Hope for the Best...Prepare for the Worst

The words get bandied about in the press, on TV, and at the water cooler.  Recession.  Inflation.  Deflation.  Stagflation.  Depression.  But what does it all mean?  Are we really heading into a bad time for the economy?  And if so, what can you do about it to protect yourself?

The truth is that whatever you want to call it, the economic forecast doesn't appear to be particularly sunny.  Banks are losing billions of dollars in the value of the loan portfolios they hold, with further deterioration expected.  This has lead to a tightening of credit standards across the board, making borrowing more difficult for individuals, companies, municipalities, and believe it or not, banks!  Contrary to what you may have heard on the TV news, this issue is not isolated to those holding sub-prime mortgages.

The effect of this credit crunch has led to a downturn in economic growth, otherwise known as a "recession".  Or as government economists would say, "A period of negative economic growth", (as if calling a pig by any other name causes it to cease being a pig).  Some of the ways you'll see the impact of this credit crunch are:

• Restricted access to credit - borrowers who've traditionally had little difficulty in borrowing funds will find it more and more difficult to do so, regardless of their credit history
• Those that do qualify for borrowed funds will find the terms less favorable
• Cities and towns will find it more expensive to borrow money through municipal bond issues, perhaps causing local budget issues and higher taxes
• Employers will look to reduce costs - lay-offs are one of the most common methods used

Recessions are typically short lived downturns in the economic cycle.  However, in the event that the recent Fed action to lower short term interest rates causes an inflationary environment within this recession, we'll have a much mortgage dangerous scenario, commonly known as "stagflation".  Stagflation occurs when the factors common to a recession are coupled with rising prices.  Consider that for a moment; money is hard to borrow, unemployment is up, asset values are down, and yet prices are rising.  Think the 70's.

So what can you can do to protect yourself in the event the economy truly heads south?  Here are some tips:

1. Priority #1 is to make sure you have an emergency cash fund sufficient to cover at least six months of living expenses if necessary.  This is so important that if you need to borrow from home equity to establish this fund, you should consider it.  Remember, CASH IS KING!
2. Assuming that you've got #1 covered, you may wish to explore whether or not paying off your mortgage faster is beneficial in your circumstances.  (I don't normally advocate paying down mortgage balances any faster than necessary; in fact, I prefer interest only notes.  However, given the current environment, I do believe some people will be best served with applying more cash to their principle balance.)
3. If you have a 401K, or other retirement fund, make sure you're talking with your financial advisor to make sure your portfolio is staying consistent with the changing economic landscape.  In other words, if you're invested in bank stocks, you might want to look at something a little less exposed to the downturn.
4. Reduce or eliminate the use of consumer credit cards for purchases.  The cost of carrying credit card balances is poised to skyrocket, despite the recent cuts in interest rates.  Remember, banks are hemorrhaging cash, and they'll be looking to make it up where ever they can.

One of the primary causes of recession is the self-perpetuating phenomenon of expectancy.  As consumers expect things to get worse economically, they begin buying less and saving more.  And because the economy is so dependent on consumer spending, this behavior ends up perpetuating the very recession consumer's fear.  So in the interests of potentially averting a recession, I encourage you to hope for the best, be positive, and make good decisions about spending.  However, it makes sense to prepare for the worst by having some emergency cash, paying down debt, and managing your spending.

As always, I welcome your comments!