Read all about it here.
The academic economist’s view of asset pricing is that asset prices are set as an interplay between discount factors and expected stream of future returns (See Cochrane’s "Asset Pricing" textbook for example). These discount factors are not just about risk, but about how the payment stream correlates with how the buyer of the asset is doing. Take a simple example: one can have two assets with the same risk (standard deviation), paying $3 half the time and $1 the other half of the time, but the asset price for the one that pays out $3 in bad times and $1 in good times will be higher than for the asset that pays out $3 in good times and $1 in bad times. Why? Because when times are bad (and you are more likely to be unemployed as a individual or have bad sales as a business) you want to have $3 more than you want to have $3 when times are good, and having $1 in bad times is very bad while having only $1 when times are good is ok. So, it’s not just about risk, but about how the riskiness of the asset corresponds to the buyer’s circumstances. Usually we can talk about risk being bad because usually the risks are correlated so for most things they do badly all at the same time and the risks are correlated, so we’d rather have less variability rather than more given those correlations.
However, that does present some interesting opportunities for institutions that don’t face the same issues. Take university endowments for example: since universities are institutions often will ensure forever, or at least over the course of centuries, they can have a longer window and ride out market downturns. Keynes, who ran the endowment at Cambridge (a university since 1231, coming up on their 800th anniversary in about a decade) pioneered investing in equities rather than sticking to fixed-income purchases which was the norm for universities, a good strategy for such a long lived institution who can ride out market downturns. Modern university endowments often invest in highly illiquid assets like forests that carry lower prices due to their illiquidity, but since university almost never need to sell quickly, the illiquidity is less of a problem for them. Individuals are not so lucky and may be forced to sell in downturn if they face unemployment or other cash flow issues. These kinds of conditions are more likely to prevail when equity prices are lower, explaining why equities tend to have a return premium over bonds: they are risky in a bad way, while bonds are risky in a good way.
However, we could think about another institution, the government, that can often endure for centuries. Because the government can create new money and force people to pay taxes, they are the institution best able to continue to provide cash flows through either the Treasury or the central bank. As a result, we naturally see a tendency for US government bonds to rise in price when there is a crisis, as everyone rushes to the safety of government payments streams. This does not hold for emerging market government debt, which is more likely to default in a crisis, just like corporations are. This is why U.S. Treasury bonds are safer in a crisis: the cash flow resulting from them don’t fall in a crisis, and so their prices rise, further improving their asset prices as this price increase occurs at opportune times.
The US Treasury could lean in to these circumstances take advantage of their advantageous cash flow position by offering securities that pay out more in crises or recessions. This would be preferred by asset purchasers facing these risks, even though in a statistical sense the payouts of these assets would be more “risky” as they would have a higher standard deviation than regular Treasury debt.
These assets should have two primary benefits:
(1) Increasing cash payments to the private sector when they are most needed- in a financial crisis or recession.
(2) Selling for a higher price as they have an insurance role in increasing cash flows when they are most appreciated.
One issue with perpetual bonds like consol bonds is that they generally sell for relatively low prices, as the uncertainty over conditions in the distant future is very large. However, a consol bond that pays out 2x, 3x, 10x, etc. in periods when the NBER declares a recession or when there are emergency Fed actions consistent with a financial crisis would raise the price of these consol bonds, and provide an automatic structure to forever increase cash transfers to the private sector in a recession or financial crisis. Now is the time for crisis consols!
In general, the DC metro area sees milder recessions than the American economy does. That’s because the DC area has a very service-oriented economy, which is a sector that generally sees much smaller declines in recessions than the goods producing sector. The DC area that has much government employment and government employment and salaries do not get cut like employment and salaries in the private sector, helping stabilize incomes and spending in recessions.
However, the upcoming recession caused by the coronavirus crisis will hit the DC area particularly hard. Services will be hit first, due to the need for social distancing reducing the kind of human interactions the service economy is based on. Plans to travel to DC for tourism will be cancelled. The largely white-collar workforce working in Washington will be able to work from home, reducing the spread of the virus but decimating downtown businesses that these employees will no longer frequent. Restaurants and hotels will see sales plummet. Prospects for recovery will require the coronavirus to recede enough that it’s safe for people to return from teleworking and return to travelling to the capitol for tourism. Even if the number of coronavirus cases stabilizes, that may not be enough to bring back economic activity to where it was before. The only regional economic silver lining is the prospects for a surge in government spending that would stimulate the local DC economy.
