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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.
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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.
