies may still crater because of uncertainty about their survival.

Indeed, this combination is exactly what we have been seeing the last couple months and the market had clearly voted for Deflation as the likely outcome…at least until the rescue bill was proposed. Uncertainty about the inflationary effects of the rescue bill made commodities skyrocket and the dollar drop by the largest one-day amount ever versus the Euro. Now we are in a bit of a holding pattern with strong deflationary effects occurring in the present and strong potential inflation in the future.

The course of action to protect yourself during deflation is pretty straightforward. Of course it will also contribute to further deflation, which is why it’s called a deflationary spiral. Once asset prices get to be lower than historical norms (as seen in a P/E ratio under 10 for the stock market, and housing prices that are more historically supported) then it makes sense to start venturing back and spending money that has been amassed. This part is crucial to the reboot of the economy and end of the spiral.

It is tougher to protect yourself against inflation, especially as it can take several forms. While deflation affects all assets in relation to the dollar, inflation can cause price increases in some asset classes but not others, especially depending on the amount of inflation.

In the first scenario, the United States will be the main industrialized country experiencing inflation. This could happen if we spend trillions of dollars to help our financial system and the rest of the world sits back. In this cash, the dollar would plummet against other currencies and it makes sense to diversify out of the dollar and use other currencies as a hedge to protect your capital.

The price of food, gas and other necessities may skyrocket in dollars, but shouldn’t be affected much in other currencies and so monthly bills would be easier to pay off if you have some foreign currency holdings.

If there is accompanying wage inflation in the US then we might even see housing stop its downturn and the stock market might reverse course and start to increase. Both the stock market and housing would appreciate less than prices are rising, so standard of living would still be going down, but they would be good for diversification. The faster inflation rose, the more necessary it would be to be invested in assets and foreign currency/assets to protect yourself, and cash is the last place you want to be. It would even make sense to start to become a bit leveraged in order to keep up with rising costs, as long as you don’t get too out of hand.

In the second scenario there is global inflation. Right now it seems that Europe and Asia are in deep denial about the extent of their problems. They blame us for the current crisis and seem to think that we are isolated, but by many measures Europe is far worse. They have even more personal debt and a greater bubble than we do and have injected a far greater amount to keep the financial system from collapsing when seen as a percentage of GDP.

In fact, there are several banks that have more assets than their host country’s GDP. Likewise, Asia in general and China in particular have seen massive cash flows into the region due to artificial devaluation of their local currency. This means that they have many dollar denominated assets and a huge amount of liquidity that is contributing to inflation. China’s inflation is currently running over 10%, as are most of the emerging countries that were such poster children for globalization. These countries do not have a good financial infrastructure and seem to be experiencing many of the problems that plague countries that grow too quickly.

This scenario (which I think is most realistic on our current path) is the hardest to navigate.

It doesn’t make sense to try and seek haven in foreign currencies, because that will not protect against price increases. Furthermore, while assets may start to rise like the stock market and housing, the mad rush of the entire world attempting to find assets that return better than their local inflation will make it very difficult to navigate. Under the first scenario it is assumed that a lot of foreigners would stay local but under this one that is no longer logical. I think there is a good chance of random bubbles appearing out of nowhere only to rapidly deflate as people jump out again.

Commodities like oil, food and metals would see consistent price gains, especially gold. Gold and oil may even form a super bubble as they would be seen as physical assets that are hedges in case fiat currency collapses. If we start to see immense increases in these products without an accompanying decrease in the dollar against other currencies, then I would think about diversifying into those asset classes. Even then I would be loathe to say “recommend” because they will be highly volatile.

Under this situation I have little good advice to be honest, other than to read a lot of what the leading professionals are doing and mirror them (by leading I mean some of the people I linked in my first piece, not the ones on TV).

Regardless of the path that unfolds, I predict that we are going to see a substantial decrease in the standard of living over the next decade or maybe even two if things are really bad. Fundamentally economics is a projection of social mood and psychology and people across the political spectrum have long started to believe that our current culture of easy credit and frivolities seems unwise.

I would take the Devil’s Advocate position and claim that many of the great advances we’ve seen in the last 30 years would not have surfaced under a different social mood, but still agree that materialism has gotten a bit out of hand and unfortunately it will start impacting basic necessities. The greatest preparation may not be anything tangible but mental.

Still I’m fundamentally an optimist and don’t believe that this is the end of the world. Even if it got as bad as the Great Depression (which I don’t think it will, at least from the suffering perspective) then we would still emerge on the other side and regroup.

My greatest worry is that people are not planning for the long term or steeling themselves for the time ahead. Instead of our leaders being honest and providing direction over the long term, they are focused only on what to pass when a crisis occurs.

Neither Obama nor McCain could even mention any specifics about what they would forego due to the Bailout Bill, let alone show any insight into how the crisis is affecting their general outlook about governance. It is disheartening to see most everyone (politicians and citizens included) become overnight experts about what to do while the views from the small minority that have seen this coming for a long time are almost universally ignored. I admit it’s fun and I’ve found myself doing it plenty of times about things I know little about even while simultaneously getting irritated about the lack of strategic vision in the economy and Iraq, two areas that I have kept up with for years. There will always be disagreement about strategy but so often our discourse is dominated by arguments over tactics, when historical evidence shows that certain tactics are just not likely to work.

A lot of resistance against the Bailout Bill is due to emotional reasons (i.e. we shouldn’t give rich people that caused the mess more money) as opposed to informed consent about what the consequences will be. Similarly a lot of support for the bill is due to fear, again without much weighing of side effects. Bernanke suggested there were little inflationary risks and even Obama insinuated maybe the government would make a gain by fallaciously comparing the plan to a depression era program during last night’s debate (that bought houses far below historical value compared to this one that would jump in far above).

I think that as a society we can persevere through very trying times as long as there is the mental and physical preparation for the challenge, but fear that willful ignorance will lead to severe overreaction even at a relatively minor trial if we are not prepared.

I would like to thank everyone that read any part of this series. The ultimate goal was to convey my thoughts about what the future may look like with the hope that at least someone would be helped prepare for the possibilities on at least a mental level; from a personal perspective I am nervous that things are actually happening but ultimately confident that things will be OK and it’s only because I’ve studied this so much. Hopefully none of this will come to pass and this whole thing will be a bloviating relic.