It's not that bad (but it could get worse)

[I sent this out to a private financial mailing list in response to the question, "How are you sleeping nowadays?" Someone asked me to post it here. It's been lightly edited from the original.]

Hard as it may be to believe, things are still not very bad in real terms. The U.S. economy is still growing, and unemployment is not very high by historical standards, though both of those are likely to change soon. Oil is cheap, and will probably remain so, and that's a very good thing, at least in the short run. We are not facing any serious droughts or famines or plagues. There aren't even really any wars to speak of. By historical standards, the conflicts in Iraq, Afghanistan and even Darfur are relatively small. (This is not to say they don't have negative impacts. They do. But we've seen worse in the past.)

So by historical standards, in real terms, things at the moment are pretty much better than they have ever been.

What we have is essentially a bookkeeping problem. Producing goods and services is just one half of the economy. The other half is keeping track of who is entitled to what when those goods and services are divvied up. More importantly, that accounting extends into the future. And we've been overallocating our future production for a long, long time now. A crash that would get people's attention was inevitable given the course we were on for the last five years or so -- it was just a question of when. And so far it's just a warning sign of real problems (which is to say, actual shrinkage in the economy, massive unemployment, sky-high oil prices, empty shelves in grocery stores) still to come -- sooner or later -- if we don't make massive changes in our expectations and how we conduct our business and government.

So in that respect, the crash, and the fact that people are scared, is a good thing. It's getting people's attention. It means that there is a chance that we might actually do the things we need to do to avoid the real problems still to come: balance the budget. Cut entitlements. Raise the retirement age. Tax social security. Pay down the debt.

I had a moment of optimism when the first bailout bill didn't pass. I thought that Congress had finally grown a spine and might actually start tackling the real problems. Unfortunately, it seems I was overly optimistic. We still seem to be looking for a way out of this that doesn't involve politicians talking about pain and sacrifice. There isn't one, at least not in the long term. And the longer we keep burying our heads in the sand the worse it will be when the real crash finally comes.

These kinds of mega-trends seem to be pretty predictable, except that the timing can vary by years, so if you want to prepare for them you have to be willing to forego quite a lot of potential gains as you swim upstream because, as we have seen, when the problems manifest themselves it can happen quite quickly.

I'm kicking myself for not taking more of my own advice. I started pulling money out of stocks a year ago, but not as much as I wish I had in retrospect. I actually fired a money manager for buying financial stocks in June ("a great time to buy -- when this turns around in a month or two our performance will be stellar" he said.) A week ago I too started losing sleep so I bought put options. Now I sleep better. But only a little, because now things have gotten so bad that they could spin wildly out of control and we could end up in a very deep hole. This is not yet inevitable. Again, in *real* terms, everything is still pretty much OK. But people are scared, and fear can become a causal agent in sufficient quantities. It may be that the only thing we have to fear (so far) is fear itself, but that doesn't mean it isn't worthy of fear.

Of course, everyone has to decide for themselves just how far they want to dial back the risk-reward knob. There's no way to hedge against all risk. It's not entirely outside the realm of possibility that all of Western civilization will collapse over the next few years and we'll enter a new dark age dominated by Muslim extremists. But this is pretty freakin' unlikely, and what would you do about it anyway? The most defensive you can get is to buy a ranch in Idaho, take yourself off the grid, and become a survivalist. And if everyone does that, then collapse becomes a self-fulfilling prophecy.

I think this situation will be the challenge of our generation. The right thing to do is not to decide whether or not to be scared, but to take the reigns and figure out how to fix the problem in the long run (I'm talking decades here) and then make it happen. That means becoming politically active and agitating for serious change in people's attitudes, starting probably with our own. {Editorial note: the target audience here was high-net-worth individuals.] I've had to adjust my own expectations downwards. It's not an easy thing to do. But if we don't do it then in 5-10 years we'll be looking back at the end of 2008 as the good old days.

The good news is this problem *can* be solved. The bad news is, we're way behind the eight ball. And every day we don't change our attitudes is another day we get more behind, and the problem becomes that much harder to solve.