I've had a number of people - including clients - argue that, if the government had not shut down the economy, resulting in what will probably be peak unemployment of around 25% for May, there would be no economy, because huge numbers of people would be dead, and thus couldn't work or consume.
Clients in particular have made that argument when I explain that they should not include the impact of credit losses, reduced earnings on loans and investments due to lower rates, reduced loan demand, reduced credit and debit card interchange income, etc., when considering pandemic risk. The reason is twofold.
The first reason is that I already have my clients assessing those risks, and we don't want to double-count the residual risk (risk after mitigation). The pandemic risk should be assessed in terms of business continuity: what would the impact have been had we not spun up all the responses to the pandemic and the resulting jurisdictional guidance as quickly and effectively as we did? And how well did those responses mitigate that impact?
The second reason - and forgive this economic purist for making such distinctions - is that the pandemic did not cause the recession. The pandemic evoked a government response, and the government response caused the recession.
Now, I'm politically agnostic about that when it comes to my clients. I'm not going to share my thoughts with them on whether that response was appropriate. There will be plenty of time for recriminations and Monday-morning quarterbacking when we actually know something about this virus: how easily it spreads, the number of actual cases, the number of actual deaths based on COVID as the direct and primary cause of death, etc. Some of that we'll never know. So I don't offer clients an opinion regarding whether the government response was right, wrong or indifferent.
I won't do it here, either. My purpose is solely to apply real math to the most severe worst-case projection, and demonstrate what, even in that worst-case scenario, the economic impact might have been had the government not responded as it did.
Also, let me say that, if the death toll were as high as the numbers I use below, it would have been a heartbreaking human tragedy. And when I say later in this post that the number of deaths among those under the age of 16 is insignificant as a data point, I'm not saying that any of those deaths were insignificant to the parents, grandparents and siblings of the succumbed. I'm only talking economic impact, because that's the argument I'm countering. Let someone else decide whether the human loss outweighs the economic impact. (But hint: let them consider suicides, reduction in life expectancy, alcoholism and drug addiction, and other human costs related to an economic collapse, especially among the most vulnerable participants in the labor force, in balancing that scale.)
Okay, let's start by looking at data regarding COVID deaths by age cohort. My source is worldometers.info, which uses data from the CDC, WHO, Johns Hopkins, and other sources. According to their data, about 72% of COVID deaths are in the age 65 and older cohort, with 28% among ages younger than 65.
Now, let's look at the U.S. civilian labor force by age cohort. Only 10% of the labor force is comprised of individuals aged 65 and older. My source here is the Bureau of Labor Statistics (BLS), and I'm using pre-pandemic data.
So, let's combine the data, by multiplying the deaths by age to workers by age. That means that 72% of the 10% of U.S. workers over the age of 65 have died, or about 7% of the total labor force. And, if we assume that all of those under 65 who died were employed (an important assumption - I'll explain momentarily), we can count the whole 28%. That gives us a total of 7% of the labor force, plus 28%, for a total of 35%.
However - and pay close attention here - we can't assume that 35% of the labor force would have been wiped out. Why?
Because the 35% is based on the total number of deaths, not people. It's not a per capita number. So it can't be applied to the entire labor force, any more than it can be applied to the entire population. If it could be, then we would indeed have 35% of the labor force, or about 55 million, deaths in the U.S. And if it were applied to the entire U.S. population, we'd have about 114 million deaths. Not even the most dire models projected numbers anywhere close to that, and the actual data is running about 0.1% - 0.2% of those numbers.
Further, while I'm going to assume, as a worst case, that all individuals under the age of 65 who died were employed, that's not the case. Some people are fortunate enough to retire before that age. Some were among the 3.2% unemployed before the government shutdown ensued. Also, some COVID deaths occurred among individuals under the age of 16, which is the low-range cutoff for BLS data on the labor force. However, those numbers are insignificant as data points. Just know that the 35% is skewed to the high side for those reasons. (It's skewed even further by the cause of death methodology employed by the CDC, but that's another discussion for another day.)
Okay, still with me? The Imperial College of London put out the first COVID model, and it has been thoroughly debunked as hot garbage. A dumpster fire. Worse than the fatally flawed IHME model, which I have debunked just as thoroughly in this blog. Suffice it to say that the Imperial College's model creator has resigned his position as a government advisor.
So why use data from the Imperial College model? First, it was the model used by the British and U.S. governments to initiate the lockdowns that have so severely affected those two countries' economies, at least the service and factory sectors thereof. And second, it projected the most dire scenario regarding total deaths if we did nothing, so it provides the ultimate worst-case data, ridiculously extreme as that data is.
The Imperial College model projected 2.2 million deaths in the U.S., a number that you've heard bandied about quite a bit, assuming you've been awake the past three months. So let's apply our combined deaths-and-employment percentage to that.
Had 2.2 million Americans died of COVID, the math indicates that 35% of them (on the high side) were participants in the civilian labor force. And 35% of 2.2 million is 770,000. Divide that by the total civilian labor force pre-pandemic of about 157 million, and you get about 0.49%.
In other words, had the government done nothing in terms of shutting down the nation's economy, had the model been accurate (and it wasn't), and assuming that all COVID deaths under the age of 65 were labor force participants (they weren't), and assuming that all reported COVID deaths actually resulted from COVID as primary cause of death (and, according to the CDC's own website, they didn't) -
The unemployment rate would have increased by 0.49%. So today, it would be about 3.7%.
Let that sink in.
Sunday, May 31, 2020
Wednesday, May 20, 2020
Insider Information
Throughout the COVID shutdown, a lot of people - friends, family, clients - have been asking me for my views related to the prospects for the U.S. economy going forward. Some are concerned that this is worse than 2008-09. Some are concerned that it's worse than the Great Depression. Some are fearful that the economy will never recover.
I have tried to put those fears to rest through a combination of data analysis, macro trends, and anecdotal evidence. I've noted that when initial jobless claims peak (which they appear to have done seven weeks ago), we're near the point where the worst is over. And that when the unemployment rate peaks (which I suspect it might with the May data, which will be released June 5 and should come in around 22%), the worst is behind us.
I have explained the significant macro difference between those past severe downturns - both top-down events that eventually took out the rest of the economy - and this downturn, resulting from a bottom-up event, with the top of the economy still primarily intact in terms of employment and incomes. Which augurs well for demand.
And there is anecdotal evidence that demand remains extant. My lovely wife and I will celebrate our 25th year of her putting up with me in 2021. We enjoy cruising, having done so more than 20 times, and one of our more memorable trips was a cruise from Vancouver to Hawaii four years ago. Yesterday, I was researching cruises coming from Hawaii to the mainland. There are two such sailings next May on our preferred cruise line. The suites are sold out, nearly 12 months in advance. True, many of the bookings are being made using credits from cruises booked for this year that had to be canceled. But that doesn't disprove the demand argument - why book with cash when you have a credit for 125% of what you paid for this year's cruise, which many lines are offering?
I have a flight to visit a client next week. While the airlines have cut routes and are capping capacity to distance passengers on the planes, my return flight is sold out.
Since my home county re-opened last week, we have dined out twice. Both times, the restaurants were busy. At one of them, our waitress said that nearly all of the staff had been brought back. At both of them, our servers said they needed to hire more workers soon, because the same crews were prepping and serving both dine-in and still-brisk curbside/delivery customers, resulting in delays. (So if you dine out during this time, please show a little more forbearance than usual regarding wait times.) And a burger joint I drove by today had a sign out front saying that they're hiring.
