Oh My Goodness? Great Depression Incoming??

Your Daily Dose of Stonk Science

Topics: Demand-Side Economics, Monetarism, Deflation, Reverse Repos, Consumer Spending, and The Federal Reserve

“Hey Drake, what’s the likelihood of another Great Depression?”

Fascinating question… If I knew the answer to that, I’d be making some massive bets on deep out-of-the-money options. But since I’m human, let’s take a look at what information we do have and go from there.

Here's your history lesson for the day:

The Great Depression occurred from 1929-1939 and was basically a decade-long period where the global economy was a hot mess (lol relateable). The stonk market (before it was officially dubbed the "stonk market") lost ~90% of its value and unemployment peaked at 23% (in the US). It wasn't until WWII that the Great Depression was officially determined to be over.

A lot has changed since then and economists still frequently debate what happened, though there are several prevailing schools of thought that provide insight as to what could happen next for us now.

1. Keynesian: A loss of consumer confidence, which led to a decrease in consumer consumption and business investment.

2. Monetarism: A reduction in the monetary supply.

3. Deflation: Inflation was negative, meaning the prices of goods and services were falling.

The Keynesian (Demand-Based) View

In its most basic form, Gross Domestic Product (GDP) is the sum of all personal consumption, government spending, investments, and net exports in an economy.

If any of these factors increase, GDP should theoretically increase too. There are, of course, other specifics that apply to the exact computation of GDP, but this formula will get us started.

So, for example, if all your friends decided to max out all 20 of their credit cards in order to buy Venti Iced Vanilla Lattes with oat milk, an extra shot of expresso, and a dollop of whipped cream, that would lead to higher GDP because consumer spending increased. Starbucks would probably invest more by building new coffee shops, hiring more workers, and researching new products so your friends keep buying stuff from Starbucks; this would increase investment in the economy, further pushing up GDP.

Those things (obviously) did not happen during the Great Depression (maybe they wouldn't have been so depressed if they were sipping on grande mochas and La Croix... smh).

Bizness was booming in the Roaring '20s as the market increased over 6x in value. Then Black Thursday rolls around (dun dun duuuuuun) and the stonk market loses 11% in one day. Oof. Investors were jittery up to this point, so once one domino fell, everyone wanted to sell; this selling pressure was amplified by margin trading. After attempts to prop up markets by several of the most influential banks at the time failed, the market continued selling off, with losses of ~13% on Black Monday and ~12% on Black Tuesday.

So... would you drop money on Gucci Loafers and Starbucks after having consecutive days of double-digit losses on your portfolio?

That's a hard no for me, but if you answered no, then you may understand the ripple effects of your decision to not spend. If consumers spend less (consumer spending), then GDP would slow. With lower demand for products and services (because people are buying less stuff), companies would have less incentive to invest, especially with higher borrowing costs prevailing during that time (investment). Because the government didn't intervene (government spending) and other economies were facing a similar dilemma (net exports), GDP took a dive off the deep end because consumers and businesses had less demand for products and services. Also, because businesses weren't expecting people to buy as much, they decided to lay off many of their employees, hurting the economy's ability to recover (bc no one is making anything, no one can spend anything, so no one can invest in anything, so no one can grow anything). Yikers.

The Monetarism View

Monetarists will claim that because the Fed didn't lower interest rates, increase the money supply, or inject liquidity into the banking system, they let the economy go from a recession to the Great Depression.

In fact, the contraction in the monetary supply during the beginning of the Great Depression was dubbed by Milton Friedman as "The Great Contraction".

As depicted in "It's a Wonder Life", there were many runs on banks as individuals demanded their money back from banks. Because banks had already invested their money in illiquid loans (such as your neighbor's mortgage, a loan for a business person to buy a company, etc) some banks were unable to provide adequate liquidity to their clients and the banks went bankrupt. The Federal Reserve could have propped up the market by reasserting confidence and providing liquidity (liquidity = mo' money fo' less) to markets, as they did during the Great Recession and the COVID-19 recession, but they chose not to.

Monetarists, including former Federal Reserve Chairman Ben Bernanke, believe that bank defaults and the inaction of the Federal Reserve at the time amplified the effects of the economic downturn. Ever since then, the Fed (and Federal Banks across the globe) has been very aggressive and assertive in influencing the economy.

The Deflationary View

If the price of everything was going to decrease over the next year, would you buy now or later?

I hope and pray that you said you were going to wait to buy, as you can oftentimes get a lot more bang for your buck if prices are falling. Falling prices are rare, but they occur, and wow did they occur during the Great Depression. Prices fell a cumulative~25% from 1930 - 1932.

Let's say, for example, that you were going to buy a new car. The economy's been in rough shape, your disposable income has been falling, and dealerships have been cutting their prices over the last few years to incentivize more people to buy. You don't see an end to the economic turmoil and are trying to conserve your money in case an emergency happens. Would you buy that new car now, or in a year from now?

Probably a year from now, right? At the very least, you'd probably delay purchases of stuff you didn't need. And, since your friends, family, and neighbors are in similar financial situations, entire populations can end up delaying or avoiding purchases of goods and services. That's the deflationary perspective and provides an explanation behind the harmful effects of deflation.