Gabriel Mathy, American University
The stock market crashed again today and seems headed to a bear market that can only now be compared with the bear market during the Great Depression. While the S&P 500 or another market weighted index is better than an index like the Dow Jones Industrial Average that simply averages the prices of the stocks on the index, the S&P 500 was not available in 1929 while the Dow Jones was. The Dow peaked in October 1929 at 381 and went down to 41 at the trough in July 1932, a decline of almost 90%. This is in dollar terms, so less severe considering the price level and the cost of living fell significantly. But even after inflation resumed, the Dow didn’t reach its old peak in 1929 until 1954. That’s a quarter of a century later. But perhaps this is all too pessimistic, and 1929 is not the right comparison to 2020. So then, let’s think about the initial shocks that set off the recession in 1929 that just kept getting worse through 1933. Here I will largely follow the account of Kindleberger in “The World in Depression, 1929-1939”
The late 1920s were a booming period in the United States, though that wasn’t the case everywhere. In the wake of the First World War, which bankrupted governments and set off waves of inflation and hyperinflation, post-war governments struggled to return to the gold standard. The United Kingdom infamously went back to the prewar exchange rate with gold, leaving the pound severely overvalued and its exports uncompetitive. As prices in pounds had gone up so much, with the old exchange rates imports were much cheaper to buy in gold prices abroad, and so gold flowed out. Gold is money in a gold standard system, so this caused monetary tightness in the UK, leading to general strikes and high unemployment throughout the 1920s. Since prices had gone up everywhere and the norm (Keynes’s “Rules of the Game”) were to return to the gold standard at the old exchange rates, many other countries had similar issues as the UK.
The United States, on the other hand, was booming, though the agricultural sector was troubled. Prices had been high during the war, and many American farmers had taken on debt to expand their operations to take advantage of the high prices. Prices fell once production resumed in areas affected by the war, prices slumped, resulting in farm bankruptcies and many bank failures in rural areas. On the other hand, by the late 1920s, a stock bubble developed, as the roaring economy created a wave of euphoria in stocks. Corporate profitability was rising rapidly, and many thought the party could never end- this was a New Economy after all! Securities market were not regulated like they are today, so short-term margin lending was common for stock purchases, which further fed the bubble. International capital flows, linked through the gold standard, meant the American capital markets hoovered up money from the rest of the world for short term loans for stock speculation on Wall Street. This further worsened monetary conditions. Germany was dependent on American loans to make its reparations payments, and so its economy started weakening in 1928 due to the tight monetary conditions. Agricultural exporting countries in Latin America saw gold outflows at the same time as agricultural prices softened, and they also saw economic weakness before 1929 as well. At the same time, the Fed tightened its monetary policy and raised interest rates in 1928 to try and check the stock bubble. With expected gains on Wall Street in the double digits while the Fed’s discount rate was still in the single digits, this did little to check the boom. The market surged further. As a result of the monetary tightness, the economy began to turn down in the summer of 1929, and industrial production peaked in July. Automobile production fell from 426,000 in July of 1929 to 319,000 in October of 1929. Then the Great Crash came. Stock plunged, and the music stopped on Wall Street. Margin loans were called in, and borrowers had to sell their stock all at once to pay off their loans. This drove the market down more. What had started as a normal recession, perhaps on the mild side, got worse. Agricultural prices worsened, setting off a deflationary wave across the world.
The Fed was not set up to act as a European-style central bank, but instead was structured to stabilize credit conditions and to keep the United States on the gold standard. As interest rates tumbled as the economy collapsed, the leadership at the Fed thought they were fulfilling their mandate. As the economy worsened, banks failed even faster than they had in the 1920s, and by the trough in 1933, over 1/3 of banks had failed. The trough of most indicators occurred within a month or so of the inauguration of a new Democratic Congress and President in 1933. The new Congress was committed to moving off the gold standard, loosening monetary conditions, and raising the price level. It worked, and the economy recovered.