There is other anecdotal evidence. But in this post, I want to share some "insider information" that points to this downturn being less severe than 2008-09.
I currently work as a risk management consultant for credit unions, which are like banks, but are owned by their depositors under a cooperative structure. I've worked with credit unions since 1992, and in this capacity since 2013. I've had clients in most U.S. states, and since this pandemic hit, I've been in contact with ongoing and former clients in 15 states. All of those states have different shutdown rules, and all have different re-opening plans and timeframes.
Regarding the various jurisdictional shutdown orders, the analogy I've been using with clients is this: we had to build the plane while we were flying it, and we had to get it up to altitude very quickly - with little, and often conflicting, guidance from air traffic control. Storms popped up everywhere, so we had to change course and altitude frequently. Now we have to plan for the descent, approach, and landing, again with little and often conflicting guidance. We have to figure out what parts we can remove, and when, and how. At the same time, we have to determine what parts may need to be put back on, and how and when and under what circumstances, as well as how we may need to change our flight plan, should the landing be aborted.
I've been impressed with how agile credit unions have been in doing all of this. Some have deployed nearly all of their work force remotely, including call centers, in a matter of days. Some have instead closed branches and deployed other personnel to that space to implement distancing across all facilities, and have deployed branch personnel to assist with the overwhelming volume seen by call centers and collections departments. Cash limits in ATMs have been increased to meet greater demand from that non-in-person channel. Plexiglas shields and floor markings have been put in place in branches. Millions of dollars of PPP loans have been extended to small businesses. Skip-payments and loan modifications have been proactively offered to keep borrowers from defaulting. HR departments have scrambled to deal with remote workforce deployment issues, CARES Act changes, and leave issues related to the pandemic.
But I'm not writing this just to congratulate the industry I serve. I'm writing it to report on what those institutions are projecting in terms of credit losses and other impacts to income, and the anecdotal evidence I hear from them. Let's tackle the anecdotal piece first.
Besides the mortgage refi business - which will help keep people whose incomes have been affected remain in their homes, and will put discretionary funds in the pockets of those who haven't been affected, so they can spend them - other business is picking up too. One client I spoke with very recently is in a state that has begun to re-open. That client, like most credit unions, is active in indirect auto lending. Under those arrangements, the credit union works with a network of dealers, and the dealers offer the credit union's auto financing at the dealership. The credit union provides the pricing (loan rate) and underwriting criteria. It's like having an outsourced auto lending business. Some credit unions do considerable volume in indirect lending, as much as 70% of total loan production.
This particular client reported that, during the shutdown, they were doing about three indirect loans a day, which is abysmal. Now that things have re-opened - just partially, mind you - their end-of-day queue - the loans they couldn't get approved that day just due to sheer volume - is 60 to 70 loans. (And they have a sizable indirect lending department.) Their dealers are reporting that May will be a record month for them in terms of sales. This makes sense: new light vehicle sales had been trending around 17 million units, annualized, as of February. In March, they fell to just over 11 million, the lowest since 2010. In April, sales fell to about 8.5 million units - the lowest ever. That's a lot of pent-up demand to pick up, and to be financed at record-low rates. And the dealerships are implementing innovations like contactless sales and delivery to make it easier to buy for those still leery about kicking tires and slamming doors at the dealership.
My primary contact at this client also told me that she and her husband had been furniture shopping recently, and the store told them that it too was looking at an all-time record sales month in May. This illustrates that demand for big-ticket items is still there. And folks - this credit union is located in America's factory belt, where unemployment rates already were systemically above the national rate by about a percentage point.
On to the data. A key measure of financial institutions' profitability is return on assets (ROA), defined as net income divided by average annual assets. Another definition we need in hand for this discussion is "basis points." One basis point is equal to 1/100th of a percent; 100 basis points (bp) equals one percent.
All of the credit unions I've spoken with are projecting about a 40-45bp hit to ROA this year. To put that in perspective, that would knock out about half a year's earnings for the average credit union with assets of $500 million or more (my clients range in asset size from about $200 million to nearly $10 billion, with the average north of a billion). In other words, industry average ROA would be about 45bp.
In 2009, the industry average ROA was 29bp. In other words, earnings were about 36% lower than what's projected this year. Many credit unions, especially those in the "sand states" where home price declines were more severe, had negative earnings in 2009.
Our firm works with over 100 credit unions, and we have validated the estimated 45bp hit to ROA through analysis of our clients' aggregate risk assessment data. The losses will come in part from charge-offs of loans that default. However, they'll also come from reduced investment income because interest rates have plummeted (credit unions can only invest in bonds, which pay interest). And from reduced loan income as auto loan demand disappeared for the two months that dealerships were shut down across most of the nation (but that demand is coming back as dealerships open, especially with loan rates this low). And from reduced interchange income (the income earned on credit and debit card swipes) during the two months that people weren't shopping, dining out and traveling (most of that demand will come back also; we'll see how contactless payment affects it). And from reduced income from wealth management services as those clients have stopped investing. And from increased expenses from the technology costs of deploying workers remotely, installing Plexiglas shields, buying hand sanitizer, and other responses to the pandemic.
So it's not just credit losses, and that suggests that credit losses won't be that widespread. Again, clients are reporting that they're proactively offering loan modifications and rate reductions to keep borrowers in their loans. As hiring in the service sectors picks up, those loans will remain current. They're also modifying business loans to keep those borrowers from failing and defaulting, as well as extending the PPP loans to keep them afloat.
And mortgage refinancings are exploding at today's record-low rates, so they're booking a lot more of those loans. True, the loans are at low rates, but most institutions are selling those loans into the secondary market (where they're packaged and sold to investors), earning fees for originating and selling the loans, as well as for servicing the loan payments. So that is helping to offset lost income. Only one of my clients is not seeing record mortgage refi volume, and they're located in a COVID hotspot.
In terms of the anticipated loan losses alone, the hit to ROA is projected to be about 20bp - roughly half the total hit, and on the order of a fairly mild recession. This has also been validated by looking at aggregate data across all of our clients.
If credit unions thought that demand wasn't coming back, and that most businesses would fail, and unemployment would continue to go up for months, they'd be reserving more for loan losses. They tend to be very conservative in establishing their loan loss reserves. And their regulator hits them hard if they don't, so the regulator isn't anticipating widespread business failures and continuously increasing unemployment, either. Reports from the banking industry tell a similar story.
So don't just take my word for it. America's financial institutions - who lend to the businesses and individuals who are affected by the shutdown, as well as those who aren't - are telling a story of a short recession overall, and a return to more normal times in 2021. The anecdotal evidence corroborates that, as do the projections by the majority of credible economists, including our current Fed Chairman.
I have tried to put those fears to rest through a combination of data analysis, macro trends, and anecdotal evidence. I've noted that when initial jobless claims peak (which they appear to have done seven weeks ago), we're near the point where the worst is over. And that when the unemployment rate peaks (which I suspect it might with the May data, which will be released June 5 and should come in around 22%), the worst is behind us.
I have explained the significant macro difference between those past severe downturns - both top-down events that eventually took out the rest of the economy - and this downturn, resulting from a bottom-up event, with the top of the economy still primarily intact in terms of employment and incomes. Which augurs well for demand.
