“The bank is something more than men, I tell you. It’s the monster. Men made it, but they can’t control it.” –John Steinbeck, The Grapes of Wrath
“The Great Depression, like other periods of severe unemployment, was produced by government mismanagement rather than any inherent instability of the private economy.” –Milton Friedman
There have been 47 recessions in the US since its founding, which at best is an estimate since we didn’t keep complete data such as unemployment and GDP until after WWII. Since WWII there have been 12 official recessions, make that 13 if you count what I believe is the current one which began this year. The average duration of a recession (typically described as two consecutive contractions in quarterly GDP growth) has averaged 10 months. The recent exception was the Great Recession of 2007-2009 which lasted 18 months in its entirety.
Since the Great War, most recessions were brought on by a Fed rate tightening cycle and an oil shock as shown in the graph below (recessions noted by red vertical bars).
In a typical business cycle, as money and credit expand in the economy, a surge in inflation eventually followed, prompting the Fed to raise interest rates in an effort to cool down the economy and control inflation. This typically led to a recession.
This rinse and repeat cycle accompanied every recession and recovery since WWII. Beginning in the 1970s, as shown in the debt graph from the St. Louis Fed, debt began to expand in every economic cycle. Unlike the past, it seldom retreated and expanded with each new economic recovery. At the turn of this new century, debt expansion accelerated as interest rates fell to levels never seen before in history. The monetary authorities attempted to ease the debt burden and encourage the use of credit by making the cost of credit less expensive to acquire.
Greenspan brought the federal funds rate down to 1% and kept it there for four years. When the Fed began to raise interest rates to cool down the economy in an effort to control inflation, it did so incrementally in quarter-point increments over a three year period when it plateaued in 2007, just before the recession began in December of that year. Then in a series of rate reductions first under Greenspan, then Bernanke, it was reduced to zero where it remained for 7 years. Beginning with Yellen and then Powell, the federal funds rate was slowly raised to 2.5% before quickly reverting back to zero in just a few quick strokes. It’s likely to remain there for years given we find ourselves in another recession, if not mini-depression, depending on how long the economy remains shut down and businesses and consumers remain quarantined.
This recession and possible depression are unlike anything we have experienced before. It was not Fed-induced, nor was it preceded by an oil shock as happened in 2007-2008. In fact, oil prices were falling below the cost of production leading to recessionary conditions in oil-producing states like Texas. The Fed was in a rate-cutting mode before the outbreak of the pandemic with the unemployment rate at multi-decade lows and the economy growing at a moderate rate of 2%.
This recession, or possibly depression, is government-induced as non-essential businesses remain closed in much of the country; travel and events have been canceled while millions of employees are either working from home or potentially without jobs. With fewer cars on the road and planes in the air, we’ve seen an astonishing reduction in energy demand globally by an estimated 20 million barrels per day. State shutdowns have led to at least a quarter of the economy now offline. On March 3rd, Hilton Worldwide Holdings Inc. added $2 billion to its stock buyback program reflecting a vote of confidence by the board and top executives of the company. Three weeks later, the hotel company would reduce the business down to its core, furloughing employees, cutting expenses, slashing capital expenditures, and suspending its dividend and buyback program.
It is hard to believe in late February the stock markets were at record levels, the unemployment rate was at 3.5%, wages were rising, and the economy was growing. Nothing in our economic history has seen an economy shut down this quickly or markets fall this rapidly. Between 1926 and 2017, there were 8 bear markets ranging in length from six months to 2.8 years and in severity from a drop of 22% to as much as 88%. This one happened rapidly with the Dow losing 38% from peak to trough between February 12th and March 23rd. Then, it bounced out of bear market territory just as quickly, rising 21% in just three days.
How long the economy remains shut down and people remain quarantined will determine the severity of the mini-depression now underway and how long it will take to recover thereafter. The economic projections vary all over the place. Jamie Dimon, CEO of JPMorgan is calling it “a bad recession.” Former Fed Chair Janet Yellen told CNBC that the real unemployment rate could be far higher with the economy possibly declining by 30% in the second quarter. As a point of reference, during the Great Depression, unemployment rose to 24.9%, the economy contracted by 25%, and prices fell by 30%. All of this took place between 1929 and 1933. Yellen is talking about the economy contracting by 30% in a single quarter. Fed Governor Bullard has suggested that the unemployment rate could hit 30% the longer the economy is shut down.