Now let’s compare this to what’s happening now. We’re facing a huge shock to demand, particularly in services, as economic activity is scaled back to address the crisis. Given the huge number of workers involved in the labor-intensive service sector, the speed of job losses could be much more rapid than in normal recessions. Stock market have plunged more than they did in 1929, reflecting expectations for a deeper downturn. On the bright side, the gold standard does not exist anymore to constrain the monetary and fiscal response to the crisis. Countries no longer need to keep interest rates high to attract capital flows and gold from abroad, but the Fed has already brought the interest rate to 0 and has said they will not go negative. The ECB has already gone negative and has signaled no interest in capping interest rates on sovereign debt. A fiscal response will be the only option large enough to offset a shock larger than what we saw in 1929. However, the austerian ideology remains strong, despite the lowest interest rates in the many millennia of recorded human history. The effects are still on display in Greece, its economy devastated by an austerity program that has reduced GDP so much that the debt-to-GDP ratio is higher than it has basically ever been in the millenia of Greek history, near 180%. The only progress that has been made has come from the European Central Bank reducing interest rates below zero, which allowed Greece to issue negative rate debt as well. However, the view that austerity was a success there endures, and this ideology will certainly remain even as the evidence of an insufficient fiscal policy response piles up in the mortuaries and the cemeteries.
Political deadlock in the United States will block any effective fiscal response, as it did in 2008, unless there can be a Democratic wave, as there was in 1933 and 2009. Even FDR disappointed on the fiscal front, campaigning against Hoover’s large deficits. He passed the austerian Economy Act of 1933 in his first 100 days that slashed public sector salaries and veteran’s benefits, and ran the budget outside of the emergency programs like the WPA on a balanced budget basis. The fiscal response was insufficient in the last recession due to moderate and conservative elements in the Obama administration that cut back on the size of the stimulus package.
Given Trump’s completely incompetent response to the coronavirus crisis and a recession whose severity will only become more evident as election day approaches, Trump's electoral prospects seem to dim more and more each day. Biden seems likely to win the democratic nomination. If Biden can win, prospects for a fiscal response on the scale required don’t look good either, even with a Democratic wave election. Biden is much more conservative than Obama and had touted his support for a balanced budget amendment in the past.
Automobile Production, Passenger Cars, Factory Production for United States https://fred.stlouisfed.org/series/M0107AUSM543NNBR
Industrial Production Index https://fred.stlouisfed.org/series/INDPRO
Kindleberger, Charles Poor. The world in depression, 1929-1939. Vol. 4. Univ of California Press, 1986.
This paper is available in PDF form here:
In the current environment, it hard to see how the United States can avoid a recession. We may want to think about the experience with previous American recessions to think about how this one may go. However, this recession will be different in at least one way from previous recessions. In most recessions, services are basically acyclical, falling little even in recessions. The one exception is the Great Depression, as we can see in Figure 1 above. However, the decline in investment is much more severe, as is the upward swing in the recovery. Services just don’t fall that much, even in the Depression.
However, this decline in the Depression is related to the deflation of the early 1930s. This is a nominal series, in dollar terms. If we control for changes in inflation by dividing the nominal services consumption series by the PCE price deflator, we can see that the real series is even more acyclical, as shown in the figure below. Real services purchases basically fall little or not at all during recessions. We can see that in the 1981-1982 recession, real services purchases even rose faster than before. Why are services so acyclical? One reason is that services cannot be stored and so to consume services during a recession, services must be purchased during a recession. You can drive that old car a little longer, but your hair keeps growing in a recession. There are furloughs of auto manufacturing workers during every recession, but barbers have not been furloughed- until now. Compare that to the annual percent change in private investment above: it collapses for basically every recession.
