Recession is coming. We can debate the timing, but the economy will turn decisively downward at some point. My own analysis, looking at the data available on April 4, says recession isn’t likely this year but unfortunately looks very probable in 2020.
In addition to when it will happen, there’s also the question of how deep the next recession will be. A shallow downturn wouldn’t be fun, but compared to the last one might feel relatively refreshing.
Alas, I don’t think we will be that lucky. I think the opposite: The next recession will be deeper, longer and far more painful to many more people than your average recession, and could persist as long as the last one. That is because the next recession in all likelihood will be truly global. If you sailed through 2007–2009 without your lifestyle changing, I wouldn’t assume it will happen that way again.
Ironically, but not surprisingly, it will be the response to the last recession that makes the next one so much worse. Part of the reason is that investors once again “learned” that if you simply stay the course, the market will get you back to where you were and more. The massive move into low-fee index investing instead of active management will make the next recession more painful.
You must understand that 75% of today’s wealth is in the hands of retirees and pre-retirees. Most have a significant portion of their money in index funds, and they’re going to see significant erosion of their retirement assets. I’m thinking especially of those depending on public pensions, which are heavily weighted to a form of index investing. Public pensions are already significantly underfunded (in general) and a bear market will make them even more so. It will be painful and I can assure you it will cause a lot of political angst. Today I’ll tell you why I think this. It may be one of the more important letters I’ve written in the recent past, so read carefully.
# Unwise Investment;
Central bankers have a well-worn playbook for handling recessions. Cut interest rates, increase liquidity, and otherwise make more capital available to the private sector. This helps businesses hire more workers and raise wages. Then gradually remove all the stimulus as growth recovers. (Usually, at least. Greenspan waited too long to tighten after the 2001 recession and begin raising rates, creating the dynamics for the subprime crisis.)
The playbook truly fell apart in 2008. The system had so much debt that adding yet more of it didn’t have the desired effect. As noted, easy money from the last crisis had created the situation. Even dropping short-term rates to effectively zero didn’t help because it was creditworthiness, not interest costs, that kept people and businesses from borrowing.
The Bernanke Fed’s answer was quantitative easing, essentially a way to stimulate lending at longer maturities. It had an effect but not the intended one. Instead of going to productive use, the new stimulus helped banks deleverage and public companies leverage up and repurchase their own shares, or as we will discuss below, simply buy their competition and short-circuit the “creative destruction” cycle. This pushed asset prices, i.e. the stock market, higher and made it appear recovery was underway. Unfortunately, the “recovery” was the slowest recovery on record.
# All that cash eventually trickled through the economy, not to people who would spend it on useful goods and services, but to yield-starved investors. Why were they starving? Because the Fed was keeping rates low. They had little choice but to take more risk, which is what the Fed wanted them to do in the first place. So they plunged money into venture capital, private equity, IPOs, emerging markets, and everything else they could find with potentially decent capital gains and/or yields.
The result was a massive wave of investment, some good and some, well, let’s just say based on hope and little else. And as we know, hope is not a solid investment strategy. Some businesses that had good stories (the so-called unicorns) found themselves covered with cash by investors for whom hope sprang eternal. Eager to show they could turn the cash into gold, the companies sought to emulate the Amazon model, using money to buy growth without profit. In the hopes of going public at some point and cashing in, they kept the game alive. Think Lyft. Investors, because they wanted to believe the story they were investing in was true, watched and waited.
# Gummed-Up Economy; We have another problem I also described recently: Capitalism Without Competition. A large and growing part of the economy is effectively “owned” by powerful monopolies or oligopolies that face little competition. They have no incentive to deliver better products at lower prices or to get more efficient. They simply rake in cash from people who have no choice but to hand it over.
This would be impossible if we had true capitalism, at least as Adam Smith, et al., envisioned it. Even if we generously concede that some businesses really are natural monopolies, most aren’t. The industries we now see dominated by a handful of companies got that way because the incumbents found some non-capitalistic flaw to exploit.
