We need a lot of capitalism to get through this crisis. We need to redeploy people out of failing sectors and into new growth areas. The signals provided by the profit and loss system play a vital role in this process of regeneration and renewal. Those signals will guide us to discover new patterns of sustainable specialization and trade.
Policy makers in Washington instead want to try to minimize adaptation and instead steer the economy back to what it looked like before the crisis hit. They imagine the old economy “restarting” or “re-opening,” and they even imagine that they have the power to make this happen. In terms of the classic Monty Python skit, they think that the pre-virus economy is “just restin'” when in fact that parrot is not coming back to life.
There are some businesses in today’s economy that are seeing more demand than they can handle. I have heard about a formerly lazy military contracting firm specializing in logistics suddenly ramping up to address the supply needs of morgues in the private sector. Another firm that helps makers of cleaners and sanitizers navigate the FDA approval process has customers beating down its doors.
At the same time, of course, large numbers of restaurants and other small service businesses are empty. Many of them will never see their revenue ramp up sufficiently to get out of the hole.
To assess the outlook going forward, I suggest using a two-dimensional matrix. Along one axis, label businesses as “essential” or “inessential,” based on how they will be perceived as long as fears of the virus remain. On the other axis, label them as “fragile” or “robust,” based on the presumed state of their balance sheets just prior to the onset of the crisis.
| Fragile | Robust | |
|---|---|---|
| Essential | hospitals, airlines | tech giants |
| Inessential | cruise ships, movie theaters, individually-owned restaurants | sports and entertainment conglomerates, major restaurant chains |
Hospitals are surprisingly fragile as economic entities. We think that they charge outrageous prices, but those prices are needed to cover a lot of overhead costs. When they have to turn away a lot of surgery patients in order to have spare capacity for an expected surge in virus cases, they suffer a significant shortfall in revenue while costs remain the same, or perhaps even increase.
Airlines are fragile, operating with heavy debt loads and relatively little in cash reserves. But airlines are essential, and they will continue to operate, either with bailouts or by working through bankruptcy.
Organizations involved in arranging conferences and training programs, and the hospitality industries that supply them, are also in a fragile position. Training may still be considered essential, but individuals and firms will be more amenable to online offerings and less willing to go to the trouble and expense of in-person sessions.
Our society has become more dependent on the tech giants that provide Internet infrastructure and key applications. Many of these companies already were in strong financial positions, with plenty of cash on hand. These firms are essential and robust.
I picture the cruise ship industry as fragile. I imagine that some of the firms finance their vessels with debt, and that the business is sufficiently competitive that they do not have a ton of cash sitting around. But cruise ships are less essential than airlines.
I picture movie theaters and individually-owned restaurants as low-margin businesses generally lacking the cash to survive. They are in the fragile, inessential category.
I picture big entertainment conglomerates and major fast-food chains as taking hits in the short term but having the financial strength to pull through. That would put them in the robust, inessential quadrant.
Another way to look at the post-crisis economic outlook is that we will see an acceleration of transformations that would have otherwise taken place more gradually. Eric Weinstein speaks of the Embedded Growth Obligations, in which industries have been structured to operate at unsustainable rates of growth. For example, consider a law office that keeps hiring associates without adding enough clients to be able to promote the associates to partners. The law profession eventually will have to restructure to reflect the fact that a smaller fraction of law school graduates is going to earn partner-level incomes. Eventually could come sooner rather than later.
Higher education also suffers from EGOs. Graduates of humanities departments often have nowhere to go other than back to the university as administrators. Universities have already reached the point where revenue sources have topped out, and they needed to cut costs. Now, the revenue from foreign students is poised to plummet, and at the same time many Americans are seeing college as imposing too much debt for too little return.
A restructuring of higher education that might have played out over decades may instead take place over the next few years. Online education will have more appeal for its cost-effectiveness. In a depressed economy, students may be less excited about majoring in Social Justice.
A big question mark hangs over the financial industry. As of now, the Fed is behaving as if banks are in the “essential, fragile” quadrant. That is how they were treated in 2008, and the public almost did not stand for it. To prevent a recurrence, the Fed developed computer-model stress tests that the banks were able to pass, but it turns out that they are failing in a real-world stress test. Does Wall Street have the lobbying clout and public-relations skills to sustain the model of privatized profits, socialized risks?
