Have you ever considered the possibility of the tallest stack of cards being the most stable? According to Wikipedia, professional card-stacker Bryan Berg claims, the more cards placed on a tower the stronger it becomes, because the weight of the cards pushing down on the base allows the occasional card to stumble without the entire structure collapsing. This seeming aberration of logic also applies to the functioning of an economy. A few financial institutions collapsing or the stock market crashing due to new-age dotcom companies is akin to falling of the occasional card. While it is likely to cause a tremor (major or minor) in the short-term, over the long-term the economy continues to grow. These tremors occur because the aura behind new ideas and concepts attract a lot of attention initially. For instance, in the early 2000s, investors were attracted to the new concept of Internet companies resulting in the mushrooming of numerous hasty players, many without a clear vision and a business plan. This resulted in a major short-term (12 months) tremor, but over the long-term it also gave rise to majors like Google, Amazon, E-bay and several other dotcom businesses that contribute handsomely to the economy.
In the recent times, few economies have escaped the tremors of recession. Understanding the reasons behind recessions and rectifying past mistakes is the most effective way of shielding global economies from the fallouts of downturns that the future may bring.
Back to the basics
Through the times, economic downturns have had their unique characteristics, with the economy being plagued by distinct factors making it difficult to apply a singular solution to each. At such times, it is important to define the phenomenon itself before analyzing it.
A recession can be based on one of two variables, unemployment or gross domestic product (GDP). If there are two quarters or more consecutive quarters where the GDP falls or there is a 1.5 per cent rise in unemployment, this period can be identified as a recession. “Recessions occur when the economy has to adjust to large unanticipated shocks to resources, technology, productivity etc. and the resultant sharp changes in relative prices within a short period of time. When the economy has to adjust to new situations, some sectors will shrink and some will expand. Changes are unavoidable and when they are larger and less anticipated, the adjustment process will be more costly and painful,” explains Mr. Ravi Jagannathan, Professor of Economics at University of Chicago.
One of the foremost examples of economic recession was the Great Depression (a 1930s economic crisis) whose primary cause was attributed to the stock market crash. For a sizeable period after the First World War, people started dabbling in stocks. They invested heavily in the stock markets as the idea was novel and generated excitement about the rising value of stocks. Once the market displayed the slightest hint of a downward trend, people panicked and overestimated this financial rut, leading to the markets crashing eventually. Thus was born the Great Depression.
Through this article, we outline four phases of economic unrest that we have seen in the past three decades and identify ways to reduce the impact of these downturns through better decision making.
The 1980’s – Stagflation takes over
In order to control inflation, the United States government increased interest rates and introduced a contractionary monetary policy, which adversely impacted the money supply. Earlier fallouts from the energy and oil crisis in the 1970’s remained unresolved, unemployment rates were at a staggering 7.5 per cent and inflation soared further to 13.5 per cent. The United States economy was in a unique state known as stagflation- an economic situation in which inflation and economic stagnation occur simultaneously for a significant period of time. To curb inflation, the Federal Reserve under Paul Volcker, hiked interest rates from 11 per cent in 1979 to around 20 per cent in June 1981. In hindsight this was considered a drastic measure. As a result of high interest rates, business houses failed to prosper with the disparity in the demand-supply ratio. The downtrend caused further unemployment that led to a recession which officially ended in November 1982.
What we learnt
Government and regulatory authorities must take a step by step approach while hiking interest rates thereby giving the economy breathing space to make necessary adjustments to the same.
1990’s – Crying over spilt oil
The raging Gulf war meant raging oil prices. Oil sold at $21 a barrel in July and hit $46 by mid-October 1990. This was a classic example of how the price of one commodity affected other sectors as the cost of transportation and manufacturing increased, resulting in steeper selling prices. Several experts believe that the accumulation of debt from the late 1980s in the US and new banking regulations post the savings and loan crisis (The S&L crisis of the 1980s and 1990s was the failure of 745 savings and loan associations) contributed heavily to this recession. However, this was a fairly short downturn that ended in less than a year. Post this, America saw its longest period of growth that continued into the late 1990’s till the dotcom bubble burst.
What we learnt
Investing in alternative energy resources even when oil prices are stable is a smart move. Innovation in the fields of alternative energy and renewable energy technology is critical to avoid over-dependence on oil. Government subsidies and regulations for green resources should be permanent, not just political trump cards that are used when oil prices are extremely high.
Early 2000’s – The rise of the Internet surfer
Although the dot com bust revolved around the burgeoning interest and investment in Internet firms during the period of 1995-2000, there were other factors that contributed to it. As people warmed up to the concept of the Internet, numerous web-related companies mushroomed, each propounding a daring innovation of their own. The bubble grew ominously big and popped when it could no longer be contained. Alongside outsourcing and the heavy hand of terrorism (the 9/11 attacks), the bubble bust laid the path to a downturn. Simply put, the market was rising too sharply as all the money was being crammed into the dotcom industry for immediate gains.
What we learnt
Invest in what you understand. Businesses need a revenue model to survive. Great ideas with no proven revenue model do not work.
Late 2000’s – Trouble on the home turf
In sharp contrast to the earlier downturns we have discussed, the late 2000’s recession was triggered by a single factor- the subprime mortgage crisis. Financial institutions and mortgage companies produced far too many complicated financial instruments whose underlying assets were homes owned by Americans. The default rates on these ‘subprime’ (a classification of borrowers with a tarnished or limited credit history) loans sky rocketed and several financial institutions were badly hit. This was also a clear case of failure in checking government policies and regulations. Investment Banks and Hedge Funds contributed to providing large amounts of the credit to the American economy, but were not regulated under the same terms as banks. Over time people lost their belief in the government as later reports proved that the government was well aware of such repercussions and decided to wait on the consequences.
The fall of Lehmann Brothers was an indication of all that was to come, an economic situation that shocked and destroyed the livelihood of many. Poor economic policies combined with the greed for immediate gratification contributed to the big crash.
“The real estate sector is in a mess. The number of households not being able to meet their mortgage payments is increasing. Mechanisms that facilitate households to reorganize without going through costly and time consuming bankruptcy/foreclosure proceedings will certainly help recovery,” says Ravi Jagannathan, Professor of Economics at University of Chicago.
What we learnt
Avoid the ‘herd mentality’. Do your own research and analyze your options carefully before making investment decisions. Panic buying to ensure ‘you’ don’t miss the boat can backfire. Fixing the mess should not be downplayed.
If there is one common thread running through these phases of recession, it is that human insecurity is at the centre of most chaos. The underlying fear of being left out in the game leaves one far short of the actual grasp of the risk-reward ratio. Is that investment a calculated risk, or merely a risk? Are you being prudent or avaricious? What impact do globalization and outsourcing have on a particular investment? Knowing the answers to all these questions and more will help make wise investment decisions. Risk-analysis, as a field, is going to gain tremendous importance, and must not be forgotten during boom periods. Although, these measures do not guarantee a recession-free economy, the smallest personal effort in the right direction could impact a change world over.