Once, there was a fishing village. It was on an island where the community thrived on the boat loads of fish brought in by its fishermen.
Some fishermen chose to fish from the safety of the shore. Never mind the lower returns. They could rest assured that the returns were safe. Some fishermen went out to sea. Returns were substantially higher, but there were risks. Ever so often, stories would emerge of shipwrecked fishermen who lost everything they owned. Some even lost their lives.
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Storms raged from time to time. Whenever a storm threatened, the fishermen clambered to shore. With a larger number of people fishing along the shore, the limited fish near the coast were shared among many, and so the returns diminished. A small number of foolhardy fishermen would continue to fish out at sea during the storm. Diminished competition allowed them to haul greater catches. With it came the promise of great riches. But only the skillful fishermen returned to shore. The less skillful ones got shipwrecked.
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Extending from the middle of this island was a seawall. It was high and uninhabitable, and the government of the island could extend it outward to sea at whim. When the seashore was left too wide, a large number of fishermen would stay ashore, severely diminishing the total haul of fish brought in by the few industrious fishermen who went out to sea. This promoted a form of laziness, and the government was wise to avoid such a situation.
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They found that pushing this seawall further out to sea had a positive impact on the total volume of fish brought in by the fishermen. That sparked an idea to use it as a tool to manage, and even boost, the total fish haul. They would keep the shoreline to a moderate width. Whenever a storm raged and the fishermen clambered ashore, the total fish haul would suffer a significant dip, damaging the overall wellbeing of the community. Towards the end of the storm, the fishermen would still hesitate to head out to sea, for the dark clouds still lingered. The government found that narrowing the shoreline by extending the seawall spurred some of the fishermen out to sea. Rather than put up with miserable returns on an overcrowded shoreline, those sitting on the fence were motivated to take that brave step out to sea.
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Soon, the clouds would clear and everything would go back to normal. The government would pat itself on the back for having brought the total fish haul back to normal sooner than it would otherwise have been had it not been for their wise intervention.
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Now, a storm is brewing in the horizon. Flashes of lightning and claps of thunder can be heard. The wind howls and the waves surge. The government recognises what this means for the total fish haul. They think to themselves, ‘narrowing the shoreline has always improved the total fish haul. Let’s narrow the shoreline now, so that there doesn’t even have to be a dip in the total fish haul.’ And so they do. In some parts, no matter how deep the fishermen press themselves to the seawall, they find themselves knee deep in water. At other parts, the fishermen barely have space for a foothold on the seashore.
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How about those who can’t navigate the storm? And this storm looks far worse than any other seen in recent times, where dark clouds rise in both East and West. How about those who can’t swim? How about the retirees, the children, and the infirm?
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Never mind them. Just bring in the fish. And the government considers pushing the seawall even further out so that people would now be waist-deep in water.
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What You Can Do in the Face of the Storm
When governments become obsessed in their pursuit of certain policy objectives, they expect monetary policy to subsidise their misguided actions. In other cases, instead of facing up to the consequences of a prolonged period of bad fiscal policy, governments choose to kick the can down the road. The wellbeing of the common citizen is thus shoved aside in order to serve the narrow-sighted ambitions of the few. Even without such self-serving ambitions, rational governments will loosen monetary policy in the face of economic storms. Those who can’t swim are affected, but it is for the sake of the greater good that the safe zone becomes less hospitable.
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When the survival of the whole is at stake, there is little bandwidth to hanker over the survival of the individual. The best thing you can do for yourself is to learn how to swim – that is, to manage your finances.
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Broadly, there are 4 things you can do:
- Understand the effects of an economic slowdown
- Be financially prepared
- Understand the effects of monetary policy
- Take advantage of the situation
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The economy fluctuates between expansion and contraction. Slowdowns can be brought about by various reasons. War, pestilence, the sudden collapse of major corporations, asset bubbles and misguided policy are but a few possibilities. Recessions result diminished business profitability. Some firms trim their headcount in order to remain afloat, while other collapse and bring their employees down along with them. Job loss results, affecting the livelihoods of many. For those who lose their jobs, their plans are put on hold. Saving for life goals takes a pause. Survival is paramount. Some may lose their homes because they cannot pay, some may go hungry because there isn’t enough money to put food on the table. Others dispose of their assets at rock bottom prices in order to stay afloat.
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It pays to recognise that economic storms come and go. We may not know when the next storm will come, but we know it will. With that knowledge, we should always be financially prepared. Debts cleared while things are going fine will greatly ease the strain when times are bad. Savings squirreled away when times are good will provide you a lifeline when times are bad. These small efforts may make all the difference between facing a financial shipwreck and weathering the storm.
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When the economic outlook is gloomy, central banks tend to adopt loose monetary policies to stimulate the economy. These policies lower the cost of capital through an increase in money supply or a decrease in interest rates. This makes it cheaper for businesses to finance their operations, thus providing a boost to economic activity. The increased economic activity, in turn, generates more jobs and provides more income for the population. At the same time, it increases the rate of inflation. This prevents a deflationary spiral where prices fall and consumers defer consumption in order to take advantage of lower prices in the future, putting the brakes on what might aggravate an economic slowdown. But brings with it an insidious side effect – it erodes the purchasing power of an individual’s savings. The money you saved on that holiday you skipped will not buy you a holiday of equivalent size; the savings you painstakingly built up for your retirement will not last as long.
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Holding on to the safety of risk-free assets including cash and cash equivalents will result in severely diminished purchasing power over the long term. That is the unfortunate price prudent savers have to pay for the greater good. But prudent savers have 2 things that work to their advantage over those who don’t save: financial resources and the presence of mind. Investment-grade risky assets generally benefit from increased inflation, some more than others. Wise savers can put their money to work to counteract the diminished purchasing power of their cash holdings. Savvy ones may even benefit from it.
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Thus, insofar as the outcome depends on you, make the best of it. For your future depends on it.