The past few weeks have seen unprecedented changes in our lives as the coronavirus pandemic has brought the economy to a near standstill. The U.S. already leads the world in cases, with nearly 400,000 people diagnosed (although the numbers out of China should be taken with a healthy dose of skepticism at this point).
Even those who haven’t felt the effects of the disease firsthand — like my family and I, who have been on lockdown for more than two weeks — are struggling to adapt to the new paradigm of social distancing. Thankfully, my kids are able to join their classes and do homework online — and even their music lessons have gone virtual, with only a few minor glitches. And though I’m sure my wife is sick of hearing clichéd business lingo on call after conference call, I can research and write from my home office.
I’m one of the lucky ones, but it’s still no fun to watch my IRA and 401(k) funds crater as capital markets adjust to the economic fallout. Even as many people hope for a quick recovery and are already looking to snap up bargains in the stock market, panic buying of non-perishables and hourlong waits at the grocery store tell us that some are less optimistic about any sort of near-term return to normalcy. And as my friend and fellow columnist Angelo Calvello recently noted, certain segments of the economy, like restaurants, will indeed be decimated and may not recover at all, as millions of people have already lost their jobs.
Economies and financial markets are highly complex systems. Unlike in physical sciences, the lead-lag relationships of social science variables can and do change over time as market participants learn and adapt. Put another way, in social sciences a cause can become an effect and vice versa, just as confidence can increase skill and that skill subsequently increases confidence. Self-reinforcing cycles like this are partly what lead to boom-and-bust behavior. Rising prices drive momentum-induced buying as the fear of missing out takes over, and falling prices trigger loss aversion as sellers rush to get out while they can.
So trying to predict how this particular crisis will play out is next to impossible, but sometimes knowing how we got to where we are can help us understand where we are going. Looking at some historical analogues for what we are observing suggests we might have a rough path ahead.
Ben Carlson of Ritholtz Wealth Management has compiled some scary information. The first thing he notes is the prevalence and severity of volatility in the financial markets, as investors attempt in real time to accurately evaluate the economic impact of recent events. Of the top-six worst daily sell-offs in the history of the S&P 500 dating back to inception, one was on Black Monday, October 19, 1987; three came in 1929; and two have occurred in the past few weeks. The Great Financial Crisis of 2008 barely sneaks into the top ten. Not good.
Early economic data is just as awful as the market convulsions. After hovering in the 200,000s for months, unemployment claims spiked to 6.6 million in the week ending March 28, up from 3.3 million the previous week, as the first waves of layoffs hit workers. The weekly number had never been higher than 700,000 or so since the Department of Labor began tracking it in 1967. Economists estimate that total job losses could take the unemployment rate to anywhere from 15 to 40 percent before this is over. That’s a big range, but remember that unemployment in the most recent financial crisis topped out at 10 percent. During the Great Depression unemployment claimed one quarter of the workforce — a staggering number.
Although the current shutdown is more or less voluntary, it doesn’t mean we will simply be able to turn the economy back to full power when the pandemic is behind us. As a friend points out, people are unlikely to go to restaurants or the movies twice as often for a few months to make up for not having gotten out for a while, nor will they take two spring vacations in 2021. That spending is gone, and that doesn’t even account for the knock-on effects, such as the Uber home from the bar that you didn’t wind up needing or the spur-of-the-moment purchases from window shopping after the movie that didn’t happen.
The Institute for Supply Management announced better-than-expected manufacturing activity in March, but still indicating contraction. The forward-looking new orders number plunged to the lowest reading in 11 years.
Clearly, we are already in a recession, and the only question is how deep and how long.
Some of the more recent projections I’ve seen suggest all of this has the potential to reduce GDP by 5 to 20 percent. GDP fell by only 5 percent during the last recession, and the nation has not experienced a double-digit recession since before World War II. From 1929 to 1932, GDP plummeted by nearly 30 percent cumulatively, and double-digit losses year over year were commonplace. It is now likely that this will be the steepest recession in at least 70 years.
Though these comparisons are alarming, any time someone tries to draw analogies between the Great Depression and a current contraction, it usually proves to be an exercise in hyperbole. So let’s step back a bit and take a look at some other important factors.
Happily, central bank intervention today is far different than it was then. During the ’30s money supply contracted by 35 percent, resulting in serious deflation, which in turn served as a deterrent to demand. Coupled with a collapse in the banking sector as numerous overleveraged banks shuttered their doors, monetary policy added fuel to the flames and in so doing extended the duration of the Great Depression. Today the Federal Reserve has interest rates essentially at zero, and with increased quantitative easing policies, including open-ended asset purchases and currency swap programs, it has taken its balance sheet above $5 trillion for the first time ever, up 12.5 percent in just a week. Broad liquidity concerns will not exacerbate the problem this time around.
And our social safety nets are far better today as well, with programs like Social Security and unemployment benefits — neither of which existed until the Social Security Act of 1935 — providing some income to the most at-risk members of the population. Additionally, the recently passed Coronavirus Aid, Relief, and Economic Security Act brings an additional $2 trillion commitment from the federal government.
The twin bazookas of monetary and fiscal policy working in unison will certainly blunt the impact of the crisis and help bring a quicker recovery. However, I think there are a few structural similarities between now and the Great Depression worth considering as well.
Broadly speaking, the economy in the early 1900s was undergoing extreme structural changes as it shifted from primarily an agrarian society to an industrial one. It is estimated that in 1900, 41 percent of Americans labored in agriculture, but by 1929 this number had been chopped almost in half, as farm workers fell to 21 percent of the labor force. This was a very large percentage of the population needing to be reskilled in a relatively short period.
