How to Survive the End of Inflation
Look around. Evidence suggests we're entering a deflationary period not seen since the 1930s. Here's how to recognize its signs and plan your way through* * *
Most of what we do as businesspeople we do because those things make sense -- like borrowing to make long-term investments in plants and equipment that will accommodate growth. Or buying real estate that will appreciate in value. We give workers annual raises partly because they've come to expect them, and because as long as the raises don't exceed the annual inflation rate, they don't really cost us anything. We plan for growth, for higher production of whatever our companies make or deliver. We borrow to finance research. All that makes sense. But change just one important characteristic of the economic environment in which U.S. companies operate, and most of what business owners and managers have seen as sensible behavior for nearly 50 years would make no sense at all.
The conventional wisdom that has defined good sense in the American business world since the close of World War II has rested on the assumption of steady inflationary growth. Not the kind of devastating inflation that cripples the economies of debt-ridden emerging nations or of the former Soviet republics. Not even the double-digit stagflation we experienced for a brief time in the late 1970s. Our business decisions are based on the assumption that inflation will be steady, mild, and offset by slightly higher economic growth, year in and year out. We make that assumption because that's the way our economy has worked, on average, since before most of us went into business. We don't give it much thought, but it shapes our notions of what makes sense.
If one assumes inflationary growth, borrowing makes sense because inflation reduces the real cost of the debt, and growth opportunities can more than offset the rest. Across-the-board nonmerit raises for employees make sense because inflation absorbs their cost. Steady growth pardons poor planning that leaves companies with too much inventory. Inflation props up the balance sheets of companies, including poorly operated ones, by driving up the value of their assets -- real estate, for instance. Inflationary growth forgives a measure of sloppiness and the occasional miscalculations of even the most scrupulous among us. But what if there were no inflation and steady growth stopped?
In 1988, when I was managing a young health-care-services company, several smudges appeared on the economic horizon that might have signaled a change in the inflationary growth trend and therefore a change in a good deal of what makes sense in business decision making. I decided to watch those and keep a lookout for other signals. Since then, here's what I've seen: falling commodity prices. In the mid-1980s farm commodity prices began to decline, which reduced the value of agricultural land. The prices of industrial commodities -- metals and chemicals -- also began to drop, which depressed the value of the land from which they were extracted and the plants in which they were refined and pro-cessed. Similar commodity-price declines preceded the stock-market crash of 1929 and the financial panic of 1893, the last two events marking the onset of catastrophic economic change in the United States.
Falling commercial and residential real estate prices. The value of U.S. commercial and residential property is no longer rising. In fact, it is falling and in some regions plunging at a horrifying rate -- 1%, 2%, 3%, 5%, even 8% per year, the reverse of its annual rise just a few years ago. A similar precipitous decline in commercial and residential real estate prices occurred in the Great Depression of the 1930s.
Plummeting foreign-stock prices. Since December 1989 Japanese stocks have lost the same percentage of their value as U.S. stocks did between 1929 and 1932. European stocks are down, too, and investors in the East and West have seen billions of dollars of wealth evaporate. The health of the Japanese banking industry now resembles the battered condition of U.S. banks in 1932. That U.S. stock prices are still as high as they are may be an aberration. In an economic storm, not all the waves move in unison.
Falling domestic interest rates. The Federal Reserve Board has lowered interest rates time after time since 1989 and has gotten little or no response from the U.S. economy from that monetary stimulation. Bank lending rates are as low as they have been in years, but borrowers aren't borrowing. Between 1929 and 1932, the Fed cut interest rates by 70% -- a reduction similar in magnitude to today's cuts -- but that action failed to rekindle economic growth.
Persistent consumer pessimism. Month after month the Conference Board's consumer-confidence index sinks lower. By this past October, it was down to 56.4, nearly half the 1985 level. It's no wonder, with reports like the one from the Bureau of Labor Statistics that 85% of layoffs between July 1990 and June 1992 were permanent, compared with an average of 56% in the previous four recessions. Alfred Sindlinger, the 85-year-old pioneer of consumer-confidence surveys and publisher of "Outlook," a newsletter in Wallingford, Pa., told Investor's Business Daily that today's conditions are "strikingly similar" to those of the 1930s. "We are now in a structural change just as we were in the 1930s," he said, "and it took World War II to get us out of that."
