Sweet are the uses of adversity,
Which, like the toad, ugly and venomous,
Wears yet a precious jewel in his head;
And this our life, exempt from public haunt,
Finds tongues in trees, books in the running brooks,
Sermons in stones, and good in every thing.
As You Like It Act 2, scene 1, 12–17
What Shakespeare was talking about is making the best of adversity. History appears to have born out his observation. During the great depression, aspects of American society and the lives of countless individuals were touched by the experience of the 1930s. The adaptive response to many of these changes later ushered economic prosperity in the 1940s and 50s.
If public pronouncements are any indication, current economic conditions are comparable to the 1930s. Job losses have been intense, business is contracting and traditional venues of middle class wealth like stocks and real estate have seen dramatic declines. While its risky to predict the future, here are some thoughts on the downturn’s potential long term implications.
1) The role of the financial sector in the economy will be reduced. The importance of banking may change in part due to a loss of public confidence in the importance of “big finance”. The loss of confidence is illustrated by several factors.
A) First, most banking analysts and traditional financial planning tools failed to predict the drop. Most of the major banking analysts failed to understand the potentially explosive nature of subprime losses. Similarly, the limitations of common financial planning tools such as Monte Carlo simulation are now obvious. Most Monte Carlo models would have predicted statistically that last years stock market declines were a low probability event. This is problematic in light of the fact that this “low probability event” had probability of 1. In short, the downturn happened when models predicted it would not. Basically, the best minds in banking and its best tools “dropped the ball”.
B) Second, anger about federal intervention in the banking sector is palpable. This week recently saw a number of “tea party” protests against current federal economic and social policy. Essentially, the mood in some parts of the body politic is becoming radically anti-bank and anti-wealth for all the “average” Americans.
It seems highly likely that suffering such a loss of confidence, big banking institutions may see tougher regulations to prevent further economic problems – this is not entirely a bad thing. In many cases big finance has promoted silly legislation or blocked needed reforms, such as meaningful regulation of hedge funds. It may also be that statisticians will reevaluate their modeling techniques giving consumers more accurate tools for managing money.
2) Individuals most affected will limit their risk. Dramatic economic downturns tend to leave a strong impression. Whats likely to happen is that individuals who lived through the stock market and housing bubbles will likely carry that impression for the rest of their natural lives. Accordingly, they will indicate a preference for low risk investments. This will likely be reflected in choosing bonds over stocks, and cash equivalents like money market accounts and savings over bonds. This is likely to be more pronounced among people in their core wealth building years, that is between 25 and 55 who had the most to lose from the drop. Building wealth is not as simple as it used to be after this economic storm plays out.
While limiting one’s risk also limits one’s upside, its entirely possible to save and invest prudently in bonds and cash equivalents. So, even though traditional thinking on risk avoidance says bonds are better than stocks, greater consumer risk avoidance can and likely will still result in healthy retirements.
Of course, the impact of the downturn is best understood in retrospect. But, if Shakespeare’s insight into the human condition is any guide, some good will come from this whole mess.
Best,
James
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