Speaking of Wall Street, I think that the stock market is much higher than I would expect, given that my outlook is for massive dislocation, with many years of required to regenerate and renew our economy. Three possibilities:
1. I am wrong, and the economy will bounce back quickly.
2. I am not wrong about the dislocation, but small business will take nearly all of the hit. The stock market will hold up, because the major publicly-traded corporations will feed on the carcasses of the small-business sector. Corporate restaurant chains will buy up every eating establishment. In other areas of retail and services, “Software eats everything” will become “Amazon, Google, and Apple eat everyone.”
3. I am not wrong at all, in which case you ought to load up on put options on the S&P 500 and, while you’re at it, pick up some inflation-indexed bonds.
The assumption here is that the stock market reflects some sort of standard of value.
However, it may be the case that the massive liquidity injected by the Federal Reserve results in asset price inflation, without much regard to any such standard.
1. I think “sustainable” should be dropped from the patterns of specialization and trade. Some “essential” businesses will only be essential until the crises is over. See ammunition makers after both world wars. Likewise, a business that helps new vendors get NIOSH or FDA approval for masks, wipes, gowns, etc. will find its market contract once markets for those products are saturated.
2. I think “essential” isn’t quite right either – rather, “essential at what size” – it could easily be that airlines are essential in the sense they still exist, but are 80% non-essential because they’ll be downsized 80% (say) and stay that way for a long time.
I think the stock market is better understood in terms like Thucydides suggests – there’s a lot of money, the managers and owners of this money are competing for return – it has to go somewhere. When 3 month treasuries are paying (slightly) negative returns to the retail investor, money will go elsewhere.
1) I don’t think that people will be as risk averse as you make them out to be. Yes, they will take more precautions than previously, but they want life to get back to normal.
2) People are starting to go stir crazy. I would give it two more weeks tops before public opinion starts to shift drastically…unless there is some drastic negative change in the virus news.
3) The “inessential” businesses that you describe bring joy and meaning to people’s lives particularly when shared with friends and family. They will return and quicker than you might think.
4) Whether we think it’s rational or not, a strong statement statement from the government and media that it is “safe” to return to something that approximates normal will go a long way.
I’m already long in the S&P 500, but anyone interested is welcome to bet against my position. Please propose your terms and my crisp $100 bill awaits your win.
And now a question (or wonderment):
If some form of “capital structure irrelevence” holds, over time, does debt load really matter?
Consider two airlines, A1 and A2. Assume equally profitable, equal size.
A1 has sold a great deal of stock, and used the money to buy airplanes. It buys new airplanes out of profits. It owns lots of airplanes, so when it slows down or shuts down, it has to park a lot of airplanes, effectively the same as piles of money, which is rotting over time. It can however reach a much lower monthly cash burden (fire everybody.)
A2 is financed all with debt. It doesn’t own the CEO’s desk, let alone an airplane. When it slows down or shuts down, its bankrupt (because its fixed cash flow needs are huge.) But it has no grounded airplanes rotting in storage.
A2 fails faster, and I guess many people think that’s bad. But even though A1 might not fail as fast, or even at all, it still has huge capital rotting in storage. In A2’s case, somebody else has the misfortune to be the owner of the capital rotting in storage.
But in some fundamental way, they’re the same. In both cases changes in circumstance means a lots of capital is being left to rot, a lot of capacity disappears from the economy, and *somebody* who provided some part of the capitalization of the firm takes a serious loss.
What does this mean for economic adjustment, changes in patterns of trade? Over 90 days? Over 3 years?
Capital structure matters. The reason the airlines are financed with so much debt is to make their cash flow less hold-up-able by their labor unions. If they finance their hard assets with debt (and bondholders get the airplanes if the firm defaults), then the workforce has much less to grab.
This was Dick Ippolito’s explanation for why the heavy manufacturing pensions were all under-funded, but the rest were not. The cheapest way to fund a pension was to fund it fully. But heavy mfring had another potential cost — holdup. Underfunding the pension creates anohter form of debt — money owed to the pension plan.
Brilliant insight! Still is.
This is brilliant! Never realized the airlines operate as fragile entities *on purpose* to pull that union leverage off the table.
Any evidence for Ippolito’s conjecture?
Airlines are one of America’s oddball industries. Craft unions — pilots, machinists, flight attendants — unlike industrial unions which is the norm in US. Each of the three dislikes the other two. Which makes airlines resemble the Italian model where a single one with a beef can strike and shut down the business.
