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Economics, Government Intervention, and Free Will

And so it begins. Preparation for a recession that was generally considered “highly unlikely” last summer, 25% possible by September, 40% possible by November, and forecast as “more than likely” by the beginning of January. Of course, a recession was always likely, because recession and growth are two fundamental components of the economic cycle. The word recession carries a huge emotional burden, much like the words cancer and bankruptcy. We don’t quite understand it, so we fear it. In fact, the word recession can be used in the same paragraph as the words optimism and health. The latest round of government responses are likely to push the recession out by another 18-24 months, and we are likely to see another run-up of growth in the meantime. Let’s talk about what this could mean to us as individuals and business owners.

Our young country and economy have done a generally admirable job of learning how to understand and ultimately manage the economic cycle, particularly when you consider how much the economic world has changed in less than 250 years. Yes, we failed to mitigate the economic meltdown that led to the Great Depression in the early 20th century, and if it hadn’t been for World War II we wouldn’t have recovered when we did. Until that time corrections had been allowed to go deep enough to rid the system of all the excesses of the prior growth period, and that had been a successful formula. The increasingly global nature of economics by the 1920s introduced new risk, and global poverty was the result. Our economic and financial management skills improved dramatically as a result of those lessons, and we can be reasonably sure that history will not repeat itself (mass exodus from the US dollar could cause that, but it’s unlikely, and we can talk about that another time).

Since the end of World War II we have been in an era of economic management that allows the economy to experience the necessary booms and busts (i.e., growth and correction), but with controls. Each upswing of the economic cycle is associated with some form of speculation that eventually builds to excess. In the 1980s it was junk bonds, in the 1990s it was tech stocks, and in the 2000s it’s been real estate. What will it be next? Watch emerging market equities and resources like alternative energy, oil and uranium – all good candidates for our next phase of excessive growth. But though the roots of the next phase of excess are being planted now, first we have to deal with the necessary correction phase, which given the recent rounds of government intervention, will likely be preceded by one more uptick in growth.

I’m not going to discuss preparation for recession today, because I covered that topic thoroughly last autumn in the articles Somebody Always Makes Money During a Recession, There’s Still Time to Prepare for a Recession, Time to Switch Gears, and Old Advice New. What I do want to discuss is how our personal responsibilities and our economic responsibilities come into potential conflict during this time of recession preparation.

Our government has launched a program of recession avoidance. From one perspective, the tax rebate and spending program is very intelligent. Theoretical debates aside (Democrats want more unemployment benefits, Republicans want to lock in Bush’s tax cuts beyond 2010), the response is sound. Getting consumers to spend more freely will have a positive impact on the contracting economy, which will delay and soften the oncoming recession. But from another perspective, the individual responsibility to save and prepare for the future, this approach smacks of immoderation. Which one is correct? Both perspectives are correct.

In an ideal world we would all have paid off our credit card debt, increased our home equity, and put money into our retirement savings and short-term liquidity accounts during the past six years of economic growth. Indeed, that type of fiscal prudence at the individual level would have reduced the economic growth we were experiencing, and it would have mitigated some (though certainly not all) of the need to bleed excess out of the system in the first place.

Now the US government will provide incentives for all of us to spend more money, starting in May when US taxpayers receive their rebates. The mere anticipation of the rebates will motivate many people to spend now, so the benefits of economic stimulation will begin almost immediately. The government response is good on a number of fronts. Stimulating the economy will delay and soften the upcoming recession. The stimulation package pleases the rest of the world economy, which needs a strong US economy to remain healthy.

How do we as individuals reconcile our need to demonstrate individual fiscal responsibility with the overall economy’s need for us to spend? Depending on your perspective, this may seem like a moot point. Those of us who have been preparing for recession for years now are savings minded. Those who have not started taking savings seriously are not likely to begin now. But this is a serious personal philosophical question with which serious people should grapple.

Start by understanding that all debt is not bad. The savings-minded have a tendency to be extremely debt averse. Debt aversion is what prolonged the Great Depression long past the point when the economy could have recovered. As long as the debt you incur will provide a greater return than savings alone would have gained, debt is an intelligent choice. Debt is bad when it fuels consumption that has no long-term benefit. Even with the housing market continuing its correction, housing remains an intelligent debt. This correction will end, the next growth cycle will begin, and smart investments in real estate will continue to pay off.

As I mentioned earlier, recent government intervention makes it likely that we will experience another short burst of growth prior to experiencing a recession. Job growth hasn’t increased because it can’t – the labor market is too tight. But an interesting trifecta – the government’s new financial incentives for business to invest in infrastructure, the weak dollar creating export growth, and the emerging baby-boomer retirement wave – should contribute to earnings growth for American workers over the next few years.

All this adds up to one more opportunity to improve our individual financial positions without the cumulative effect of short-term contraction of the economy. If individuals were not spending so much money servicing existing credit card debt, those dollars would be available for consumption that has no long-term economic benefit, giving individuals rewards such as vacations while providing the economy with cash flow. So now is a great time to invest in our homes and commercial real estate, invest in reasonable-return infrastructure for our businesses, pay down short-term debt, and put ourselves in a position to be financially healthy when the correction does occur. If increased wages pan out, we will have money to both spend and save. The discipline is to ensure that saving is a well-considered part of that equation.

(c) 2008. Andrea M. Hill

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