Pick your poison

by John R. Burgess

Which way is the american economy heading??

Oil prices have been trading above $90+ per barrel, housing starts down 34 percent, gasoline is $3.30 a gallon, unemployment is up, new job creation is down.

Which way is the American economy heading? What is going to happen next? What impact will a recession or inflation have on small business and...

How can it be best dealt with?

The Federal Reserve

In order to review the situation, we must look back to make a reasonable assessment regarding what has precipitated reaching the current state. Any follower of economics understands that the Federal Reserve Board’s major focus is to stop inflation. The reason for this is that an inflationary spiral, or spike in prices, causes fixed income assets to be worth less over time. This makes it extraordinarily difficult for the average American to maintain the same standard of living they enjoyed prior to the inflationary period. The Federal Reserve Board also has to look at how they continue to move the economic activity forward in order for the overall economy to continue to provide all the goods and services necessary to afford that same standard of living.

It’s all strikingly similar.

The truth is it’s diametrically the opposite. Look at what happens during a period of inflation. The price of goods and services escalate to the point where the average buying power decreases in relationship to the average earning increase. In other words, a person that earned $800 per week was buying goods and services equivalent to $800 per week. The reason there’s no difference between the goods and services being bought is because the savings rate in America has reached a historically low percentage of zero. Yes, zero. Zero means that in the aggregate, no one saves in America. Take into consideration, of course, that there are many people who do save, there are also people who don’t. Many people build up short- term indebtedness greater than the amount of monies that people actually are saving; therefore, the net effect is zero.

Look at this inflationary spike and consider its impact on all Americans. The average American family would not be able to maintain the same standard of living which they previously enjoyed. Certain portions of a standard of living can’t really be altered, such as home mortgage payments. However, mortgage payments would actually go up. Why? Even if there is a fixed rate of interest, there is no doubt that during inflationary periods of time property taxes increase.

The reason for this is that the municipality, which is increasing the tax rate on your home, is having the same difficulty with inflation. It puts them in a position to have to raise more funds. In most municipalities, the only reasonable way to raise funds is by raising the property tax because they don’t have any other significant source of income. Property tax escalates as well as home heating costs. Why? During any inflationary spiral the energy cost is a key component of the inflationary spiral. This includes the cost of food and clothing, as well as the cost of insurance which might increase, but only on the carrying charges of any obligations that the insurance companies have. Theoretically, they can get a rate of return on their investment so those numbers might stay stagnated, but many of the other operating expenses will increase.

So, what’s the consumer to do? Cut something out. What should be cut out? Those are hard choices to make.

The other end of the spectrum is a recession, defined by the United States government as two consecutive quarters with declining gross domestic product. If the Federal Government says the gross domestic product increase for all of 2007 is only going to be 2 percent, note that they’re projecting 2.7 percent for 2008, and these numbers are dangerously close to being a negative on the gross domestic product, taking into consideration the many years with gross domestic product increases of 4.5 percent, 5.5 percent, and 6.5 percent.

Assume that the economy spirals into a recession. What impact does that have on the average American citizen? Clearly, a recession means that there are less people working and less opportunity for chances to earn money. Big employers, the largest companies in the system, are forced to become lean and mean to accommodate their need to produce profit for shareholders. Where is the first place to cut expenses? Employees. Currently, the country enjoys an extremely low unemployment rate of approximately 4.7 percent, but that number would escalate. In the past, we’ve seen it in the 9-10 percent range. Would we see that during the next recession? Only time can tell.

What else happens during a recession? The declining economic activity in America causes the average consumer to be concerned with the capability of meeting future obligations, thus further reducing the economic activity. Why? Fear and greed are the two principle components that drive any economy.

What’s next?

Realistically, if 100 economists were lined up and asked, "Is the economy going into recession or are we going to enter into a period of much higher inflation?" they would be divided in half. It’s almost impossible to tell what’s going to happen.

At the moment, it is incredibly difficult for the Federal Reserve Board of Governors to regulate the economy. Realistically, housing starts down 34 percent and that number is horrendous. Nationally, the average price of homes is going down for the first time in many decades.

So, what do we have to do? Clearly, it’s not right that the average American finds their singular greatest asset, their home, has become non-liquid. In addition, there is a loss of equity. Nor is it right that all of these individual homebuilders and their hundreds of thousands of employees are left with no business whatsoever. On the other hand, if interest rates are lowered to accommodate the improvement of overall housing industry economic conditions, what happens to inflation? What happens to an overheating economy when a barrel of oil costs $90+ and a gallon of gas costs $3.30?

When was the last time you were at the grocery store and didn’t think the price of meat, bread or milk had gone up? Or, the price of the meal at a restaurant? Or, the price of clothes when shopping for your children? There are pains of inflation, even though we are told there aren’t any. The reason there aren’t any sharp pains is due to productivity gains. The greater amounts of technology in the manufacturing processes throughout the country are masking the pains of inflation.