Services make up a bit less than half of the economy now, as we can see in the below figure. The share of services surged in the Depression as expected, as the goods producing sector imploded, but data does not go back before 1929. Goods production was particularly important around mid-century with manufacturing share of the economy peaking around that time. In general, services go up as a share of the economy in recessions (given by the shaded bars) as other parts of the economy shrink faster. Services, by their very nature, largely involve human interaction. In a pandemic, unlike in other recessions, that will mean sales in the service sector will collapse due to social distancing. Unlike with goods, the output of the service sector cannot be stored. That means that layoffs will have to start very soon as businesses adjust their employment downward. While people’s hair will continue to grow, we may see many bankruptcies among barbershops and hairdressers as people cut their own hair to avoid infection. If people cut their hair at home, there won’t be much effect of pent up demand to cause demand to surge once the pandemic recedes. This is similar to what we see when people stay home due to extreme weather events- people eat out at restaurants more in the wake of the storm. This is very different than what we see in basically any recession in modern experience.
Retail employment peaked just below 16 million employees and is down closer to 15.5 million now (February 2020 data). The retail sector is already hurting, and the closure of malls is unfortunately likely to accelerate. The restaurant industry employs over 12 million workers. The layoffs in this industry will be painful as more people make meals at home. Total nonfarm employment is about 150 million. In February 2020, the retail and restaurant industries combined were over 18% of total US nonfarm employees. Almost one in 5 US nonfarm workers works in these two sectors alone. If we take the over 130 million workers in the overall service sector, they make up 86% of total nonfarm employment. By contrast, all employees in automobile manufacturing, including parts production, are less than 1 million workers, less than 1% of total employment. Starting the recession with a shock to the services sector with a much larger share of workers can only accelerate job losses relative to a recession that starts in goods-producing industries One can imagine how devastating job losses could get given the large number in employees in the labor-intensive service sector.
As Americans see the prospect of unemployment looming over them, they will cut back further, beyond the spending which is just no longer occurring due to social distancing and people staying home more. This will then spread the downturn to the goods producing sector as people delay purchases of consumer durables and other consumer goods (basically the usual dynamics in a recession). Even people who might spend will be stuck at home and may not spend. Firm investment cannot but fall as firms are much more capacity than they need to make sales. As demand for air travel (another service) collapses, it’s hard to see when new airplane purchases will next be made given that coronavirus appears to be here to stay in some form. Boeing has a lot of cash and has many side businesses, but their profitability will be impaired significantly in 2020 in the wake of a wave of order cancellations related to the 737 MAX.
The coronavirus epidemic has the prospect to be one of the biggest economic shocks ever experienced, eclipsing the shocks of 1929 and even 9/11. However, the response to a sectoral shock like this one initially should not be to stop GDP from contracting, as social distancing is necessary to control the virus. The focus should be on allowing business to continue operated without massive layoffs in a way that’s not a big giveaway to business, expansion of unemployment insurance and extension of the eligible duration of collecting unemployment. There will be few job openings and job search is not optimal in this situation. We want to ensure the unemployed do not cut back on necessities and can continue to pay their bills. There should be a payment to all Americans as well to ensure that spending doesn’t contract too much and so people can purchase necessities. Once the epidemic recedes then the standard stimulus measures can be applied. At the same time, monetary policy is constrained by being close to the effective lower bound to interest rates at or near zero. Federal debt levels are perceived to be high, limiting the fiscal response, which was already disappointing in the last recession. This could be a very long and painful recession.
Related to my work on economic history and Huey Long, I got interested in the Huey Long assassination, which remains one of the great American unsolved mysteries. The official story is that a mild-mannered, apolitical doctor named Carl Weiss killed Long. It was not an accident, as many believe, where Carl Weiss punched Huey Long in anger and the bodyguards overreactied and richocheting bullets accidentally killed Long. Instead the bodyguards killed Huey intentionally. Huey was going to be indicted for tax evasion by the same Treasury agents that took down Al Capone, and with Huey dead, the machine stayed in power. More than that, Huey Long's battles with FDR meant that New Deal monies were restricted. In the wake of Long's death, the Long machine made peace with the administration, and federal money gushed into the state in what is sometimes called the Second Louisiana Purchase. The theory is fully fleshed out here:
This is just a place for me to put some of my thoughts down for future reference.