Confusion. I see and hear profound confusion, just as in the 1930s, among the people best trained and equipped to read the signals and understand what is happening in and to the economy. Is this just a recession we're having, a blip in the business cycle that, for all its apparent differences from other recessions, will nonetheless melt away? Yes. Maybe. No. Who knows?* * *
An academic can wait for all the data to come in before deciding what has happened. A politician can wait for the poll results. But for people running companies, signals like those outlined here tell me that it's prudent to take precautions. The question is, though, precautions against what? Continued recession? Maybe. Serious economic depression? Possibly, but possibly not. The answer in almost any case, I think, is to take precautions against a change in our long-held inflation assumption. What if, even for a relatively short time of several years, we see prices fall? What if we see deflation and an end to growth? If so, what makes sense, then, for business owners becomes very different.
In a deflationary or no-growth economy, borrowing to buy new plants or equipment might make little sense, even assuming you could find a bank that will lend the money, because the financial value of the assets you acquire will soon fall to less than the outstanding principal of the loan, and their operating value will be nil if demand and then your company's production fall off.
Financing current operations or receivables with lines of credit makes no sense, because even if nominal inter-est rates were low -- down to as little as 1% or 2% -- real rates would be high enough to eat up any profit. In a deflationary economy, the real interest rate is the nominal rate plus the rate of deflation. When prices are falling at a 10% annual rate, a 2% nominal interest rate is really 12% -- and most of that is not tax deductible.
Current entitlement-like compensation plans that escalate each year don't make sense, because in a no-growth economy the value employees add to a product or service doesn't grow every year. Employees won't earn more; they may earn less as the dollar value of a company's product falls. Furthermore, unless wages are reduced, labor productivity has to increase every year by at least the rate of deflation or the rate by which sales decline, just for a company to break even. That means even more pressure on business owners to learn how to do more with fewer people.
Carrying finished-goods inventory, even inventory you know you can sell, makes little sense in a deflationary economy, because prices of goods are falling. The product a company makes loses market value every day it sits in a warehouse. Furthermore, the cheapest raw materials a company can use are those it purchases today. Anything bought last week and stored for later use is, in a deflationary economy, more expensive.
Deflation punishes the little business errors that inflation forgives -- the excess inventory, the extra payroll costs, the too-optimistic sales projection. In a deflationary, no-growth economy, planning and control make sense; seat-of-the-pants operations do not.
The only times since its founding that this country has experienced serious deflationary downturns have been times of economic chaos, periods marked by what I call discontinuous change. By that I mean change that is not incremental -- a little more of this, a little less of that -- but abrupt and transforming. The last time the United States experienced a period of chaotic, discontinuous change -- the Great Depression of the 1930s -- the industries and companies that existed before it were not the same as those that emerged on the other side. In fact, few aspects of our economy stayed the same.
That was also true of the economic and political turmoil from 1837 to 1857, which pushed the country into war against itself, and of the worldwide depression of the 1890s, which marked the dawning of the modern industrial age. All three economic storms rearranged the U.S. business landscape, putting lots of companies out of business and clearing growing space for others. They turned the environment for business inside out and upside down. The U.S. economy that came out of those storms bore slight resemblance to the economy that went in.
For current business owners, the most terrifying aspect of the discontinuous change that accompanies economic chaos is that it is unpredictable. Furthermore, the transformation it brings is not even discernible until after calm returns.
Is another of these storms brewing? If so, what kind? Frankly, I don't know, but if you agree with me -- if only for the sake of discussion -- that warning signals of the deflation and market shrinkage that often accompany such storms are in the air, is that enough to act on? If you think something's going to happen, but you aren't sure what or when, can you get ready? I think you can.* * *
Tune Your Antennae
The worst error any company owner could commit today would be to pay no attention to the warning signs. Monitor worldwide economic and political trends, even if they don't seem immediately relevant to your company. A good daily business newspaper or weekly business magazine is the place to start.
Watch what the Federal Reserve Board does with interest rates and what happens as a result to the money supply. If interest-rate reductions don't prompt robust growth of the M-2 or M-3 aggregates, that's a strong hint of a no-growth economy to come.
Watch what the new administration and Congress do about the budget deficit. Any action is going to have some economic consequences. Taking no action only delays the reckoning.
