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U.S. Economic Crisis

Warning Signs and How to Protect Yourself

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U.S. Economic Crisis

Falling home prices triggered the last U.S. economic crisis.

(Credit: David McNew/Getty Images)
The U.S. seems to have an economic crisis every ten years or so. They are difficult to eradicate completely because their causes are always different. However, the results are pretty much the same -- high unemployment, low levels of bank lending or even near-bank collapse, and a slow-down in economic growth. These are all symptoms of recession, but an economic crisis doesn't have to lead to recession if it's addressed in time. Similarly, a recession is not always caused by an economic crisis.

Economic Crisis History

To know whether an economic crisis will happen again, you first need to review the economic crises of the past. This will help you understand when government action prevents complete economic collapse, and when it makes things worse. Second, it's important to recognize the warning signals of economic crisis. These will give you the clues to tell you how to prepare. Here's a review of the major economic crises in modern U.S. history.

2008 Financial Crisis -- The first warning came in 2006, when housing prices started falling and mortgage defaults began to rise. Many analysts ignored it, thinking it was just an over-heated housing market cooling off.

In 2007, the subprime mortgage crisis was in full bloom. Banks and mortgage companies had lowered their credit guidelines, allowing too many people to take out subprime mortgages. Lending institutions thought they were insured against default because they had purchased credit default swaps. When too many banks started to call in their insurance, insurance companies like AIG started quietly running low on cash. By mid-summer, banks were reluctant to lend to each other, afraid to receive subprime debt as collateral.

In 2008, the Federal Reserve and then the U.S. government stepped in to keep AIG, investment banks like Bear Stearns, and mortgage guarantors Fannie Mae and Freddie Mac afloat. When they finally let Lehman Brothers go bankrupt, it caused a global banking panic, driving the Dow down 770 points, its worst one-day drop ever. Panicked companies pulled out a record $140 billion in deposits from the money market funds. If confidence was not restored, it would have removed all liquidity from the U.S. economic system. Within weeks, companies would not have had the cash to operate. At the urging of Treasury Secretary Hank Paulson, Congress approved a $700 billion bailout package, which restored confidence, and prevented an economic collapse. This economic crisis led to a devastating recession.

9/11 Attacks -- The attacks on Wall Street stopped air traffic. The NYSE did not open on 9/11, and remained closed until 9/17, when the Dow promptly dropped 617.70 points. There was no real warning for the general public. The crisis threw the U.S. back into the 2001 recession, extending it until 2003. However, some of this was not because of the attacks themselves. It was due to uncertainty about whether the U.S. would go to war. Furthermore, the resultant War on Terror added $1.3 trillion to the U.S. debt.

1989 Savings and Loan Crisis -- This crisis was caused by Charles Keating and other unethical bankers who tried to raise capital by using Federally insured deposits for risky real estate investments. They were helped by Senators (the Keating Five) who accepted campaign contributions in return for decimating the bank regulator so it couldn't investigate the criminal activities. There was little warning to the general public since the banks had lied about their business dealings. The S&L Crisis resulted in 1,000 bank closures, a recession in Texas and bailout that added $126 billion to the national debt.

1970s Stagflation -- This was kicked off by the 1973 OPEC oil embargo. However, the government reaction turned this into a full-fledged crisis of double-digit inflation AND recession. The inflation occurred after Nixon untied the dollar from the gold standard, while businesses started to lay off workers when they weren't allowed to lower wages or increase prices. The crisis caused by fiscal policy was only resolved by contractionary monetary policy when Federal Reserve Chairman Paul Volcker raised interest rates to quell inflation. The warnings signal was the announcements from OPEC and Nixon over their proposed disruptive actions.

The Great Depression of 1929 -- The first warning was a bubble in the stock market. Wise investors could have started taking profits in the summer of 1929. However, it's always difficult to call the top of a market.

The Depression was kicked off by the 1929 stock market crash. It was further aggravated by contractionary monetary policy as the Federal Reserve sought to protect the value of the dollar, then based on the gold standard. Instead, it created massive deflation. As prices dropped, many manufacturers went out of business. The Dust Bowl contributed to famine and homelessness, helping to drive the unemployment rate to 25%, and housing prices down 31%. The cycle was finally resolved by massive government spending on social programs and World War II, driving the debt-to-GDP ratio to a record 126%.

Outlook

The easy answer is, "Of course it will." Given modern U.S. economic history, it seems the next one would occur in 2017 - 2020, right on schedule. That doesn't necessarily tell you where it will come from, what the result will be, and how to defend yourself. What would have protected you in previous crises might be the worst thing to do in the next one. Therefore, the best thing to do is watch for the warning signals.

Many economic crises are preceded by some kind of asset bubble. In 2008, it was housing prices. In 2001, it was high tech stock market prices. In 1929, it was the stock market in general. This is usually accompanied by a feeling that "everyone" is getting rich beyond their wildest dreams by investing in this asset class. You will also see lots of advertisements for this asset class. You might even feel like you are being left out. And, this is true for some time leading up to the crash. That's the nature of an asset bubble. However, it's extremely difficult to call the top of any bubble. and follow

The best preparation is to immediately take the following steps.

  1. Work with a financial planner you would trust with the key to your house.
  2. Create a financial plan that will meet your needs. This will determine the composition of your diversified asset portfolio.
  3. Rebalance once or twice a year. That means regularly skimming off profits from any asset class that has grown substantially. That will protect you from losing most of your savings in an economic crisis.
Article updated February 15, 2013

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