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Dirk van Dijk, CFA

A Decade of Zeroes


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A decade ago when the ball fell in Times Square, there was an enormous sense of both optimism about the future and relief that the world did not come to an end. I’m not talking about some sort of round-figure Armageddon, but the much more real fear back then that all the computers in the world would stop working as their internal calendars would not be able to handle the year 2000.

That potential problem was very well telegraphed, and led to a huge amount of spending in the Tech sector to try to avoid it. It provided the final few pumps to the Tech bubble that was already well under way due to enthusiasm about a revolutionary new technology, the Internet. The enthusiasm proved to be way overdone, even though the Internet did largely fulfill its promise to transform vast swaths of business and culture.

What Came First: The Strong '90s

The 1990’s had been a hugely successful decade for the United States, and we were almost as dominant then as we were at the end of WWII when the rest of the world was in ashes. Our previous big rival, the USSR, had been dissolved and its successor was an economic basket-case. The stock market was hitting new highs on a regular basis, the economy was near full employment and inflation was low.

The dollar had soared to new highs, which helped keep inflation low, and was great for our sense of national pride (though not so good for our net exports). The stock market was fully pricing in a very optimistic outlook for the economy and was trading at record high valuations, not just for the tech-heavy Nasdaq, but for the S&P 500 as a whole. The Federal Reserve was warning that our biggest economic problem was that the Federal debt was in danger of being fully paid down, and that would make it difficult for the Fed to conduct monetary policy.

Laissez-Faire Policies Took Hold

Under the surface, some things had happened that would prove to be extremely harmful. The culture had grown so that entrepreneurs were celebrated above all others, and the feeling was growing that the best thing the government could do for the economy was to get out of the way.

That the game was best played when the refs kept their yellow flags in their pockets. The financial rules were made far less strict under the passage of Graham Leach Bliley and the Commodities Futures Modernization acts. The first largely repealed the Glass-Stiegel separation between banks and investment banks (it had been greatly eroded over time, so in some ways the law was only recognizing and legitimizing the reality of the time). Bob Rubin, who was most responsible for the undermining of Glass-Stiegel at the government end of things before the law was repealed had quit government and gone on to become Vice-Chairman of Citigroup (C - Analyst Report), which was at the forefront of the new “financial supermarket” model.

The Tech Bust...and Then 9/11

After Y2K turned out to be one of the greatest non-events in recent history, investment in the Tech sector plummeted, in large part because so much of it had been pulled forward in anticipation of the problem. This threw the economy into a shallow recession starting in early 2001. The governmental response was fairly quick and came in the form of a series of interest rate cuts and a massive tax cut, one aimed primarily at the people paying the highest marginal tax rates.

Then, just as the economy was about to pull out of that recession, the events of 9/11 happened. The direct macroeconomic effects of that were small -- the loss of 2 office buildings, another severely damaged, four airplanes and 3,000 lives lost. The indirect effects -- mostly the fear that if it happened once, it could happen again -- were much more serious. People cut back on travel significantly, hurting the airline and hotel industries. Much of Wall Street had to relocate to mid-town, at least temporarily.

The country had to respond. We did so first by invading Afghanistan, which was the country that harbored the people who attacked us and refused to turn them over. We did so in a half-hearted way, and as a result the people who attacked us were able to slip away. We invaded Iraq, which had nothing to do with the attacks but was headed by a world-class jerk -- one who held a grudge against the U.S. and who we feared might be inclined to attack us. That we did not do half heartedly. While we went to war, another massive tax cut, again aimed at the rich, was passed. That danger of having no Federal debt outstanding was safely defeated. 

Unemployment never got to horrendous levels in the 2001 recession, but it led to a weak recovery, particularly in terms of net job creation, but the percentage of people in the work force was no longer growing, which helped keep a lid on the unemployment rate.

Housing Boom Turned Housing Bubble

The low interest rates greatly helped the housing sector. With house prices rising, people were able to tap the new found housing wealth and consume it through refinancing, second mortgages and home equity lines of credit. Housing prices soared, but as they did, a strange thing happened -- in aggregate the percentage of equity people had in their homes did not go up. Normally with a leveraged investment, if the price rises, the amount of debt remains the same, so the equity portion soars.

In the housing bubble, though, the country was pulling that equity out as fast as it was being created. Since “real estate only goes up” people were using more and more leverage to buy it in the first place, once bought it was used as an ATM machine.

The tax laws that make only mortgage interest tax deductable, but not other forms of interest deductable, certainly encouraged this behavior. After all, it seems to make a lot of sense to pay 6% interest that is tax deductible on your mortgage instead of paying a non-deductable 18% rate on your credit card. What does not make sense, though, is borrowing for 30 years to payoff a dinner at TGI Friday’s, which is essentially what people were doing when they refinanced their homes (or used a home equity line of credit) to pay down their credit cards. After 9/11, the government told us that the most patriotic thing we could do was to go shopping...and we did.

Unlike other recessions, housing never really suffered in the 2001 recession. In the recovery, it was clearly the leading area, greatly assisted by a boom in consumer spending. Median incomes were not rising, but rising housing prices provided a substitute. If the price of the underlying asset is going up and you pull out some of the equity, you are not worse off. Rising home prices attracted more and more speculators, causing even faster appreciation in housing prices.

However, the U.S. is generally not land-constrained (at least outside of some major cities), and the higher prices for existing homes set of a boom in building new houses. Between December 1999 and January 2007, there were 1.028 million new jobs in construction created, or more than one in five total new jobs.

