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.