23 Aug 2008

Basic Steps to Prepare for a Possible Crisis

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I am pessimistic about the U.S. economy‘s prospects for the next five years. So let’s go over some very basic and obvious steps every household should take, as quickly as possible. Note that the goals don’t have to be achieved overnight, but setting those goals should be done ASAP.

(By the way, I admit that what I am talking about in this post is nothing brilliant. But it’s like going to church every week to hear a sermon on what you ought to be doing. You know what you’re going to hear, but you need someone else to say it once in a while.)

OK so here are some basic steps every American household should take:

(1) Set up a monthly budget that has a long-range view. Make it very convenient for yourself, to be able to just change a few entries and then see how, say, saving an extra $100 per month, impacts your net worth in five years.

(2) Don’t pay off dollar-denominated debts, even credit cards. Rather, defer those as best you can, and use the freed up dollars to tackle steps (3) and (4).

(3) Figure out how many months you would need, in order to find a job that could pay the bills, assuming you lost your present source(s) of income. People throw around rules of thumb, but I think that’s ridiculous; individual circumstances are very different. For example, in my case I have bounced around quite a bit, and do most of my work on a laptop. So I figure I really only need about two months’ worth of regular income in terms of very liquid reserves. That’s because if something happened and I lost my major source of income right now (I’m a consultant so I don’t have “a job” to lose), we could go into austerity mode and make two months’ of normal income stretch out for three, and I am certain that I could at least partially restore my income flow within three months. Even if I were in a car accident, I could still work unless I died (in which case my life insurance would cover things).

Yet for somebody else, maybe someone who works at a factory but doesn’t have obvious alternatives if that factory should shut down, maybe that household ought to have six months’ of income in the bank. Also remember that if you lose your job because of a crisis, then a lot of other people will be looking for work too. So the question isn’t, “If I quit tomorrow, how long to find another comparable-paying job?” No, the question is, “If I get laid off tomorrow, how long…?”

(4) If you currently do not have the liquid funds that you figured out in step (3), then start working towards that amount. When doing so, consider acquiring actual gold coins as at least a portion of your liquid savings. Again, some might quote you formulas for what percentage of your reserves should be dollar-denominated, and what percentage should be in gold coins, but it will depend on the individual’s tastes. Some people might feel like Indiana Jones if they kept $15,000 in gold hidden around their house, and economics can’t say that preference is irrational. People spend lots of money on fancy sports cars too; there’s nothing wrong with spending your money in a way that pleases you. So by the same token, if it excites you to own gold–maybe you are a libertarian and think you are giving a nod to a time when the dollar was tied to gold–then go ahead and make a larger fraction of your liquid fund consist of gold coins. On the other hand, if gold seems really scary and volatile to you, then invest in government bonds to supplement your checking account. (In future posts at Free Advice, we will develop more formal analyses as to “smart” investments, but a lot will still ultimately depend on subjective tastes.)

One final thought on gold: Unless you have to deal with tax consequences (because you have an IRA etc.), I would recommend getting the actual physical gold, rather than gaining exposure to a gold ETF in your portfolio. In the type of scenario where you might really need to access those emergency, liquid funds, the government could quite easily declare a financial crisis and suspend withdrawals from commodity ETFs. So in such a calamity (after a terrorist attack, or if Israel starts bombing Iran suddenly), you would be in a much more secure position if you held the actual coins in your possession.

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