I doubt management has leverage against its unions. Labor costs are generally the same across the industry — I think there’s pattern bargaining. Most customers seek out cheapest tickets possible. The genius of frequent flyer programs was to give business travelers a reason to prefer one airline over another. Profitability, consequently, is a function of fuel costs which management can’t control.
All of which suggest neither management nor labor can weather a long strike.
Whether planes are owned or leased probably has more to do with taxes than crippling union’s bargaining power. But I’d love to see evidence to the contrary.
On rereading (twice) I now think this entire discussion (including what I said) suffers from a fallacy of sameness over the scale of the US.
It could easily be that everybody in Queens and the Bronix is utterly cowed by the horrible experiences. That people avoid nursing homes even more, raising the demand for home health support.
And that many states (almost all of them away from the coasts) will return to relative normal pretty quickly. The experience of the pandemic in Spokane has been VERY different from Seattle. Atlanta very different from NYC.
So, we might see the Green Bay Packers playing to full seats, while the NY Jets don’t play home games for a year or two. Baseball (outdoors) does OK at least away from NY.
Dancing returns as a strictly outdoors open-air light breeze activity, except in NYC where it is still shunned.
The Italian Grand Prix is canceled for years, but Sat night dirt track racing on rural tracks goes full speed ahead. So F1 is replaced by the World-of-the-Outlaws.
The key variable with regard to restaurants in the short to medium term is: Do you have a drive-thu window and are your key consumer benefits convenience and speed? Drive-thru restaurants can deliver via drive-thru, curb-side pick up and delivery. Few sit down restaurants (and bars) can survive, regardless of financial strength, if they are constrained on seating capacity by government or consumer imposed social distancing, and with the loss of most or all alcohol sales. The margins are too thin. Takeout won’t make up the difference. The dine in restaurant experience is what they selling and that has been severely damaged. Corporate drive-thru restaurant chains largely won’t buy up existing establishments. They will just absorb a portion of their business. A vaccine could allow things to go back to the way it was, or if consumers suddenly become less panicked.
The $443 billion long-term care/nursing industry would be considered fragile and I would think individuals are now coming up with alternative solutions to meet their own needs and circumstances. Perhaps it will come to be considered non-essential as well.
Despite being perhaps the most heavily regulated of industries, the deaths keep coming and the wave doesn’t recede. Dr. Kling asked in a previous post what could be done to turn this around. Reading the new CMS and CMS guidance issued the last few days, it appears the experts are doubling down on more of the same. Your average 6th grader could do better.
Comparing USA long term care to that in Japan, after reading some articles one gets the impression that even with mandatory LTC insurance, the elderly are more likely to receive in-home services than in the USA.
The potential demise of this industry would have far reaching social change implications as well create new economic opportunities. One wonders whether we will see shrinking existing home sales as people hang on to their houses longer. Will homes be retrofitted or designed to meet prepper considerations including features to promote safer in-home quarantines? Will demand for larger lot sizes increase as people anticipate doing more gardening in their senior years? And will even more retired individuals flee urban areas?
On a different topic, not sure at all why big tech is considered essential. As it becomes more evident than that technology will be used in the USA similar to the way it is used in China’s social credit system, more people will protectively opt out. I tend to leave my cell phone at home now much more often when I am out walking or bicycling for that reason. Yes, blow up your TV and throw away your papers, but be sure to toss your cell phone, a similar weapon of authoritarian control, away with them.
Where would you put smaller companies – tech startups or otherwise, that are providing services/products that wouldn’t have made sense in the pre-Corona world? Are these “essential” or “inessential”? They are certainly fragile in a sense, but also robust given the world we’re moving into? For example:
1. We’re seeing new competitors to Zoom pop up. These aren’t nearly as big yet, but they may be better than Zoom in many ways.
2. Startups in companies based around work-from-home services and products made to ease the burdens of a more socially-distant society in the coming weeks/months/years.
I think #2 is most correct of your three options, but would also add that the fed has demonstrated they will go to any length to support prices and the SP500 has very lopsided sector representation at the moment.
Since Volcker all inflation has gone into asset prices (especially if we consider certain kinds of human capital to be an asset).
Maybe we will get inflation but it won’t show up in the CPI. That would make the proposed trade awful.
I do feel bad for a world where independent restaurants and small businesses are gone. That is one of my joys.