The truth of the matter is that nobody knows as we have not found ourselves in this situation for more than a hundred years since the Spanish Flu pandemic of 1918. The problem lies in the pandemic itself, how quickly it plateaus and burns itself out, or, worse, returns. There is also the unknown of government policy and its response to the pandemic. That said, we are shortly reaching the point where the cure is worse than the disease. Imagine the media headline: The operation was successful but the patient died.
The issue with economic or market models is they rely on linear data. In terms of this virus, we simply don’t have enough inputs to model it correctly. Trends in place are expected to remain in place. If yesterday was bad, tomorrow is sure to be just as bad or if yesterday is a good day, tomorrow is sure to be a good one as well. Sentiment fluctuates with trends in place and remains so until something changes.
The real issue is uncertainty and there is nothing more that businesses or investors fear more than the unknown or the uncertainty around that unknown. As Greg Ip recently pointed out succinctly in the WSJ, “Today, there are at least four distinct sources of uncertainty: the severity and spread of the pandemic; second, the breadth and duration of social distancing measures; third, the economic and financial impact of those measures; and fourth, the policy response.” To these four I will add a fifth: the political fallout.
As Murray Rothbard wrote in his book “America’s Great Depression,” what should have been a recession was turned into a Great Depression as a result of government policy. Rothbard wrote in 1963, “While it is theoretically true that deficits financed by the sale of bonds to the public are not inflationary, it is also true that the huge deficits (a) exert enormous political pressure on the Fed to monetize the debt; and (b) cripple private investment by crowding out private savings and channeling them to unproductive and wasteful government boondoggles which will impose higher taxes on future generations.”1
We see this on display now in government policy as Modern Monetary Theory (MMT) provides the framework and justification for larger deficits and debt monetization. Conventional economic theory acknowledges that business cycles do exist but has yet to figure out their cause or how to fully explain them. The greatest mistake we can presently make is to blow an economic hole so big we are unable to dig our way out unless by the helping hand of big government. To quote Rothbard again: “If the modern array of monetary-fiscal management and stabilizers cannot save capitalism from another severe depression, this large group will turn to socialism as the final answer. To them (the socialists) another depression would be the final proof that even a reformed and enlightened capitalism cannot prosper.”2 This very debate is at issue in this year’s presidential election.
This pandemic is impacting every form of government from a tribal society, a monarchy, dictatorships, a capitalistic society, to socialistic and communistic governments. To lay the blame for America’s economic loss due to the coronavirus at the feet of American capitalism is to advance an illegitimate, misleading question.
The central question is not which form of government is most at fault for the present crisis, but rather which system of government will be most effective in bringing about the quickest, and most thorough restoration of the economic prosperity we were experiencing before the pandemic. In the simplest of terms, the choice will be between a centralized, state-run economy operating through a bureaucracy or a system that relies upon innovation, entrepreneurialism, competition, and free markets. Fortunately, we have the benefit of a historical perspective in wagering on the outcome.
I try to remain apolitical. I do not have the luxury of allowing my political beliefs to improperly influence my investment decision making. Rather, I must view the political outcomes and weigh them in terms of their impact upon the economy and the investment markets that follow.
Now to the very issues at hand: I have spoken about the number of programs the Fed has put in place, and the $2.2 trillion stimulus package that was passed is the first of many more to follow. The deficits are exploding, and in the not too distant future will be approaching $30 trillion in total US debt. At some point, due to the double whammy of massive spending and a loss of revenues from economic contraction, we are going to see multi-trillion dollar deficits far into this decade which, I believe, will ultimately lead to a devaluation of the US dollar.