Elsewhere: Weak Jobs Recovery

Outside of construction, and some related financial areas like mortgage finance, the economy was not creating a lot of jobs. It was not producing much in the way of higher incomes for the majority of Americans (total compensation went up more than wages, since an ever-growing proportion of the total comp package went to benefits, most notably health care. Higher employer contributions for health care insurance, especially ones that go to cover higher health care costs, not reducing employee contributions and co-pays, do not leave more money in workers pockets to pay their mortgages.

Housing prices in the long run are going to be largely a function of two things -- incomes and rents. Income, since mortgage debt has to be serviced out of income, and rent, because renting a house is a reasonable substitute for owning a house. At the height of the bubble, the price of housing was way out of whack with historical norms relative to both. Innovative financing like teaser-rate adjustable mortgages hid the income side of things for awhile.

Creative Financing Takes a Toll

In a sense, it was a decade in which the creativity of our financers and accountants exceeded the creativity of our inventors and artists. Creativity is an admirable trait, and one that is greatly needed for the economy, but it is not a good one for accountants to have. I would also argue that it is a greatly overrated virtue when it comes to finance. The financial innovations of the past decade, mostly endless permutations of derivatives like futures and options, and expanding of the range of assets that they were applied too, mostly have not worked out all that well.

Many of these (but not all) were tied to housing. As long as the price of housing was going up, the mortgages, and hence the derivatives on those mortgages, were almost all money good. After all, even if the homeowners ran into cash flow problems and thus could not pay the mortgage, they always had the option of either refinancing (and thus using previously built-up equity to pay current carrying costs) or selling the house, and doing so at a profit.

And Then...the Bubble Pops!

As soon as housing prices started to fall, things started to go bad in a very big way. Cash flow problems lead to defaults and foreclosures as soon as the sell or refinance options go away due to falling prices. If you owe more on a home than it is worth, then it is economically rational to simply default on the loan and lose the house.

All the players in the mortgage market, which by this time included every major bank and investment bank, as well as Fannie and Freddie was standing in front of a tsunami of bad debt. This led to a massive bailout of Wall Street. Had this not occurred, the dominos were all lined up for a cascade of financial failures which would have plunged the world into a second Great Depression.

The Great Seize-Up

At the end of last year, the financial system was completely frozen, and even letters of credit were not being honored. That can be more effective in shutting down world trade than a fleet of submarines roaming the oceans and sinking ships. Unfortunately, many of the people who were at the heart of the failures that led to the crisis were the ones who benefited the most from the bailout.

The net result was essentially the worst decade this country has seen economically since the end of WWII. Taken as a whole, there was zero net job creation for the decade. Each of the previous two decades had seen cumulative 20% growth in total payrolls, and even those were slowdowns from earlier postwar decades. Total payrolls expanded by 27% in the 1970’s and by 31% in the 1960’s. Industrial production (as measured by the industrial production index) was unchanged between the beginning and the end of the decade. The average gain for the prior six decades was 49.3%, and the previous worst decade was the 1980’s when the industrial production index gained “only" 20% over the 10-year stretch.

We had the lowest cumulative growth in Real GDP during the decade -- 17.8% -- by a very large margin. The next lowest growth decade was the 1980’s at 34.9%, and both the 1990’s (38.6%) and the 1970’s (38.1%) produced cumulative growth of over 38%, while the 1950’s and 1960’s saw cumulative growth of over 50%. Real household net worth actually declined by 4% over the course of the decade, mostly due to a very weak performance by the stock market and the fall in housing values towards the end of the decade.

While household net worth data does not exist for the 1940’s and 1950’s, the prior four decades all saw real household net worth rise sharply over the course of the decade. The next weakest performance was the 1970’s where real net worth was “only" 28% higher at the end of the decade than it was at the start. The 1960’s and 1980’s both saw gains of over 40% and the gain in the 1990’s was 58%.

The 00's One Bright Spot: Inflation

The one area where the economy was successful in the last decade was on the inflation front, with the headline rate of the CPI rising at its lowest total level for a decade since the 1950’s (up at a 2.84% annual rate, vs. 3.45% in the 1990’s, and 2.90% in the 1960’s and 2.47% in the 1950’s. The 1970’s were by far the worst inflation decade with an average of 8.24% on a headline basis).

Core inflation data does not exist for the 1940’s and 1950’s, so we can safely say that the 2.36% average rate for the 00’s was the record low -- well below the 2.88% rate for the 1960’s, which was the second lowest, and less than a third of the 7.53% average rate for the 1970’s. On average, inflation was also a fairly big problem in the 1980's, with an average headline rate of 5.67% and an average core rate of 6.34%, but we ended the decade at rates which were far below the rates we started the decade.

Market Performance Takes a Hit

Not surprisingly, given the poor overall economic performance during the decade and the lofty valuations it was trading at back -- when we were partying like it was 1999 (because it was), it proved to be a very bad decade for the stock market. We ended the decade with the S&P 5000 at 1115.1 down 24.1% from the 1469.25 level we started the decade at. The 1990’s had seen the market more than quadruple from the 353.40 level it started at, and that came on top of a more than tripling in the 1980’s which started with the index at 107.94. Even the 1970’s produced a 17% gain over the course of the decade, although most of that gain was eaten up by inflation.

Looking Ahead

It strikes me that we can do a lot better as a country than we have done over the last 10 years, and it is highly likely that we will do so. Clearly the country has big challenges in front of it, but we have overcome big challenges in the past. I therefore feel little nostalgia for the decade that we are leaving, and have hopes that the decade to come will be much better than the one we just left.

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