And there is anecdotal evidence that demand remains extant. My lovely wife and I will celebrate our 25th year of her putting up with me in 2021. We enjoy cruising, having done so more than 20 times, and one of our more memorable trips was a cruise from Vancouver to Hawaii four years ago. Yesterday, I was researching cruises coming from Hawaii to the mainland. There are two such sailings next May on our preferred cruise line. The suites are sold out, nearly 12 months in advance. True, many of the bookings are being made using credits from cruises booked for this year that had to be canceled. But that doesn't disprove the demand argument - why book with cash when you have a credit for 125% of what you paid for this year's cruise, which many lines are offering?
I have a flight to visit a client next week. While the airlines have cut routes and are capping capacity to distance passengers on the planes, my return flight is sold out.
Since my home county re-opened last week, we have dined out twice. Both times, the restaurants were busy. At one of them, our waitress said that nearly all of the staff had been brought back. At both of them, our servers said they needed to hire more workers soon, because the same crews were prepping and serving both dine-in and still-brisk curbside/delivery customers, resulting in delays. (So if you dine out during this time, please show a little more forbearance than usual regarding wait times.) And a burger joint I drove by today had a sign out front saying that they're hiring.
There is other anecdotal evidence. But in this post, I want to share some "insider information" that points to this downturn being less severe than 2008-09.
I currently work as a risk management consultant for credit unions, which are like banks, but are owned by their depositors under a cooperative structure. I've worked with credit unions since 1992, and in this capacity since 2013. I've had clients in most U.S. states, and since this pandemic hit, I've been in contact with ongoing and former clients in 15 states. All of those states have different shutdown rules, and all have different re-opening plans and timeframes.
Regarding the various jurisdictional shutdown orders, the analogy I've been using with clients is this: we had to build the plane while we were flying it, and we had to get it up to altitude very quickly - with little, and often conflicting, guidance from air traffic control. Storms popped up everywhere, so we had to change course and altitude frequently. Now we have to plan for the descent, approach, and landing, again with little and often conflicting guidance. We have to figure out what parts we can remove, and when, and how. At the same time, we have to determine what parts may need to be put back on, and how and when and under what circumstances, as well as how we may need to change our flight plan, should the landing be aborted.
I've been impressed with how agile credit unions have been in doing all of this. Some have deployed nearly all of their work force remotely, including call centers, in a matter of days. Some have instead closed branches and deployed other personnel to that space to implement distancing across all facilities, and have deployed branch personnel to assist with the overwhelming volume seen by call centers and collections departments. Cash limits in ATMs have been increased to meet greater demand from that non-in-person channel. Plexiglas shields and floor markings have been put in place in branches. Millions of dollars of PPP loans have been extended to small businesses. Skip-payments and loan modifications have been proactively offered to keep borrowers from defaulting. HR departments have scrambled to deal with remote workforce deployment issues, CARES Act changes, and leave issues related to the pandemic.
But I'm not writing this just to congratulate the industry I serve. I'm writing it to report on what those institutions are projecting in terms of credit losses and other impacts to income, and the anecdotal evidence I hear from them. Let's tackle the anecdotal piece first.
Besides the mortgage refi business - which will help keep people whose incomes have been affected remain in their homes, and will put discretionary funds in the pockets of those who haven't been affected, so they can spend them - other business is picking up too. One client I spoke with very recently is in a state that has begun to re-open. That client, like most credit unions, is active in indirect auto lending. Under those arrangements, the credit union works with a network of dealers, and the dealers offer the credit union's auto financing at the dealership. The credit union provides the pricing (loan rate) and underwriting criteria. It's like having an outsourced auto lending business. Some credit unions do considerable volume in indirect lending, as much as 70% of total loan production.
This particular client reported that, during the shutdown, they were doing about three indirect loans a day, which is abysmal. Now that things have re-opened - just partially, mind you - their end-of-day queue - the loans they couldn't get approved that day just due to sheer volume - is 60 to 70 loans. (And they have a sizable indirect lending department.) Their dealers are reporting that May will be a record month for them in terms of sales. This makes sense: new light vehicle sales had been trending around 17 million units, annualized, as of February. In March, they fell to just over 11 million, the lowest since 2010. In April, sales fell to about 8.5 million units - the lowest ever. That's a lot of pent-up demand to pick up, and to be financed at record-low rates. And the dealerships are implementing innovations like contactless sales and delivery to make it easier to buy for those still leery about kicking tires and slamming doors at the dealership.
My primary contact at this client also told me that she and her husband had been furniture shopping recently, and the store told them that it too was looking at an all-time record sales month in May. This illustrates that demand for big-ticket items is still there. And folks - this credit union is located in America's factory belt, where unemployment rates already were systemically above the national rate by about a percentage point.
On to the data. A key measure of financial institutions' profitability is return on assets (ROA), defined as net income divided by average annual assets. Another definition we need in hand for this discussion is "basis points." One basis point is equal to 1/100th of a percent; 100 basis points (bp) equals one percent.
All of the credit unions I've spoken with are projecting about a 40-45bp hit to ROA this year. To put that in perspective, that would knock out about half a year's earnings for the average credit union with assets of $500 million or more (my clients range in asset size from about $200 million to nearly $10 billion, with the average north of a billion). In other words, industry average ROA would be about 45bp.
In 2009, the industry average ROA was 29bp. In other words, earnings were about 36% lower than what's projected this year. Many credit unions, especially those in the "sand states" where home price declines were more severe, had negative earnings in 2009.
Our firm works with over 100 credit unions, and we have validated the estimated 45bp hit to ROA through analysis of our clients' aggregate risk assessment data. The losses will come in part from charge-offs of loans that default. However, they'll also come from reduced investment income because interest rates have plummeted (credit unions can only invest in bonds, which pay interest). And from reduced loan income as auto loan demand disappeared for the two months that dealerships were shut down across most of the nation (but that demand is coming back as dealerships open, especially with loan rates this low). And from reduced interchange income (the income earned on credit and debit card swipes) during the two months that people weren't shopping, dining out and traveling (most of that demand will come back also; we'll see how contactless payment affects it). And from reduced income from wealth management services as those clients have stopped investing. And from increased expenses from the technology costs of deploying workers remotely, installing Plexiglas shields, buying hand sanitizer, and other responses to the pandemic.
So it's not just credit losses, and that suggests that credit losses won't be that widespread. Again, clients are reporting that they're proactively offering loan modifications and rate reductions to keep borrowers in their loans. As hiring in the service sectors picks up, those loans will remain current. They're also modifying business loans to keep those borrowers from failing and defaulting, as well as extending the PPP loans to keep them afloat.
And mortgage refinancings are exploding at today's record-low rates, so they're booking a lot more of those loans. True, the loans are at low rates, but most institutions are selling those loans into the secondary market (where they're packaged and sold to investors), earning fees for originating and selling the loans, as well as for servicing the loan payments. So that is helping to offset lost income. Only one of my clients is not seeing record mortgage refi volume, and they're located in a COVID hotspot.
In terms of the anticipated loan losses alone, the hit to ROA is projected to be about 20bp - roughly half the total hit, and on the order of a fairly mild recession. This has also been validated by looking at aggregate data across all of our clients.
