Avoiding Conceptual Traps

A depression is a confusing thing. Many things which were apparently normal one's whole life aren't happening any more. Economic growth and 'progress' seemed like orderly, lasting processes. Disorder and breakdown now abound. There is a tremendous temptation to renormalise observed events into patterns that just aren't there. Patterns create a sense of place and order; lack of them causes anxiety.

We would like to take a look at a few conceptual traps that will ensnare the unwary. These traps are created in one's mind in a desperate effort to carry on as usual in the face of circumstances that require a change of strategy. Change is difficult - the 'same old' is easy.

The Value Trap is claiming many victims even as we write. The Value Trap happens when the prices of an asset falls to a level which seems like a good deal. Buyers who may have sensibly avoided 'bubble' pricing, now buy what appear to be bargains. Unfortunately, prices keep falling. Buyers of houses with mortgages find themselves soon 'under water', with their downpayment wiped out. It is imperative to adjust one's frame of reference as to the value of a prospective investment, and if something seems like a good deal - beware.

Institutional Security is misplaced confidence in employers, pension funds, governments, and so forth. Many of these institutions are in really terrible shape financially, and will not be able to deliver on their promises (the State of California comes to mind). There, a lot of people have been banking on long-term employment, contracts, and pensions that will not last. Do not assume even that U. S. government, or any other national government, will fulfill its obligations. It is critical under the present circumstances to develop self-reliance. Could you support yourself if left to your own devices? If presently self-employed, do you have a broad base of customers and suppliers?

The Sound Dollar Trap results from putting one's faith in the U.S. Dollar (or any other currency). Dollars steadily lose purchasing power (for a discussion, see this article and pay special attention to Figure 1). Currencies are themselves institutions (in a broader sense) that are unquestioned, background 'realities'. Keeping some currency is a necessity for most transactions, but it is not a vehicle for any kind of long-term savings or investment. Just because it may have done less badly recently than other assets, does not make it in any way 'good'.

Bailout Rebound is our term for the notion that "happy days are here again" due to some new government program, or bailout. This manifests itself in investment markets as Bear Market Rallies - upward price movements on some 'good news' in spite of the pervasive trend downwards. One wants to believe that the 'bottom is in', that markets are recovering and it's time to invest, or buy that bigger house one has been wanting. One wants to latch on to any sign of an emerging trend towards recovery. In the 2007 Depression there will be many bailout rebounds, false dawns followed by greater darkness.

A variant of the 'rebound' is Dodging Bullets. This is a type of wishful thinking that results from surviving incremental adversity. Just because you survived the first round of layoffs doesn't mean you'll make it through the next. If a mortgage has been renegotiated, the borrower will still likely default (see this article). While maintaining a positive attitude is always beneficial, do not delude yourself with survival bias. Remember that we tend to hear stories of survival only because non-survivors are not able to tell their stories! Things look bad all around, and they are probably going to get worse. The 2007 Depression is going to mark a major shift in everyone's modus operandi. Vigilance and caution are the watchwords of the hour.

Finally, we would advise bewaring the possibility of a Crack-Up Boom. A crack-up boom happens when the people lose faith in their currency due to accelerating inflation. When severe inflation is universally acknowledged, people will buy things - anything - to get money out of their hands and into something that won't lose as much value as the money does. This repudiation of currency creates an enormous demand for goods, and the consequent increase in production looks like a return to prosperity. But don't be fooled if this event comes to pass. It would be but a phase of the 2007 Depression as it morphs into a hyperinflationary depression.