Recession proof your business

How can a business owner recession-proof the company? The first thing to do is review all costs, including labor, overtime and overhead. Also, look at how the business could increase worker productivity to maximize investment and to reduce labor costs.

A company can look at its credit and collection policies and make sure that they are collecting their accounts receivable in a timely fashion. They can also look at their own credit worthiness and make sure it is so impeccable that they further reduce their own credit and carrying charges going forward. Create an optimized inventory in order to eliminate excess inventory not producing both a profit and a positive cash flow. Look at long and short-term debts to take advantage of declining interest rates. More importantly, seek to reduce short-term obligations by delaying some debt to a long-term obligation, taking into consideration that long-term debt is collateralized by assets. The assets may decline in value greater than the amount of the reduction in debt, therefore, creating a negative posture. Thoroughly review the ramifications of that decision. Small businesses looking to recession proof should compare their cost structure with the bestmanaged companies in the industry. Review cost trends for the past four years and aggressively manage the cash flow during an economic slowdown in order to maximize the cash flow during that period. Take an in-depth look at how to increase employee productivity while revenues decline. Do this by implementing a productivity-based excess profit incentive program for those employees who most impact the bottom line. Look at an overall methodology of controlling every critical variable within the business to increase the likelihood that any one of those critical variables do not cause even more of a decline in profitability.

An interesting circumstance for every business is what to do with the increased costs. Should it be passed on to the ultimate consumer? It has always been the quandary of the individual business person to make an assessment as to whether this strategy will cause revenue loss. It is interesting to note that during any period of economic slowdown, it is incumbent upon the business owner to make a determination as to what the impact on profit and cash flow will be. During regular economic times, small business owners are inclined to believe they should be revenue-driven. During the times of a recessionary- driven economy, it is necessary that every business owner take into consideration profit and cash flow, rather than just revenue, in the decision making process.

Moving forward

The United States will reach a very complex position in history. The complexity is something that no one has ever even imagined. As the dollar continues to decline, we should be fearful that other countries will believe that the United States is not in the right place to invest monies. A heavy withdrawal of monies out of the system, fixed rate investments, equities market, residential property, or the commercial real estate market would clearly put the country in a position where a recession is likely. Additionally, if folks were to take money out of the system, equities, fixed-rate interest investment items, or whatever they might be, the country would clearly be in the position where the value of the dollar declines even more precipitously.

Look at how much the dollar has declined. I specifically recall the first time I went to Europe, after the introduction of the Euro, when it was worth about 80 cents to the dollar. The second time I went, it was worth equal and I thought that was horrible. The last time I went, it cost me $140 for 100 Euros. My gosh, what a difference. It’s gone from 80 to 140 and that’s about a 70 percent decline.

American citizens have always been compelled in this country by three, four and five percent increases or declines and considered that amount to be great. Now, we are looking at 70 percent decreases—70 percent decline in the value of our dollar. At what point does that, the trade deficit or federal deficit, become important? Rather than arguing that, as a percentage of gross domestic product, our overall deficit in this country is still a relatively modest percentage in relationship to the all-time highs, lets look at the total indebtedness.

Two sides to every story

Why is it wrong that Mr. and Mrs. Smith have so much debt that they have to contemplate bankruptcy, but yet, it’s fine that the Federal Government has so much debt it has to contemplate raising the amount that we have to pay to offset the carrying charge? On the adverse side of the argument, assume that there isn’t a recession, but rather, escalating in- flation. That would cause the Federal Reserve Board to increase the interest rates dramatically. Assuming, for a moment, they would increase the interest rates from 7 percent to 10 percent. Oh my gosh! What would happen to the carrying charge on the national debt? It would literally go up three points against seven, which is three-sevenths, or 40 percent. What would that do to the tax rates in America?

At what point is it okay for Mr. and Mrs. Smith or the Federal Government not to be reasonable or prudent? It’s time to become more of an activist in this country. Become more attuned to the 60’s and 70’s—and focus on what’s necessary for the best interest of the country going forward. Every business owner has an obligation to themselves, their employees, vendors, customers and everyone else that comes into contact with the business, to act responsibly in its management.

In order for this country to remain the strongest economic society of all time, which it clearly is, it is necessary that every vital component of that economy continues to move forward. Look at the obstacles going forward. If we pick our poison between recession and inflation, it will absolutely happen that one of the two will occur within a relatively short period of time. The Federal Reserve will overplay its hand and either reduce interest rates too much, or raise interest rates too high. The alternative to that will be recession or inflation. Business owners need a plan to attack both of the alternatives head on. That is both the role and obligation within the broader framework of the U.S. economy.