If credit unions thought that demand wasn't coming back, and that most businesses would fail, and unemployment would continue to go up for months, they'd be reserving more for loan losses. They tend to be very conservative in establishing their loan loss reserves. And their regulator hits them hard if they don't, so the regulator isn't anticipating widespread business failures and continuously increasing unemployment, either. Reports from the banking industry tell a similar story.
So don't just take my word for it. America's financial institutions - who lend to the businesses and individuals who are affected by the shutdown, as well as those who aren't - are telling a story of a short recession overall, and a return to more normal times in 2021. The anecdotal evidence corroborates that, as do the projections by the majority of credible economists, including our current Fed Chairman.
Monday, May 18, 2020
Whose Side? Supply Side!
In the last post, I touched on supply-side, or "trickle-down" economics. I noted that the fact that both the Great Depression of the 1930s, and the Great Recession of 2008-09 were caused by asset bubbles that imploded the "top" of the economy - the higher-paying jobs in the financial and other sectors. That resulted in a "trickle-down" (or, more accurately in the case of those downturns, a cascade down) effect that took out the "bottom" of the economy - the relatively lower-paying jobs in the service sector. Those jobs depend on spending by those higher up on the economic ladder to sustain those service businesses. In turn, the employment provided in the service sector creates the ability for all participants in the economy to have funds available for discretionary spending (depending on how well they manage their finances, at all levels regardless of income).
This illustrates that supply-side, or "trickle-down" economics does indeed work as stated. However, there are many detractors who claim it's a farce, a hoax, a myth, that it doesn't work. Unfortunately, the vast majority of those folks don't really understand economics, and the detractors who do are big-government politicians and policy wonks trying to gin up the folks who don't understand it, so they'll be opposed to any politician who supports it. Those politicians and the folks who, unfortunately, believe them, would rather deploy big-government social programming.
The fundamental premise of supply-side economics is that if you apply stimulus to the supply side of the economy - the side where jobs are created and goods are produced - that will eventually "trickle down" to the lower end of the economy. A simple example is a cut in the corporate tax rate that allows companies to price more competitively. That stimulates demand, and those companies then have to hire more workers to keep up with the demand, which creates jobs, which provide income, which stimulates further demand, etc.
The detractors make the usual tired claim that if you cut the corporate tax rate, the tax expense savings just wind up in the executives' pockets. This is a liberal myth, though there may be some indirect truth. Those executives have no incentive to just pocket the savings and do nothing to grow the companies' revenue. However, they probably have stock options that result in increased personal income if they do things to drive the stock price higher, and then exercise those options at a gain. And to drive the stock price higher, they generally have to increase net income, which means working harder and smarter to expand market share, increase revenue, etc. So to the extent they use the tax savings to grow revenue, market share, etc., they may indeed be compensated for that, on a performance basis.
President Reagan was a strong proponent of supply-side economics, as was Dr. Art Laffer, one of Reagan's top economic advisers and one of the great economic minds of our time. At some point, some bright aide probably got the idea that voters couldn't grasp what "supply-side" economics meant, and coined the term "trickle-down" economics to make it more understandable to the public at large.
That actually had the opposite effect. People thought they understood what it meant, but they didn't. They expected it to do something it was never intended to do, and when it didn't do that, they grumbled that it was a myth. Also, opposing politicians had a field day with the "trickle-down" term, and used it to derisively oppose supply-side economics in favor of policies that would stimulate the demand side (such as the recent government handout of $1,200 per person, whether the recipient's income had been affected by the COVID-19 shutdown or not).
So what, you ask, do these detractors expect "trickle-down" economics to do? They expect it to eradicate income inequality. And because income inequality still exists - and by some measures is increasing - they blindly assume cause and effect, and assert that as proof that "trickle-down" economics doesn't work. They're wrong.
I'm not going to go into a treatise of the various causes of income inequality, other than to make a couple of points. First - I'll pick on Apple CEO Tim Cook here - if Apple's board believes that Tim Cook brings at least $3 million in value to Apple's shareholders, then he's "worth it." (His salary last year was $3 million, and he earned another $7.6 million in incentive-based pay - meaning he either met and exceeded bonus targets, or he drove the stock price higher and profited from exercising options, or both.)
Apple's stock price doubled in 2019. Based on the number of shares outstanding, that means the value of its shareholders' aggregate investment increased by more than $650 billion. It employs nearly 140,000 people. It created 7,000 jobs in 2019, a 5% increase in its workforce. Its total payroll expense is in the billions of dollars. It provides many more thousands of jobs for its suppliers and manufacturers of accessories. So a lot of workers benefited from Apple's growth.
If I represented Apple's shareholders, and Tim Cook came to me and said, "I can increase your aggregate wealth by $650 billion, but it'll cost you a cool $3 million just to take a chance on me - and if I hit that target, I'll want another $7.6 million" - I'd make that trade every day. Especially if his strategy and execution also created thousands of jobs and spawned additional business formation that also created jobs - all of which trickles down as those new employees spend money in the service sector, pay taxes, etc.
The detractors, of course, will deride the "fat-cat" shareholders. Guess what? If you have an IRA or a 401(k), there's a very good chance you own Apple stock, through mutual funds or exchange-traded funds (ETFs) in your account. Apple's largest shareholder isn't some evil rich guy, it's The Vanguard Group, which is the market leader in passive index ETFs. Those funds buy the stocks that are components of underlying indices like the Dow Jones Industrial Average or the S&P 500, and are used by vast numbers of investors to passively invest in the broader markets without making bets on individual stocks.
In fact, 9 of Apple's 10 largest shareholders are mutual fund companies (the 10th is Warren Buffett's Berkshire Hathaway holding company, which is arguably a mutual fund itself). Vanguard manages 5 of the 10 largest mutual fund holders of Apple stock; its aggregate share of the Apple pie (pun intended) is about 7.4%. That's more than $80 billion of Apple stock - directly owned by Vanguard, but indirectly by you, me and a lot of other retirement savers. We doubled our money on Apple in one year. That doesn't happen often.
The most profoundly immutable law of economics is the law of supply and demand. And given the results Tim Cook has delivered at Apple, if its board suddenly went woke and told Cook he's only worth $500,000 (still too much for some of the income equality crowd), Samsung or another competitor would snatch him up in a Silicon Valley minute. The market price of anything is whatever the next person is willing to pay for it - supply and demand. That and that alone determines private-sector compensation, as the laws of supply and demand apply equally to talent.
Here's an example. Early in my career, I worked for a large savings and loan association that had an incredibly complex investment portfolio. We employed a number of Ivy League MBAs and engineering PhDs to help manage and analyze the portfolio. (I hold an MBA degree, but from a small Midwestern state university - far from Ivy League. That job provided my real education in the investment world.) We had developed a fairly extensive library of research materials - this was before the internet really took off - and our Vice Chairman, himself a Wall Street alumnus and U. of Chicago Finance PhD holder - wanted to hire a librarian to manage it.
I was on a committee that graded jobs for purposes of pay ranges. We used a vendor-supplied system to do that. As we were grading out the Research Librarian job, which required a Masters' degree in Library Science, someone on the committee asked whether that degree was to be valued the same as an MBA. The head of HR said yes. The Chief Marketing Officer and I nearly fell out of our chairs.
