For consumers seeking to get through the current recession with minimal long term damage, you should consider the following:

1. Reduce your debt levels, especially high interest credit debt and other consumer loans.

2. Try to build and maintain an emergency cash reserve.  Ideally you would have your reserves already, but better late than never.  If you have a stable job, shoot for at least 3 months x your monthly expenses.  If you are self-employed or your income varies, try for 6 months x your expenses.  This seems like a huge sum, but this was normal for past generations to maintain substantial cash reserves.

3. Focus on maintaining your employment.  Losing a job during an economic recession can be devastating.  Maintain your professional network.  Focus on building skills that are essential to your company and keep your eyes open for potential warning signs that layoffs are coming.

4.  If you are nearing retirement, consider postponing retirement.  Retiring during an economic downturn when you have to rely on selling stock investments for income can destroy your retirement plan and force you back to work in the future.

5.  Do not panic with your long-term stock and mutual fund investments.  It is way too late to sell anything now and if you can hold on, you will likely be much better off in the future by not exiting the market now.  At least that is what history teaches us.

Folks who have low levels of debt and plenty of cash reserves are typically in a good position to take advantage of times like this when assets fall in value.  Income property, stocks, commodities and most other assets are dropping in price and once the recession ends, buyers who were able to scoop up bargains during the recession will enjoy the benefits of their increasing wealth.

This recession will end as they always do, but this will likely be longer than either of the past two recessions (7/90 – 3/01 and 3/01 – 11/01) which both ended after 8 months.  The current recession will likely look more like the recession of 7/81 – 11/82 which was 16 months long.  So if the recession began last November and lasts 16 months, then we could be heading out of it by the spring of 2009.  The problem is we won’t know for sure for another year after.

Hang in there.

In order to understand our current financial situation it is best to take a closer look at the recent history of our country’s economics.

A Bit of History

During brief recession of 2001, the Federal Reserve reduced interest rates sharply and kept the interest rates low for an extended period of time.  The availability of cheap money was one reason for the dramatic escalation in house values from 2000 – 2005.  The easy underwriting of mortgage loans also contributed to the housing bubble.  The very low interest rates were helpful to consumers, but reduced income for investors who participated in the fixed income markets.  The search for higher returns led to the creation of sub-prime loans as these borrowers paid much higher interest rates than traditional borrowers.  Other investors earned higher returns by borrowing money very cheaply and using the borrowed funds to speculate in assets around the globe.

Everything worked fine as long as the collateral (single family homes) continued to increase in value, but once home prices began to fall, many of these debt instruments tied to home values, began to fall apart causing huge losses for investors.  As losses mounted for mortgage lenders, investment banks, and commercial banks, we witnessed first hand the dramatic negative impact that excessive leverage can have on investments.  Bear Stearns was sold over a weekend to JP Morgan Chase.  Countrywide was forced to sell to Bank of America, Lehman Brothers is in bankruptcy, Merrill Lynch was sold to Bank of America for an amazingly low price, Washington Mutual was sold a fire-sale price to JP Morgan Chase, and Wells Fargo bought Wachovia.  The major investment banks have either been forced to merge with banks or they became commercial banks.  The impact of de-leveraging is still causing major volatility in the stock markets around the world.  As institutional investors desperately try to reduce their debt loads, they were forced to raise cash by selling other assets including stocks which continue to add to the market volatility.

Since housing is such a significant driver of economic growth, once home values began falling, consumer spending also began to slow dramatically.  Fully 2/3 of our economy is based on consumer spending.  Home equity lines provided plenty of credit for consumers who wanted to buy a new car or plasma TV or remodel the kitchen.  Much of consumer spending has been cut back dramatically.  When consumers cut back their spending because they are afraid of losing their job or they have maxed out their credit, business sales and profits are reduced, which can eventually lead to business layoffs.  Increasing unemployment increases consumer fear and this leads us back to reduced consumer spending and the circle continues to drag the economy down.

In an attempt to curtail this recessionary spiral, the government has tried to stimulate the economy.  The first attempt was to reduce short term interest rates.  After 8 interest rate cuts, our short term rates are now down to 1.5%.  In addition, a fiscal stimulus was announced where a tax credit was used to give most citizens a check they could spend.  The increased consumer spending was noted in the summer of 2008, but it quickly dissipated.  At this point the government is trying to figure out how to stem the tide of foreclosures hanging over the housing markets.  It could be that the cure is worst than the disease.  There is a chance that excessive intervention by the federal government to try to reduce or mitigate the recession could actually prolong the recession.  In a capitalist society, if you try to make sure nobody can lose, you will also create an environment where nobody can win.  Time has a way of taking care of imbalances in our economy and eventually balance will be restored, though it will be very tough to individuals and businesses who took on more debt than they should have.

We have seen forced selling by hedge funds, banks, and mutual fund companies to satisfy the demand for cash.  When market participants are forced to sell in a short time frame, the result is dramatically falling stock prices.   Over the past several months we have seen panic selling that defies logic.  Current stock prices are at multi-year lows and have likely been pushed below what is fair value.   At this point, investors are anticipating a severe recession in which corporate earnings are going to be sharply reduced.

On the brighter side, the recent collapse of energy prices has helped to bring gas prices back down from their historic climb earlier in the year.  Things would be much worse if we still had to deal with $150 per barrel oil.

While the news media debates whether we are officially in a recession or not, the reality of the current situation is that we have likely been in a recession for at least several quarters and possibility for up to a year already.

What Is a Recession?

The confusion comes from the definition of a recession. Some in the media mistakenly define a recession as:

“Two consecutive quarters of contraction in the Gross Domestic Product” or GDP.”

For those who did not major in economics, this simply means a period of time when the economy is shrinking. In a perfect world, our economy would expand continuously at a reasonable growth rate of 2 – 4% per year. If the growth rate is higher, we typically see excessive inflation, which is the Federal Reserve would seek to avoid by raising interest rates to slow down the economy. If the growth rate is lower, the Federal Reserve seeks to stimulate the economy by reducing interest rates and other policies that encourage lending and investment.

Our federal government has a special research group whose job it is to tell us when recessions officially begin and end. The National Bureau of Economic Research (NBER) is charged with this responsibility. According to the NBER, a recession is best defined as:

“A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

By the time the NBER announces the beginning of a recession, normally we are closer to the end of recession than the beginning. I would be willing to bet that by next spring, we will hear from the NBER that the recession began in late 2007.

Clearly our economy now easily satisfies every part of the definition of recession, especially with the substantial drop in consumer spending over the past 6 months as well as the recent increases in unemployment.

Recessions are a natural part of our economic system helping to curb excesses and maintain proper balance.  One reason why the current recession may be longer and more severe than the past recessions is that we have a bursting “credit bubble” at the same time as we are entering a recession.