The world economy is not about to turn for the better. We have not reached the bottom. The downturn is not slowing down. The relative lull we have right now is just gaining momentum for a full-speed downward spiral. At least according to Robert Prechter. He has a book out - Conquer the Crash: You Can Survive and Prosper in a Deflationary Depression - where he conjures a scenario of impending doom, of a recession worse than anything we've seen in two hundred years, including the stock market crash of the 1920s and oil crisis of the 1970s. He uses the Elliott Wave Theory for his predictions and maintains that we are headed to what he calls a new "grand super cycle" of the economy. Although there are examples of his previous successes as well as failures in another interview, there are people who are even more skeptical. Nevertheless, he raises several issues that are very important to address even if they don't lead to a worldwide economic meltdown.
But by no means is he the only one with doom and gloom on his mind. One of the less-publicized news from the World Economic Forum in Davos, Switzerland was the dread leaders of the world expressed with the near future of the world economy and general helplessness as to the remedies. Japan has been in the throes of deflation for years and interest rates have gone below zero. Basically, if you go to a bank and ask for 10,000 loan, they give you 10,100. In practice this happens only in certain special circumstances, but in effect lending money is almost non-existent. Japan also warned G7 economists of an impending worldwide deflation; Germany is already strikingly close. In the US, consumer confidence crashed and woke up economists to a waking nightmare. And the Fed has cut interest rates to 1.25%; soon there will be nothing left to cut.
More problems arise from a growing US credit bubble. Consumer debt-service burden reached 103% in 2002. Yes, you read that right: an average American gathers more debt than he collects paycheck. It shouldn't come as a surprise that over 6% of credit card debts are bad. This is related to a debt bubble on a grand scale, the one of US national debt. Gross federal debt will break 6 trillion dollars (6,000,000 million!) during this year when US GDP is 10.5 trillion dollars. Interest expenses alone are over 300 billion (300,000 million) dollars per year PDF Google html. And the debt is projected to rise. In other words, the US has no intention, nor the ability to pay off its debt. This kind of spending on credit works as long as everything goes well, but not longer. Deflation, extended worldwide economic recession and other shocks to the system are just a few of the possible reasons why things could go wrong. And even if the credit bubble does not burst, the deflation mentioned in the previous paragraph is a real threat. Regardless of whether a war breaks or if there are new terrorist strikes.
"But I thought deflation was a Good Thing?" It is true that prices fall and holding on to your cash its value will rise with time. But it also means that people will cut back on spending to wait for prices to fall even lower, banks can't get business because people and companies don't borrow money due to very low or negative real interest rates, and businesses cut on investments because it will be cheaper in a year and people don't buy their products in any case. So any level of deflation is worse than a healthy level of inflation which stimulates growth.
"So what? Why should I care? How does this affect me?" It depends a lot on how bad the recession will be. Nobody obviously knows how deep the hole we are plunging into is, and therefore doesn't know how long the fall will be. I will present two scenarios; the reality will probably lie somewhere between these extremes.
Scenario 1 - Long PFFFFFFT
World economy goes into a wide-ranging but somewhat manageable deflation. Business investment goes down but major bankruptcy-waves are avoided. Unemployment will go up and governments take measures to hold back deflation. In a few years deflation is history, inflation level is back to the healthy 2-4% and interest rates are back to normal. Unemployment and consumption will take longer to normalize. Although John Doe might not get laid off, the recession might result in losses that amount to the price of a new car. The losses will be even higher if he has debt, or owns stocks or bonds.
Scenario 2 - Four Horsemen
World economy plunges into an apocalyptic deflation cycle headed by Japan and the US. Fed doesn't know how to handle deflation and takes drastic knee-jerk measures with apocalyptic results. Deflation is defeated, but inflation will keep on rising leading to hyper-inflation. The credit bubble bursts sinking banks and pension funds all over the continent. The US dollar crashes. With it go many currencies pegged to the dollar; others will float or are pegged to the euro. Although the euro is relatively well-guarded from changes in USD, the world economy can not handle the massive compounding effects of the biggest currency taking a downward spiral and many of the aforementioned pegged economies along with many independent ones fail. The shockwave travels across the world: the already frail economy of Japan implodes and Europe's diminishing exports take down the whole EU. Company profits turn red and governments try all possible measures which result in even worse circumstances. People's trust in stocks, banks and even money itself weakens and finally just ends. The entire fiat-system of money fails with cataclysmic after-effects. People will use precious metals as currency and/or move to barter trade. It will take the world at least a generation to recover.
So, what can John Doe do to protect himself? Bob Prechter has several suggestions. If at all possible, the most important thing is to get rid of all possible debt, stocks and bonds as well as land and property which are not essential. Cash will be the king, and some of that should be invested in precious metals. Not in companies that mine precious metals, but in gold, silver, platinum. Dont' by luxuries. If you are experienced in short-selling, now is the time to do it. If the situation resembles Scenario 2, there is not much you can do. Cash will be worthless, so John will do better if he has most of his cash in precious metals.
What if Bob Prechter is wrong? What if the economy recovers and sun shines? Good, it would be nice to see optimists being right every once in a while. Reducing debt and postponing big investments is not very expensive for John Doe. If he does, he will only be marginally worse if the economy doesn't fail. If he doesn't, he should remember the headlines in the 20s when stock brokers hurled themselves off buildings in desperation.