As we explained to the committee, based on the laws of supply and demand, there just aren't as many jobs that require an MLS degree as an MBA. MBAs, being higher in demand, command greater compensation. And if the two degrees held equal value, there would be a mass exodus out of relatively more difficult MBA programs, and into MLS programs, which, in the days before the internet, big data and data mining, were a whole lot easier to complete.
(No disrespect to librarians intended; these are just the facts. If you're looking at grad school and are undecided between an MLS and an MBA, and it's money you're after, pick the MBA. But if your passion is to be a librarian, choose the MLS degree - your earnings will be lower than, say, a portfolio manager's, but the most important thing is to love what you do.)
Look, the reality is that there are a lot fewer people who can successfully run a company like Apple than there are people who are qualified to flip burgers. So supply and demand, as well as performance and results, are going to dictate that Apple's CEO will make more than a burger-flipper at McDonald's. Yes, the economy needs both. No, they shouldn't receive the same pay, unless McDonald's believes a lone burger-flipper can add $650 billion to the firm's market capitalization.
Income equality was never promised as part of the American Dream. Opportunity equality was. What each individual does with that opportunity is what determines their income potential, by and large. Not everybody has the ability to be a Tim Cook. But an awful lot of people do, if they put in the work to get where he's gotten. The business world abounds with rags-to-riches stories like that of Sam Walton, who built the Wal-Mart empire. There are also a lot of near-rags-to-success stories, like my own. To be sure, there are some who do not have equal opportunity, and I'm all for addressing that. Opportunity is the most valuable commodity a society can offer. But that isn't related to supply-side economics, nor does it (nor should it, nor can it) bring the promise of income equality. The system isn't perfect in terms of opportunity equality, but it's pretty darn good.
Those who argue for income equality can never achieve what they really want. What they want is for the Tim Cooks of the world to have their pay capped at a level low enough that their own compensation can be raised to match his. Their premise is that everybody would be equally compensated, and at a pretty high level.
Not only would the math not work, but it wouldn't work economically, either. The Tim Cooks would find some country that didn't enforce such policies and run a business there - or move Apple's headquarters offshore. The U.S. economy would be decimated from companies leaving our borders. Corporate tax rates would shoot up for small businesses in an effort to make up the lost tax revenue from larger corporations, and unemployment would go through the roof. And the supply of available burger-flippers would suddenly skyrocket.
The only true path to income equality is through a totalitarian regime, either Socialist or Communist. That's happened before. However, instead of providing equal prosperity, those regimes have produced equal poverty, as the powers that be at the top of the regime enrich themselves far beyond anything Tim Cook could imagine and leave the crumbs for their subjects. In fact, those regimes tend to have much higher income inequality than free-market democratic republics.
They also carry carry nasty side benefits like pogroms and ethnic cleansing and imprisonment (or worse) for exercising rights we all take for granted, like free speech, freedom of religion, liberty, and the pursuit of happiness. Be careful what you wish for.
This illustrates that supply-side, or "trickle-down" economics does indeed work as stated. However, there are many detractors who claim it's a farce, a hoax, a myth, that it doesn't work. Unfortunately, the vast majority of those folks don't really understand economics, and the detractors who do are big-government politicians and policy wonks trying to gin up the folks who don't understand it, so they'll be opposed to any politician who supports it. Those politicians and the folks who, unfortunately, believe them, would rather deploy big-government social programming.
The fundamental premise of supply-side economics is that if you apply stimulus to the supply side of the economy - the side where jobs are created and goods are produced - that will eventually "trickle down" to the lower end of the economy. A simple example is a cut in the corporate tax rate that allows companies to price more competitively. That stimulates demand, and those companies then have to hire more workers to keep up with the demand, which creates jobs, which provide income, which stimulates further demand, etc.
The detractors make the usual tired claim that if you cut the corporate tax rate, the tax expense savings just wind up in the executives' pockets. This is a liberal myth, though there may be some indirect truth. Those executives have no incentive to just pocket the savings and do nothing to grow the companies' revenue. However, they probably have stock options that result in increased personal income if they do things to drive the stock price higher, and then exercise those options at a gain. And to drive the stock price higher, they generally have to increase net income, which means working harder and smarter to expand market share, increase revenue, etc. So to the extent they use the tax savings to grow revenue, market share, etc., they may indeed be compensated for that, on a performance basis.
President Reagan was a strong proponent of supply-side economics, as was Dr. Art Laffer, one of Reagan's top economic advisers and one of the great economic minds of our time. At some point, some bright aide probably got the idea that voters couldn't grasp what "supply-side" economics meant, and coined the term "trickle-down" economics to make it more understandable to the public at large.
That actually had the opposite effect. People thought they understood what it meant, but they didn't. They expected it to do something it was never intended to do, and when it didn't do that, they grumbled that it was a myth. Also, opposing politicians had a field day with the "trickle-down" term, and used it to derisively oppose supply-side economics in favor of policies that would stimulate the demand side (such as the recent government handout of $1,200 per person, whether the recipient's income had been affected by the COVID-19 shutdown or not).
So what, you ask, do these detractors expect "trickle-down" economics to do? They expect it to eradicate income inequality. And because income inequality still exists - and by some measures is increasing - they blindly assume cause and effect, and assert that as proof that "trickle-down" economics doesn't work. They're wrong.
I'm not going to go into a treatise of the various causes of income inequality, other than to make a couple of points. First - I'll pick on Apple CEO Tim Cook here - if Apple's board believes that Tim Cook brings at least $3 million in value to Apple's shareholders, then he's "worth it." (His salary last year was $3 million, and he earned another $7.6 million in incentive-based pay - meaning he either met and exceeded bonus targets, or he drove the stock price higher and profited from exercising options, or both.)
Apple's stock price doubled in 2019. Based on the number of shares outstanding, that means the value of its shareholders' aggregate investment increased by more than $650 billion. It employs nearly 140,000 people. It created 7,000 jobs in 2019, a 5% increase in its workforce. Its total payroll expense is in the billions of dollars. It provides many more thousands of jobs for its suppliers and manufacturers of accessories. So a lot of workers benefited from Apple's growth.
If I represented Apple's shareholders, and Tim Cook came to me and said, "I can increase your aggregate wealth by $650 billion, but it'll cost you a cool $3 million just to take a chance on me - and if I hit that target, I'll want another $7.6 million" - I'd make that trade every day. Especially if his strategy and execution also created thousands of jobs and spawned additional business formation that also created jobs - all of which trickles down as those new employees spend money in the service sector, pay taxes, etc.
The detractors, of course, will deride the "fat-cat" shareholders. Guess what? If you have an IRA or a 401(k), there's a very good chance you own Apple stock, through mutual funds or exchange-traded funds (ETFs) in your account. Apple's largest shareholder isn't some evil rich guy, it's The Vanguard Group, which is the market leader in passive index ETFs. Those funds buy the stocks that are components of underlying indices like the Dow Jones Industrial Average or the S&P 500, and are used by vast numbers of investors to passively invest in the broader markets without making bets on individual stocks.
In fact, 9 of Apple's 10 largest shareholders are mutual fund companies (the 10th is Warren Buffett's Berkshire Hathaway holding company, which is arguably a mutual fund itself). Vanguard manages 5 of the 10 largest mutual fund holders of Apple stock; its aggregate share of the Apple pie (pun intended) is about 7.4%. That's more than $80 billion of Apple stock - directly owned by Vanguard, but indirectly by you, me and a lot of other retirement savers. We doubled our money on Apple in one year. That doesn't happen often.