Further, the rise of manufacturing created opportunities for the entrepreneurially minded to build huge businesses leveraging mass production and assembly line technologies for the first time, benefiting from economies of scale. Industrialists such as John D. Rockefeller, Andrew Carnegie, Henry Ford, Andrew Mellon, and William Randolph Hearst consolidated interests in oil, steel, coal, transportation, paper, and finance to build massive enterprises. The share of manufacturing assets owned by the 100 largest corporations rose from 20 percent before the 1920s to 42 percent by the late ’30s. Five to seven firms dominated most sectors.
This concentration in the means of production led to significant disparities in wealth distribution across the nation. Data maintained by the World Inequality Database shows that in 1929 the top 1 percent of the country took home 21 percent of the total income, whereas the bottom half collectively accounted for only 14 percent. Decades of increasing egalitarianism after World War II saw the top 1 percent of incomes drop to just 10 percent collectively, with the bottom half rising to 20 percent by the mid-1970s.
But those trends have reversed since 1980. Today the top 1 percent again earns more than 20 percent of the total pretax national income and the bottom half is down to roughly 12.5 percent — disparity not seen since the ’20s.
Though an oversimplification of the whole story, these facts paint a picture of a concentrated and fragile economy undergoing serious structural changes in the early part of the 20th century. Certainly, actions taken by the Federal Reserve then did not help, but it’s hard to imagine how such significant economic and demographic factors could not lead to financial dislocation and economic unrest.
Fast-forward to today, and we see some interesting parallels.
As mentioned earlier, wealth inequality has returned to levels last seen in the 1920s. And recent research shows that 75 percent of U.S. industries have undergone significant concentration of market power. Over the past two decades, the average industry concentration as measured by the Herfindahl–Hirschman index has risen by 90 percent, the most in nearly a century. Once again five to seven firms control at least three quarters of many sectors.
This is thanks in no small part to rampant consolidation. According to the Federal Trade Commission, mergers spiked from 300 a year in 1922 to more than 1,200 by 1929. More recently, the average number of mergers has surged from 2,000 or so per year in the 1980s to 12,000 each year currently.
As the number of nodes in a network shrinks, that network becomes more fragile. The loss of a specific node in a concentrated network is more damaging, as it propagates cascading failure faster throughout the network. Similarly, industry and wealth concentration increases systemic risk, making both an economy and a society more fragile.
And today we are also in the midst of an ongoing transformation from an industrial economy to an information economy, with all the structural upheaval that entails. Since the ’80s, information sectors — like professional services, finance, and information technology — have become a far larger percentage of total U.S. gross domestic output than old-world industrial companies, such as those in manufacturing, mining, and utilities. Along the way millions of Americans have struggled to adapt to changing skill demands from the shifting economy.
Systemic risk, single points of failure, market concentration, and job/skills mismatches layered on top of a rapidly evolving economy once again mean the effects of acute shocks to the system can be both more protracted and deeper than otherwise anticipated.
Returning to the 1930s, a series of severe droughts and dust storms swept across the heartland, blowing the dry and eroded topsoil into huge clouds that blackened the skies. The Dust Bowl period, which lasted about eight years in total, was not the most important causal factor in the Great Depression, but it contributed greatly to the problems. The phenomenon devastated 100 million acres of cropland across the South and the Midwest, and tens of thousands of farmers were forced to abandon their farms in search of a means of survival. This exodus served only to hasten the demise of the family-owned farm, as well as of the agricultural sector as a whole, and by increasing the supply of unemployed laborers, it further decreased the return to labor, expanding the market power of industries.
The extent of the Covid-19 pandemic is unknown, but one thing is for sure. It is hitting some sectors of the economy far harder than others. As manufacturing and processing plants close, restaurants shut down, and many elements of the transportation and distribution networks grind to a halt, workers in these industries disproportionately find themselves unable to support their families. (Business for Amazon is booming, however.)
On the other hand, many employees of the information economy — like computer programmers, researchers, lawyers, teachers, and, thankfully, writers and investors like me — have been able to remain productive working from home, albeit with a few accommodations.
Perhaps this pandemic will catalyze positive changes to our economy. Unfortunately, mom-and-pop restaurants and small stores — like family farms in the Dust Bowl — will fare the worst, likely giving rise to more market power for chains and larger franchises. Fortunately, the CARES Act should give some direct fiscal relief.
I think these events may also hasten automation and instrumentation of production processes within manufacturing industries. Just as the industrial farms brought scale efficiencies and technological innovations to agriculture, information technology will continue to improve the productivity and efficiency of industrial sectors. Robots cannot get sick.
Similarly, we may see an acceleration of the rise of the information sectors relative to GDP and a decline in the share of the industrial sector. Compared with our historical example, agriculture today sits at a mere 1.2 percent of U.S. GDP, despite being critical for our survival. And even more workers will need retraining than in the 1930s.
I don’t think things are likely to be as bad for as long as in the Depression — we have too many policy advantages working in our favor, and the average American is still far better off today than then. But I do think it’s prudent to price in uncertainty around return assumptions and to extend hold periods in investment underwriting base cases.
And if there is a silver lining in any of this, it might be precisely the decline of production and excess consumption as the basis of our economy.
Just as the Depression caused a generation of Americans to become frugal with food, maybe the coronavirus crisis can be the trigger to cause us as a society to reevaluate our desire for more and more stuff. We should all now be acutely aware that there are far more important things in life than the accumulation of material things — even when they’re on sale.
Take care of each other.