In theory, this problem should solve itself as technology and consumer preferences change the conditions that let the monopolies arise. Yet it isn’t happening. Axios outlined the problem in a recent article on farm bankruptcies.
Across industries, the U.S. has become a country of monopolies.
* Three companies control about 80% of mobile telecoms. Three have 95% of credit cards. Four have 70% of airline flights within the U.S. Google handles 60% of search. The list goes on. (The Economist)
* In agriculture, four companies control 66% of U.S. hogs slaughtered in 2015, 85% of the steer, and half the chickens, according to the Department of Agriculture. (Open Markets Institute)
* Similarly, just four companies control 85% of U.S. corn seed sales, up from 60% in 2000, and 75% of soy bean seed, a jump from about half, the Agriculture Department says. Far larger than anyone, the American companies DowDuPont and Monsanto.
# Some economists say this concentration of market power is gumming up the economy and is largely to blame for decades of flat wages and weak productivity growth.
“Gumming up the economy” is a good way to describe it. Competition is an economic lubricant. The machine works more efficiently when all the parts move freely. We get more output from the same input, or the same output with less input. Take away competition and it all begins to grind together. Eventually friction brings it to a halt, sometimes a fiery one.
The normal course of events, when politicians and central banks don’t intervene, is for companies to grow their profits by delivering better products at lower prices than their competitors. It is a dynamic process with competitors constantly dropping out and new ones appearing. Joseph Schumpeter called this “creative destruction,” which sounds harsh but it’s absolutely necessary for economic growth.
With creative destruction now scarce as zombie companies refuse to die and monopolies refuse to improve, we also struggle to generate even mild economic growth. I think those facts are connected.
# Helicopter Governments;
Helicopter monetary and fiscal policy that seeks to protect the economy can instead accomplish the opposite.
Access to capital is necessary for economic growth, but free and/or subsidized capital is its long-term enemy. Managers and entrepreneurs have less incentive to innovate and operate efficiently when they can always count on another VC funding round or leveraged loan. When they don’t actually have to compete with more innovative competitors thanks to low-cost capital and their huge scale, creative destruction gets short-circuited. We no longer live in the world Schumpeter envisioned.
That’s not a complaint, just reality. I am old enough to have read numerous stories lamenting the small farmer’s demise. And I sympathetically read them, agreeing it was sad, yet happily buying lower-priced food. “Scale” in so many businesses really matters.
This doesn’t mean the Fed should keep interest rates extra-high. That would create different problems. The real barrier is this group of people who sit around a table in Washington and make decisions affecting the entire economy. That’s bad enough, but they do it based on incomplete data and flawed models.
This is a terrible situation but here’s the worst part: It isn’t going to change.
The Fed will keep manipulating interest rates downward, capital will stay cheap, businesses will keep wasting it and investors will keep believing this time is different. They’ll be partly right. This time will be different but not in the happy way they think.
# The result will be a US economy that increasingly resembles Japan’s, stuck in a loop, dependent on other countries over which it has little influence or control, with an economy going sideways while a demographic tidal wave strikes.
Where does that lead? For Japan, it’s meant 30+ years in a holding pattern. I’m not sure the US will be so lucky. But at the very least, we’re going to see a decade of little or no growth and a whole lot of pain.
We could have avoided this by accepting a little more pain in the last recession. In hindsight, I’m not sure QE accomplished anything useful. For capitalism to work, lenders who make poor decisions must lose their money, not get bailed out. While I reluctantly agreed that QE1 was sadly necessary (in the words of my friend Paul McCulley, it was “responsibly irresponsible”), I still believe QE2 and QE3 were overkill. Central bankers gone wild. And not just in the US. Our incentive structures are now so distorted I don’t see any way out. A much bigger crisis is coming and it’s going to hurt....