The most profoundly immutable law of economics is the law of supply and demand. And given the results Tim Cook has delivered at Apple, if its board suddenly went woke and told Cook he's only worth $500,000 (still too much for some of the income equality crowd), Samsung or another competitor would snatch him up in a Silicon Valley minute. The market price of anything is whatever the next person is willing to pay for it - supply and demand. That and that alone determines private-sector compensation, as the laws of supply and demand apply equally to talent.
Here's an example. Early in my career, I worked for a large savings and loan association that had an incredibly complex investment portfolio. We employed a number of Ivy League MBAs and engineering PhDs to help manage and analyze the portfolio. (I hold an MBA degree, but from a small Midwestern state university - far from Ivy League. That job provided my real education in the investment world.) We had developed a fairly extensive library of research materials - this was before the internet really took off - and our Vice Chairman, himself a Wall Street alumnus and U. of Chicago Finance PhD holder - wanted to hire a librarian to manage it.
I was on a committee that graded jobs for purposes of pay ranges. We used a vendor-supplied system to do that. As we were grading out the Research Librarian job, which required a Masters' degree in Library Science, someone on the committee asked whether that degree was to be valued the same as an MBA. The head of HR said yes. The Chief Marketing Officer and I nearly fell out of our chairs.
As we explained to the committee, based on the laws of supply and demand, there just aren't as many jobs that require an MLS degree as an MBA. MBAs, being higher in demand, command greater compensation. And if the two degrees held equal value, there would be a mass exodus out of relatively more difficult MBA programs, and into MLS programs, which, in the days before the internet, big data and data mining, were a whole lot easier to complete.
(No disrespect to librarians intended; these are just the facts. If you're looking at grad school and are undecided between an MLS and an MBA, and it's money you're after, pick the MBA. But if your passion is to be a librarian, choose the MLS degree - your earnings will be lower than, say, a portfolio manager's, but the most important thing is to love what you do.)
Look, the reality is that there are a lot fewer people who can successfully run a company like Apple than there are people who are qualified to flip burgers. So supply and demand, as well as performance and results, are going to dictate that Apple's CEO will make more than a burger-flipper at McDonald's. Yes, the economy needs both. No, they shouldn't receive the same pay, unless McDonald's believes a lone burger-flipper can add $650 billion to the firm's market capitalization.
Income equality was never promised as part of the American Dream. Opportunity equality was. What each individual does with that opportunity is what determines their income potential, by and large. Not everybody has the ability to be a Tim Cook. But an awful lot of people do, if they put in the work to get where he's gotten. The business world abounds with rags-to-riches stories like that of Sam Walton, who built the Wal-Mart empire. There are also a lot of near-rags-to-success stories, like my own. To be sure, there are some who do not have equal opportunity, and I'm all for addressing that. Opportunity is the most valuable commodity a society can offer. But that isn't related to supply-side economics, nor does it (nor should it, nor can it) bring the promise of income equality. The system isn't perfect in terms of opportunity equality, but it's pretty darn good.
Those who argue for income equality can never achieve what they really want. What they want is for the Tim Cooks of the world to have their pay capped at a level low enough that their own compensation can be raised to match his. Their premise is that everybody would be equally compensated, and at a pretty high level.
Not only would the math not work, but it wouldn't work economically, either. The Tim Cooks would find some country that didn't enforce such policies and run a business there - or move Apple's headquarters offshore. The U.S. economy would be decimated from companies leaving our borders. Corporate tax rates would shoot up for small businesses in an effort to make up the lost tax revenue from larger corporations, and unemployment would go through the roof. And the supply of available burger-flippers would suddenly skyrocket.
The only true path to income equality is through a totalitarian regime, either Socialist or Communist. That's happened before. However, instead of providing equal prosperity, those regimes have produced equal poverty, as the powers that be at the top of the regime enrich themselves far beyond anything Tim Cook could imagine and leave the crumbs for their subjects. In fact, those regimes tend to have much higher income inequality than free-market democratic republics.
They also carry carry nasty side benefits like pogroms and ethnic cleansing and imprisonment (or worse) for exercising rights we all take for granted, like free speech, freedom of religion, liberty, and the pursuit of happiness. Be careful what you wish for.
Saturday, May 9, 2020
Bottom-Up vs. Top-Down
No, I'm not talking about drinking vs. driving a convertible. (Please don't do both at the same time.) I'm talking economics.
I've seen a lot of comparisons of the economic fallout from the government's response to the COVID-19 pandemic to the Great Depression of the 1930s and the Great Recession of 2008-09. However, this downturn is quite different from those infamous economic declines - 180 degrees different, in fact.
Before I get into the meat of this post, let me explain what I mean by the "top" and "bottom" of the economy. I'm generally referring to relative compensation in the banking and finance sectors, tech, pharma, some of health care, etc. - the top of the compensation curve, at least for private employers - vs. those at the bottom of that curve - service sector workers like restaurant staff, hotel clerks and maids and bell desk workers, most cruise line employees, hair stylists, dog groomers, etc. This is not meant to be demeaning to any group, nor am I making any points regarding the relative value of one worker vs. another, which is determined by supply and demand.
On to the bottom-up vs. top-down discussion. Both the Great Depression and the Great Recession resulted from asset price bubbles - stocks in the late 1920s, housing in the early 2000s - that were inflated by too-accommodative monetary policy. (In the 1920s that policy was effected by dramatically increasing the supply of money circulating in the economy; in the 2000s it was through interest rates held at then-historically low levels for too long after the dot-com recession of 2000.)
I won't go into great detail about the Depression, in large part because I wasn't around to witness it.
Honest.
But it was precipitated by the stock market bubble, which had been inflated by the aforementioned increase in the money supply, bursting in 1929. The Dow Jones Industrial Average lost half its value in just two months. After a couple of brief partial rebounds, by 1932 the Dow had lost about 90% of its value. Stocks weren't as widely held as they are now; there were no 401(k)s or IRAs, hardly any mutual funds, no online brokerage accounts. So this primarily affected those at the top of the economy - banks, investment firms, wealthy industrialists.
As those institutions failed and those people lost their jobs and investments and stopped consuming, people lower on the economic spectrum got scared, and everyone stopped consuming. Manufacturing all but shut down, which caused the economy to shed lower-level jobs. President Hoover tried to intervene to prop up the economy, but his efforts only caused it to weaken further.
(This is in stark contrast to the false narrative that Sen. Chuck Schumer is pitching in comparing President Trump to Hoover, saying both did nothing. Hoover tried to prop up the economy, and so has the Trump administration, to the tune of $2.4 trillion and counting. Too soon to tell whether that's a good thing; I'm just noting that Schumer is lying again, which should have been evident from the movement of his lips.)
President Roosevelt doubled down on Hoover's stimulus, which weakened the economy even further and prolonged the Depression. (And Schumer is calling for "Rooseveltian" action. Heaven help us.) Only the massive spending on WWII, and subsequent economic growth as soldiers went back to work rebuilding the manufacturing sector for private vs. military needs, saved the economy. The lesson is that economic activity is more stimulative to a struggling economy than government intervention.
So in short, the economy imploded at the top, and that took down the rest of the economy.