I would disagree with some of Kling’s essential vs. non-essential classifications, just as I disagree with the governments’. Indeed, no one central entity can properly determine which businesses are essential because such information is localized and distributed. What is central planning, other than the centralized determination of which economic activities are more essential than others? Remember, even people that are part of the supply chain of an “essential” good may not know that they are part of that supply chain. (See “I, Pencil”.) I believe that explains at least in part why we are seeing empty grocery store shelves right now — not just for toilet paper but for a series of rotating other goods too — even though government has promised to keep open “essential” businesses that grocery stores rely on as suppliers. What is the entire grocery supply chain? The Soviet Union was infamous for never having figured that out, resulting in long lines and shortages of staples like…toilet paper.
For me, at least one type of restaurant must be in the essential list because that is how I eat. Kling’s list classifies all restaurants as non-essential, some fragile and some robust. Some people might claim that restaurants are non-essential because one can instead cook at home. By that logic, one could claim grocery stores are non-essential too because one could grow food at home. Indeed, that would have been true in the past when most people lived on farms. Today, we have more specialization where most people do not grow their own food. Myself, and others like me, are even more specialized where we don’t cook either.
The financial industry is obviously essential, or at least it should be obvious, unless we want to go back to the days when everyone worked until they died, consuming their output immediately as they produced it. It’s especially essential during and in preparation for a pandemic when many people aren’t producing and must rely on consuming either out of savings or by borrowing on credit cards. Finance is nothing more than the trading of cash flows (consumption) of different timing and risk, for example offloading the risk that one won’t be receiving cash flows during a pandemic by paying fixed cash flows ahead (savings) or after (borrowing) the pandemic. Such trading is essential nowadays for individuals, and it has been essential for quite some time before that for firms. (Of course, one might be able to argue that most of finance could be done online with minimal in-person work and, indeed, most of Wall Street seems to be working from home right now.) I don’t think one could even make a pencil without the financial industry.
The issue is one of some legal interest. There is no possible good legal definition of ‘essential’, and yet the word is deployed liberally in rules and orders as if it had an unambiguous meaning. On the individual side, one is really just being asked to exercise judgment and restraint. In such circumstances, it functions like a legal call option, a power that the authorities aren’t particularly interested in exercising at all, in cases which would be hard to win. But they reserve the right to try in a few egregious, conspicuous “pour encourager les autres” cases.
How is one supposed to make a legal decision about whether what one is doing is ‘essential’ or not in a marginal case? I think the real answer is, “If this went to trial, and I had to try to defend my decision and explain my reasoning to other people, would they sympathize with me and let me off?”
So maybe you are an air conditioner repair man. Are you essential? You aren’t on the bottom tiers of “Maslow’s Hierarchy of Needs” essential. Most people didn’t even have AC until fairly recently, and they can open windows and use fans. But I think a jury where I live would give that guy a pass. What if the internet goes out, and you can’t stream? Pass.
See what I mean? It breaks down to something like Katz’s twofold requirement for privacy, first that a person exhibits an actual (subjective) belief that his activities are ‘essential’, and, second, that the activity is one that society is prepared to recognize as ‘essential’.
Unfortunately, the government will decide that government is essential and act on that decision.
What is essential is that you get enough calories into you to not starve. For that you need food, but not necessarily restaurant food.
In terms of maximizing caloric intake to virus risk its obvious that groceries overtake restaurants. A single grocery trip might get me everything I need to eat for many weeks or more. Sitting in a restaurant leaves me exposed for hours in close quarters and I get one meal worth of substance out of it.
Re: “Embedded Growth Obligations”
Most people just say “debt”.
In general, debt is a good way to get capital in a high-growth environment and a bad way to get capital in a low or negative growth environment. The demands of the market for returns on equity, in the previously relatively stable environment, have pushed companies to structure themselves in ways that only made sense in a high growth environment. Ditto individuals; borrowing $100,000 for a B.S. degree only makes sense in an environment with either high growth or high inflation. The big question is whether we can unwind that without a depression.
“I think that the stock market is much higher than I would expect, given that my outlook is for massive dislocation, with many years of required to regenerate and renew our economy.”
It’s the denominator effect.
A stock is a growing perpetuity. All else equal, if you wipe off a year’s earnings, then it’s the same perpetuity one year out, which when discounted to the present at say 10% is worth about 91% of its former value.
But all else is not equal. You’ve got those lower interest rates which means that you’re discounting those near years’ earnings at a lower discount rate. It’s those near years that contribute the most to the value of a stock.
If you have low earnings for a few years, then you’ll also have low interest rates for a few years.