However, this is only part of the story for, as a country, the pandemic will forever change us and how we act socially and economically. The pandemic is accelerating trends already in place before the pandemic ever surfaced. I mentioned that supply change disruption will change the manufacturing supply chain. China will emerge as a major loser as no company will want to find itself as they do today dependent on one country for supplies or intermediate manufactured goods. This is no more important than when it comes to drugs and vaccines which mainly come from China. Retail will change forever with online retailing becoming the dominant form of shopping. The longer this shutdown and quarantine last, the more consumer behavior will change. More and more consumers will get used to staying at home and buying online. More importantly, they may adapt to buying less. If frugality and savings become the new norm, it is safe to say that many of our shopping malls will disappear as we have more of them than any country on the planet. The big box stores will prosper and get even bigger. They are the ones doing the hiring while other retailers furlough or lay off workers. Many of today’s marque department stores may not survive or, if they do, will be reduced in size and number.
Socialization will also be different whether it is sports, rock concerts, restaurants, bars or movie theaters. How soon will you feel comfortable cozying up to a raucous sports fan spilling his beer and drooling on your arm? Think of being inside a movie theater where the guy next to you sneezes in your popcorn or coke. Or imagine your own ostracization if you begin to sneeze or experience a coughing spasm yourself.
To quote Bill Gates who predicted the danger of a pandemic in a TED Talk in 2015 (while commenting on mass gatherings), “Until you’re widely vaccinated, those may not come back at all.” Major events have been canceled deep into the summer. It is no longer a given that sports teams will play this year. Gavin Newsom, California’s governor, said last Saturday that he doesn’t believe his state’s three football teams will be playing in front of fans come September. The Olympics have been postponed until next summer, while Wimbledon will be skipped in 2020.
Life will go on and eventually return to normal but we will forever be changed by today’s events in the same way the Great Depression and WWII shaped the lives and behavior of a whole generation of Americans.
The good news is that this virus will be beaten, and things will return to normal over time. We have the technology, and medical know-how and capabilities to win this invisible war.
“Americans will always do the right thing, after first exhausting all possible alternatives.” (Attributed to Winston Churchill)
Side Note
This weekend I made my weekly pilgrimage to Costco. As I was driving on empty streets with only an occasional car passing me by, I drove by empty shop after empty shop with signs hanging from their darkened windows reading, “Closed for Business”. I’m not so sure of how many will reopen the longer the quarantine goes on. The corner gas station was still open along with the local CVS. I thought as I drove, I was going to the one place everyone else was allowed to go to which was the grocery store. What were the chances I would come into contact with everyone who has the virus and not knowing where it would also be going to?
I was prepared. Wearing an N-95 mask, latex gloves covered over by a pair of copper-infused gloves. I was going into a war zone and felt I was prepared as best as I could be. I am not a doctor or epidemiologist, but I was prepared for any attack that would come my way. When I pulled into the Costco parking lot, I was struck by a scene I have never seen in my life. I felt I was on the movie set of the film “Outbreak.” The upfront parking spaces and handicap zones had been cordoned off by a line of shopping carts that prevented anyone from driving around each parking aisle.
Orange parking cones had been set out to form lines for customers to stand in line and in order to get inside the store. Employees stood abreast to make sure anyone standing in line kept up with social distancing protocol.
I was lucky. I am over 60 so I got to go to another line. I grabbed a freshly sanitized cart and ventured inside with my honey-do-shopping-list in hand. The lines outside kept traffic inside to a minimum making social distancing possible without any effort of bumping into another human being. It was still strange to see others dressed in garb similar to myself.
I was able to get just about everything on my list with the exception of toilet paper. Why is it always the toilet paper? Will someone explain the obsession of hoarding toilet paper, an item more appropriate to a gastrointestinal virus than a respiratory one?
I asked a store employee when paper products might become available. He said at least several more weeks. The only paper products available were computer paper. I told him don’t tell anyone as that could become in short supply as a substitute. He did inform me that trucks get to the store early and they open the store for a brief period at 6:30 AM. But I would need to get in line as people starting gathering at 5:00 AM. The toilet paper sells out within the first half-hour. It reminded me of the gas lines during my college days when I waited until midnight when the fuel trucks would arrive so I could keep my gas tank filled and get to work and school.
I thank God for the management of Costco and the employees that do their best to keep their customers safe. It’s the beauty of a private enterprise system.
Until this clears, stay safe, wear a mask if possible when going out in public and love the ones closest to you.
Jim
1 America’s Great Depression, by Murray N. Rothbard, p xviii
2 Ibid, [xxxvi-xxxvii]
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