In the 2007-09 downturn, the economy again imploded from the top down. That downturn was precipitated in large part by new wrinkles in the mortgage market. I won't get technical, but these loans allowed people to leverage themselves into more house than they could afford, with initial payments that were much lower than what it would ultimately take to pay off the loan in 30 years. They featured triggers that would result in increased payments so that the loan would pay off fully in 30 years.
The housing boom was so massive that lenders couldn't keep all the loans they made on their books without running out of liquid funds, or liquidity, to make more loans. So they were packaged and sold to investment and commercial banks, pension funds, even Fannie Mae and Freddie Mac, the government's housing finance agencies.
Once the triggers in these loans kicked in, many borrowers couldn't afford the increased payments, and they walked away from their homes. That left the banks and investors holding the bag. Some insurance companies had created credit insurance instruments to make the pools of loans more attractive to investors, and they got hit with huge claims under those instruments.
At the same time, the teachers, factory workers, hotel and airline and restaurant and casino employees, hair and nail salon workers, and others who had taken out those loans still had their jobs. They just no longer had the house they had financed with those loans (plus they had destroyed their creditworthiness, sadly). They rented apartments or homes, or lived with relatives, or even lived in their cars. But they still had jobs. This is a critical point.
As was the case with the Great Depression, the financial sector - banks, investment firms and insurance companies - failed first. The stock market was down only 10% from October '07 to March '08, as home values began to decline. Then Bear Stearns, which was at the forefront of mortgage finance, failed. In April, unemployment was at 5%, vs. 4.4% at the low in May 2007. (Note that I'm lagging the unemployment rate by a month after the event, in this case the failure of Bear Stearns.)
In September 2008, Lehman Brothers failed, and many other banks, investment banks and large insurers like AIG were at the brink of running out of cash, all on the same day. I'll never forget that day. I was in Flagstaff to deliver an economic outlook to a bunch of credit unions, and I was in the bar and watched it unfold - and the market tank - on the news. The next day I told the attendees to disregard my slides, which they'd received in advance, because everything had just changed overnight. In October (lagging a month again), unemployment hit 6.5%. I remember seeing images of investment bankers walking out of buildings on Wall Street in droves, carrying boxes of their belongings. So now we'd seen unemployment go from 4.4% to 6.5% in 16 months - bad, but not terrible; you see, the financial sector only makes up about 5.5% of the nation's labor force.
It took another year for unemployment to peak at 10%. That's because the top of the economy (higher-paid people) failed first. They stopped eating out, going to movies, taking vacations. They couldn't find other jobs, because that sector was toast. A guy from Bear Stearns who used to sell investments to the brokerage firm I ran at the time is now teaching middle school in Virginia. Financial institutions slashed their travel budgets - my clients no longer came to our investment schools and other conferences. So hotels were affected. Banks stopped holding conventions in Vegas due to the optics as well as the expense, so casinos got crushed (and the former high rollers didn't have money to gamble anyway).
Hotel, airline, restaurant, bar, casino, theater workers lost jobs. The implosion at the top of the economy took down the bottom, and all sectors collapsed. However - another critical point - not all workers in those industries lost their jobs, because their employers remained open for business, unlike today. There was just less demand, so a hotel might only need half its staff, for example.
Again, the economy imploded at the top, and that took down the rest of the economy.
This time, the bottom was pulled out from under the economy when the government forced businesses to shut down, primarily in the leisure and hospitality, retail and service sectors - restaurants, theaters, hotels, airlines, cruise lines, hair and nail and massage salons, and many retail stores. It wasn't a function of demand; the demand was evident in the fact that cruises, flights and hotel rooms had already been booked and had to be canceled. Prior to the shutdowns, restaurants had long wait times on the weekends, retail stores were busy, and people were doing discretionary things like getting their nails done or having a massage.
Restaurants got hit first, especially the mom and pops (which is the majority of the industry). Lower-level hotel workers got hit hard. The managers have to be retained to stay open and to re-open, but you don't need many maids at less than 10% occupancy. Same with the airlines - you need a lot less of the lower-end employees, but you've got to have management, logisticians (especially now that routes have been slashed), and pilots. The cruise lines have largely retained crew, but land-side personnel have been laid off.
The retail, leisure and hospitality, and other services sectors employ about 25% of U.S. workers - five times the financial sector. That's why this time, unemployment shot up from 3.5% to 14.7% in two months, vs. what we saw in those two earlier downturns. The vast majority of these jobs are at the lower end of the compensation scale.
However - the top of the economy is almost entirely intact. The banking sector is largely unaffected in terms of what we saw in '08-09, though there will be layoffs of some lower end employees (especially as the banks try to navigate whether they still need branches to the extent they did before, since branch traffic is way down but customers are still accessing their accounts via digital channels). But most long-term employees will just be re-deployed to other areas because of their institutional knowledge.
Wall Street is largely unscathed. They make money buying and selling investments. The supply chain is roaring - the stocks of Amazon, WalMart, Target are all up, and those firms are hiring, though many of those jobs aren't at the top of the economy. Most of tech is doing well. Some of pharma is doing quite well. The relative health of the top of the economy is one reason why the Dow has already recovered about half of the 35% or so that it lost from late February to late March. At this writing, it's down 17%, which doesn't even meet the definition of a bear market.
I've previously written about the evidence of demand for leisure and business travel, cruises, dining out, entertainment and sporting events, etc. So unless we reverse course on re-opening, the recovery from a failure at the bottom of the economy is going to look much better than a top-down failure, because there's still demand for all of those things on the part of people that have to date been unaffected, who have the means to spend money on them. That will bring back jobs at the lower end of the economy, and those Americans will be able to resume discretionary spending as well.
One final note: for those who believe that supply-side or "trickle-down" economics is a myth, these examples prove you wrong. A failure at the top of the economy will trickle down and crush the bottom. A failure at the bottom won't necessarily take down the top. And in the next several months, the spending by those at the top that I describe above will indeed trickle down to salvage the bottom of the economy. This lesson is free of charge.
I've seen a lot of comparisons of the economic fallout from the government's response to the COVID-19 pandemic to the Great Depression of the 1930s and the Great Recession of 2008-09. However, this downturn is quite different from those infamous economic declines - 180 degrees different, in fact.
Before I get into the meat of this post, let me explain what I mean by the "top" and "bottom" of the economy. I'm generally referring to relative compensation in the banking and finance sectors, tech, pharma, some of health care, etc. - the top of the compensation curve, at least for private employers - vs. those at the bottom of that curve - service sector workers like restaurant staff, hotel clerks and maids and bell desk workers, most cruise line employees, hair stylists, dog groomers, etc. This is not meant to be demeaning to any group, nor am I making any points regarding the relative value of one worker vs. another, which is determined by supply and demand.
On to the bottom-up vs. top-down discussion. Both the Great Depression and the Great Recession resulted from asset price bubbles - stocks in the late 1920s, housing in the early 2000s - that were inflated by too-accommodative monetary policy. (In the 1920s that policy was effected by dramatically increasing the supply of money circulating in the economy; in the 2000s it was through interest rates held at then-historically low levels for too long after the dot-com recession of 2000.)
I won't go into great detail about the Depression, in large part because I wasn't around to witness it.
Honest.
