What is a recession and how would we deal with one?
We’ve recently passed the ten year anniversary of Lehman Brothers’ collapse. The 150 year-old investment bank filing for bankruptcy is often seen as a pivotal event in the run up to the global recession.
However, one thing we did not discuss in detail was this: what is a recession and what should young people like me do if there is another?
What is a recession?
Just like hiking mountainous terrain has its ups and downs, so do economies and markets. Thinking of a recession as the flat part of a trail may help you understand it (I am a big fan of analogies and nature).
A recession is commonly described as a prolonged period of reduced economic activity, usually a fall in GDP in two successive quarters.
Going back to my hiking analogy – when you're either climbing up the mountain or going down, you are spending more energy and resources. However, once you reach a flat portion you drastically reduce your work.
The economy does something similar when there is a recession – it reduces its activity level. There might be a specific event or cause that sparks a recession, but a common factor is a sudden decrease in overall economic activity.
What would a recession mean for my finances?
The economy and markets are complex and continuously evolving. There is no one absolute way that a recession occurs, and there would be various implications.
The effects on personal finances would depend on each person’s situation. It’s also important to note that even though there might be some historical trends we can reflect upon, this does not necessarily mean we can refer to history as if we have a crystal ball for future events.
With that being said, the following are some common developments during a recession:
1. Global stock markets and GDP (Gross Domestic Product) fall
When global stock markets and Gross Domestic Product – an estimate of the total monetary value of a country’s goods and services - fall, invested assets often also decrease.
During the worst phases of the most recent crisis in 2008, Japanese and European stockmarket indices lost more than half of their value, as measured by the MSCI Japan and the MSCI Europe (excluding UK) indices. World, US and Asia (excluding Japan) indices all fell by more than 40%, while the UK lost over 35% of its value.
Here in the US, where I live, this wiped out trillions of dollars in retirement assets across defined benefit, defined contribution and individual retirement savings accounts. Overall retirement accounts lost around 31% of their value.
2. Reduction in available credit
Banks could also reduce their lending activity, which can decrease the available credit consumers and businesses can access (heard the phrase “credit crunch”?). For consumers, this could in turn reduce spending everything from homes to cars or holidays.
Across the pond, some of the largest US credit card companies reduced their customer credit lines by 4.5% during the second quarter of 2008.
3. Business revenue and investments decrease
When consumers (that’s us) stop spending, it also may affect business revenues. When revenues are down, businesses start to focus on cost savings and may halt investments in their workforce and development. Reduced employment levels, stagnant wages and pay freezes could occur.
It was estimated in a report by PricewaterhouseCoopers that 7 million jobs were lost across the developed world from the second quarter of 2008. The US was said to have been worst affected, with a loss of almost 2 million jobs (including mine) in the last four months of the year.
Recessions sound scary!
Just like hiking into the unknown can be daunting, recessions can be equally as intimidating. The recovery and market reactions could either be a steep climb out over a short period of time or a gradual walk out over the course of years.
Governments and central banks will sometimes step in and introduce policies to help the economy pick up its pace. For example, interest rate decreases or quantitative easing (where governments buy financial assets such as bonds to increase liquidity, i.e. money supply) could be implemented to help the economy by encouraging spending.
How could young adults prepare for a recession?
It’s not easy to plan for a major economic event and a have a set crisis response to something that is widely unknown until after it hits. It’s much easier to plan for a blizzard. However, there are some reactions and situations you may be able to avoid.
1.Pay down credit card debt
As discussed above, one of the most common reactions of banks during recessions is to reduce lending, which could mean your personal credit limit being reduced. The rates and fees on personal credit cards may also increase and impact your overall credit score.
2. Don’t get caught up in the media hype
According to Nobel prize-winning behavioural economist Richard Thaler; “Paying attention day-to-day is damaging to one's financial and emotional well-being.” Maybe a digital detox is not just good for your productivity, but also your investments?
Richard focuses on the human element of markets and investing. Part of this is how “loss aversion” influences investors. In his words; “loss aversion can prevent investors from taking advantage of the long-term opportunities in stocks.”
When investors see the value of their investments start to fall, they might decide to sell low to avoid more loss. However, this could be seen as a missed opportunity when the market rebounds, especially for the young investors with time on their side.
Although be aware that your money is always at risk with investing.
3. Save, save, save
Having a rainy day fund is incredibly important during times of financial uncertainty. As the economy slows down, so do some employers’ ability to increase salaries and continue hiring. You might not be able to have twice your salary saved, but having some sort of cushion will help.
At MoneyLens we are constantly sharing ways to save money.
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