Anything that reduces U.S. exports is potentially dangerous. When President Hoover signed the Smoot-Hawley Tariff Act, in 1930, the new law put a serious crimp in trade. Watch the progress of the General Agreement on Tariffs and Trade (GATT) talks, what Congress does with the North American Free Trade Agreement, and Europe's progress in achieving economic unity. Setbacks to any of those are bad news.
Watch for stories about Japanese banks. They're pulling back on loans and investments in the United States to cover huge speculative losses at home. Any abrupt dumping of their U.S. assets, including U.S. Treasury debt, will spell credit trouble for small businesses.
Most depressions are international in scope, so in that sense any good economic news from Europe and the Far East is good news for the United States. Watch for gross-domestic-product (GDP) and stock-market news from major European cities and Tokyo. Falling output and prices there are not good signs here.* * *
Check Your Assumptions
It is dangerous to assume that what has been true in the past will remain true in the future, which means that nothing you currently do as a business owner or manager should go unexamined. Ask questions:
How much inventory do we carry? Why?
What's our policy on receivables? Why?
What makes a customer creditworthy? Why?
What are the terms and length of our current contracts with suppliers? With customers? What terms might we want to adjust? Where is there room for adjustment? Where is there not?
How do we compensate production workers, staff, and salespeople? Why?
Are we locked into a fringe-benefits package?* * *
If a business owner thinks, as I do, that some chance of deflationary economic shrinkage exists -- whatever the nature of the storm that brings it -- there are hedging steps to be taken. They involve capital expenditures, real estate, debt structure, inventory, compensation, and work force. The general rules would be these: (1) don't buy what you can't pay cash for, and (2) avoid commitments that lock you in. Here are some specifics:
Lease, don't own. Plants, equipment, office machines, vehicles, and real estate are all assets whose prices could plummet and do serious damage to your balance sheet. Besides, in a serious downturn you may not even need all of them. If you need some now, get them on a short-term lease. If you own them now, see if you can sell and lease them back.
Shed debt. Any new debt or debt you currently owe will only get more expensive with deflation. You'll be paying it off with dollars that are worth more than those you borrowed. New debt won't be a problem if you lease instead of own, provided you can get out of the lease. Existing debt you should try to get rid of. If I owned a small business right now, I'd think about cutting my salary and using the savings to pay down long-term loans. I'd think about raising equity -- from friends, family, a partner who wasn't looking for an active role -- and using it to reduce the company's debt load. Bankers can and will call most business loans during a crisis, so I would consider converting unsecured business debt to a personal home-equity loan, which offers greater stability.
Shed people. Some portion of any company's employees are superstars -- they're worth more than they're paid. Another group probably just earn their wages. And a third group you keep because, when averaged with everyone else, they get the job done. It's difficult and sometimes unpleasant to bother finding out which employees belong in which group. Take the trouble, then make sure you keep the first group as employees. Consider converting the second into contract labor so you won't be stuck paying for their increasingly expensive benefits and automatically escalating wages. The bottom third you probably don't need. Productivity is survival in a deflationary, no-growth economy. That means wringing the best from the brightest, who will respond to incentive-based compensation. Contract labor gives companies flexibility to respond quickly to changing demand. And people who aren't adding value to the company's product or service that is at least equivalent to what they're paid have no place in the organization, anyway.
Examine contracts. If a long-term agreement locks your customer into a price, that's good; if it locks you into a price with a vendor, that's not good.
On the cusp of the 21st century, old-fashioned conservatism -- save your money, and don't buy what you can't afford -- has a lot of appeal.
But what if I'm wrong? What if the 1990s turn into a decade of more of the same -- solid growth with mild inflation? If I'm wrong and you've taken my advice anyway, I'll still be relieved. On the one hand, you will have been holding back when you should have been reaching, so your company's sales won't be as big or your market share as large as if you had vigorously pursued growth. On the other hand, even if I'm wrong and you've missed some growth, your company's profit margins will have improved with the productivity gains you've made, and -- more to the point -- you will still have a company. That won't be the case if I'm right and you've continued along the old course, doing those things that used to make sense.* * *
Eric Kriss is the former CEO of Medi-Vision, a 1989 Inc. 500 company. He has devoted the past two years to the public sector as chief financial officer of the Commonwealth of Massachusetts. To voice your opinion on this piece, you may write Kriss care of Inc. , 38 Commercial Wharf, Boston, MA 02110; fax him at 617-248-8090; or call 617-248-8111 to record your comments.