But it was precipitated by the stock market bubble, which had been inflated by the aforementioned increase in the money supply, bursting in 1929. The Dow Jones Industrial Average lost half its value in just two months. After a couple of brief partial rebounds, by 1932 the Dow had lost about 90% of its value. Stocks weren't as widely held as they are now; there were no 401(k)s or IRAs, hardly any mutual funds, no online brokerage accounts. So this primarily affected those at the top of the economy - banks, investment firms, wealthy industrialists.
As those institutions failed and those people lost their jobs and investments and stopped consuming, people lower on the economic spectrum got scared, and everyone stopped consuming. Manufacturing all but shut down, which caused the economy to shed lower-level jobs. President Hoover tried to intervene to prop up the economy, but his efforts only caused it to weaken further.
(This is in stark contrast to the false narrative that Sen. Chuck Schumer is pitching in comparing President Trump to Hoover, saying both did nothing. Hoover tried to prop up the economy, and so has the Trump administration, to the tune of $2.4 trillion and counting. Too soon to tell whether that's a good thing; I'm just noting that Schumer is lying again, which should have been evident from the movement of his lips.)
President Roosevelt doubled down on Hoover's stimulus, which weakened the economy even further and prolonged the Depression. (And Schumer is calling for "Rooseveltian" action. Heaven help us.) Only the massive spending on WWII, and subsequent economic growth as soldiers went back to work rebuilding the manufacturing sector for private vs. military needs, saved the economy. The lesson is that economic activity is more stimulative to a struggling economy than government intervention.
So in short, the economy imploded at the top, and that took down the rest of the economy.
In the 2007-09 downturn, the economy again imploded from the top down. That downturn was precipitated in large part by new wrinkles in the mortgage market. I won't get technical, but these loans allowed people to leverage themselves into more house than they could afford, with initial payments that were much lower than what it would ultimately take to pay off the loan in 30 years. They featured triggers that would result in increased payments so that the loan would pay off fully in 30 years.
The housing boom was so massive that lenders couldn't keep all the loans they made on their books without running out of liquid funds, or liquidity, to make more loans. So they were packaged and sold to investment and commercial banks, pension funds, even Fannie Mae and Freddie Mac, the government's housing finance agencies.
Once the triggers in these loans kicked in, many borrowers couldn't afford the increased payments, and they walked away from their homes. That left the banks and investors holding the bag. Some insurance companies had created credit insurance instruments to make the pools of loans more attractive to investors, and they got hit with huge claims under those instruments.
At the same time, the teachers, factory workers, hotel and airline and restaurant and casino employees, hair and nail salon workers, and others who had taken out those loans still had their jobs. They just no longer had the house they had financed with those loans (plus they had destroyed their creditworthiness, sadly). They rented apartments or homes, or lived with relatives, or even lived in their cars. But they still had jobs. This is a critical point.
As was the case with the Great Depression, the financial sector - banks, investment firms and insurance companies - failed first. The stock market was down only 10% from October '07 to March '08, as home values began to decline. Then Bear Stearns, which was at the forefront of mortgage finance, failed. In April, unemployment was at 5%, vs. 4.4% at the low in May 2007. (Note that I'm lagging the unemployment rate by a month after the event, in this case the failure of Bear Stearns.)
In September 2008, Lehman Brothers failed, and many other banks, investment banks and large insurers like AIG were at the brink of running out of cash, all on the same day. I'll never forget that day. I was in Flagstaff to deliver an economic outlook to a bunch of credit unions, and I was in the bar and watched it unfold - and the market tank - on the news. The next day I told the attendees to disregard my slides, which they'd received in advance, because everything had just changed overnight. In October (lagging a month again), unemployment hit 6.5%. I remember seeing images of investment bankers walking out of buildings on Wall Street in droves, carrying boxes of their belongings. So now we'd seen unemployment go from 4.4% to 6.5% in 16 months - bad, but not terrible; you see, the financial sector only makes up about 5.5% of the nation's labor force.
It took another year for unemployment to peak at 10%. That's because the top of the economy (higher-paid people) failed first. They stopped eating out, going to movies, taking vacations. They couldn't find other jobs, because that sector was toast. A guy from Bear Stearns who used to sell investments to the brokerage firm I ran at the time is now teaching middle school in Virginia. Financial institutions slashed their travel budgets - my clients no longer came to our investment schools and other conferences. So hotels were affected. Banks stopped holding conventions in Vegas due to the optics as well as the expense, so casinos got crushed (and the former high rollers didn't have money to gamble anyway).
Hotel, airline, restaurant, bar, casino, theater workers lost jobs. The implosion at the top of the economy took down the bottom, and all sectors collapsed. However - another critical point - not all workers in those industries lost their jobs, because their employers remained open for business, unlike today. There was just less demand, so a hotel might only need half its staff, for example.
Again, the economy imploded at the top, and that took down the rest of the economy.
This time, the bottom was pulled out from under the economy when the government forced businesses to shut down, primarily in the leisure and hospitality, retail and service sectors - restaurants, theaters, hotels, airlines, cruise lines, hair and nail and massage salons, and many retail stores. It wasn't a function of demand; the demand was evident in the fact that cruises, flights and hotel rooms had already been booked and had to be canceled. Prior to the shutdowns, restaurants had long wait times on the weekends, retail stores were busy, and people were doing discretionary things like getting their nails done or having a massage.
Restaurants got hit first, especially the mom and pops (which is the majority of the industry). Lower-level hotel workers got hit hard. The managers have to be retained to stay open and to re-open, but you don't need many maids at less than 10% occupancy. Same with the airlines - you need a lot less of the lower-end employees, but you've got to have management, logisticians (especially now that routes have been slashed), and pilots. The cruise lines have largely retained crew, but land-side personnel have been laid off.
The retail, leisure and hospitality, and other services sectors employ about 25% of U.S. workers - five times the financial sector. That's why this time, unemployment shot up from 3.5% to 14.7% in two months, vs. what we saw in those two earlier downturns. The vast majority of these jobs are at the lower end of the compensation scale.
However - the top of the economy is almost entirely intact. The banking sector is largely unaffected in terms of what we saw in '08-09, though there will be layoffs of some lower end employees (especially as the banks try to navigate whether they still need branches to the extent they did before, since branch traffic is way down but customers are still accessing their accounts via digital channels). But most long-term employees will just be re-deployed to other areas because of their institutional knowledge.
Wall Street is largely unscathed. They make money buying and selling investments. The supply chain is roaring - the stocks of Amazon, WalMart, Target are all up, and those firms are hiring, though many of those jobs aren't at the top of the economy. Most of tech is doing well. Some of pharma is doing quite well. The relative health of the top of the economy is one reason why the Dow has already recovered about half of the 35% or so that it lost from late February to late March. At this writing, it's down 17%, which doesn't even meet the definition of a bear market.
I've previously written about the evidence of demand for leisure and business travel, cruises, dining out, entertainment and sporting events, etc. So unless we reverse course on re-opening, the recovery from a failure at the bottom of the economy is going to look much better than a top-down failure, because there's still demand for all of those things on the part of people that have to date been unaffected, who have the means to spend money on them. That will bring back jobs at the lower end of the economy, and those Americans will be able to resume discretionary spending as well.
One final note: for those who believe that supply-side or "trickle-down" economics is a myth, these examples prove you wrong. A failure at the top of the economy will trickle down and crush the bottom. A failure at the bottom won't necessarily take down the top. And in the next several months, the spending by those at the top that I describe above will indeed trickle down to salvage the bottom of the economy. This lesson is free of charge.
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