"Coolio Drake, but how does stuff from like a century ago impact me? It's not like we still use outhouses and wall phones..."

I'm very glad you asked...

Let's take the three big-picture, high-level macroeconomic factors influencing the economy during the Great Depression and apply them to us now: demand, monetary policy, and deflation.

Demand-Based (But in 2022)

Demand from consumers has remained strong despite decreases in net disposable income as a result of higher inflation relative to growth in wages (inflation of 7.1% YoY vs wage growth of 5% YoY). However, as a result of elevated consumer spending in spite of higher costs and lower disposable income, savings rates have dropped to their lowest levels since July 2005; in fact, since July 2005, savings rates have never been lower (based on data since 1959).

Now, at this point, I hope that you're asking yourself "well, people are spending more because they have a boatload of money saved up from their COVID-19 stimmy checks. So really, Drake, the increase in spending is warranted."

Actually, consumers have historically low amounts of money saved up. In fact, the amount of savings that consumers have is the lowest since August 2008.

Starbucks' spending sprees (yes, I know my audience sooo well) were largely financed through credit card spending, which has resulted in increases in credit card interest rates to their highest levels ever (based on available data since 1994). If y'all got debt on credit cards, pay it off ASAP or you'll pay (even more).

Consumer spending going forward will largely be influenced by employment, wage growth, and slowing inflation (higher inflation erodes purchasing power). Considering layoffs are the new norm, wage inflation is lagging behind total inflation, and inflation is still high, it appears likely that consumers will tighten their belts and cut spending to build up some safety nets. If they continue taking out credit card debt to spend, many individuals would become extremely susceptible to economic downturns and would be in a very bad financial position.

I find it ironic that retail spending dropped 0.6% over the last month. That's gotta be a coincidence... right?

Monetary Policy (But in 2022)

The Federal Reserve was heavily involved during the COVID-19 pandemic and they are still heavily involved in the market right now; the script has flipped from them being expansionary to contractionary, however.

During COVID-19, the Fed cut reserve requirements for banks to 0%, cut ST interest rates to ~0%, and engaged in quantitative easing to provide liquidity to the markets.

Since COVID-19, the Fed has maintained a 0% reserve requirement, has raised ST interest rates, has reduced the size of its balance sheet, and has engaged in a substantial amount of reverse repurchase (reverse repo) agreements.

"Here he goes again, making up random words that sound sophisticated."

Hold your horses, homie.

Effectively, the Fed's reverse repurchase operations involve the Fed borrowing money from counterparties (typically other banks), with that "loan" secured by safe, highly liquid assets (assets from the Fed's balance sheet, such as treasuries, agency securities, etc...). Also, by secured, the asset actually is transferred from the Fed's books to the counterparty's books; if the Fed doesn't pay back the loan, the other party can keep the pledged security. At the culmination of this "loan", which is typically overnight, the Fed will buy back the security at a slightly higher price; that "price" is set so that the effective annual return is roughly equal to the prevailing effective federal funds rate. 

For banks who have excess cash on their books and are looking for an extremely safe return, this is a top option; though they receive slightly less than they would earn by lending to other banks (the fed funds rate), they transact with a "risk-free" borrower, with their "loan" being fully secured by assets they control.

Reverse Repos take liquidity out of the market, as those engaged in these transactions would otherwise invest this money in other banks, ST treasuries, or other highly-liquid securities.

The size of the Fed's reverse repo facility, you may ask?

$2.2 trillion.

Here is the size of the Fed's balance sheet vs. the reverse repo facility.

In actuality, the Fed has barely reduced the size of its balance sheet. They've implemented contractionary monetary policy through higher interest rates and an increase in reverse repo transactions. The Fed started reducing the size of its balance sheet around September 2022.

In the case of an economic or monetary crisis, the Fed can reduce the rate they are willing to pay for reverse repos, and that $2.2 trillion can and likely would flood the market. By pairing this with lower interest rates plus ample amounts of bank reserves, the Fed can provide a significant backstop in case economic activity takes a turn for the worst.

Deflation (But in 2022)

This will be quick, but there is a very low likelihood of transitioning from a disinflationary environment (prices still going up, just less) to a deflationary environment (falling prices).

A not good scenario would be higher inflation for longer. Bad would be persistent inflation paired with an economic recession (whatever your truth is in defining that). The worst would be deflation.

Because we aren't (and likely won't be) in a deflationary economic environment, consumers don't have an incentive not to spend unless their confidence wanes and they decide to save up cash or they lose their jobs. If consumers do decide not to spend, it could decrease inflation and economic growth to the point where we enter a V bad economic time. If the economy reaches this point, however, the Fed will likely step in with expansionary monetary policy and (try to) save the day.

Summary

1. Consumer spending hasn't fallen materially, though based on lower savings and diminished net disposable income, it appears likely that consumers will tighten their belts in the near future and cut spending.

2. The Fed is implementing contractionary monetary policy, largely through higher interest rates and reverse repo facilities. They have mechanisms by which they can influence inflation and markets, though they sometimes have a lag in impacting markets.

3. There is a slim chance we enter into a deflationary environment, as experienced during the Great Depression, as the Fed would (likely) step in to prevent that.

Soft landing? Probably not.

Recession? Probably

Depression? Yeah, that's a no from me, dawg.