- Nobel Prize Winner Myron Scholes — Investing Using Time Diversification
- Gamestop Special with David Brail, Julio Depietro, Larry Goodman, Randy Cohen and Marcy Engel
- Nicholas Bloom — Future of Work
- Brendan Hoffman — the State of the Shoe Industry
- Brad Stone — Amazon: Alexa, Groceries, and Logistics
- Dean Adler — What Happens Next in Real Estate
- Charles Goodhart & Manoj Pradhan— the Great Demographic Reversal
- Daron Acemoglu — Will the Post-Covid World Have Too Much Automation
- Kenneth Rogoff — Negative Interest Rates and the End of Cash
- Chad Syverson — the Economic Consequences of COVID Fears
- John Kay — Radical Uncertainty
Nobel Prize Winner Myron Scholes — Investing Using Time Diversification
Gamestop Special: David Brail
David Brail Transcript
I am now going to hand the call off to our first speaker David Brail.
Thanks Larry. GameStop is the crescendo of an extraordinary period for stocks since the COVID pandemic took hold. What began as a panicked 35% crash quickly gave way to a frenzied rally, as many companies like Zoom, Netflix, Peloton, and Amazon benefited mightily from the pandemic. With time on their hands and cash in their pockets, many new investors became interested in the stock market for the first time. This group was young, well-versed in video gaming and gambling and comfortable with technology. A large community of like-minded traders emerged on the subreddit Wall Street bets and a new brokerage firm called Robinhood, which offered a very slick gamified app and charged zero commissions. David Portnoy, who founded Barstool Sports and who masterfully built a high profile on social media, brought together the world of sports betting and stock trading.
After a few weeks of successful day trading, Portnoy unveiled the mantra that summed up the second half of 2020, stocks only go up. Everyone was happy. The new traders were making money. Robinhood was building an enviable business and the Reddit boards were helping new traders learn the ropes of stock market investing with the emergence of vaccines and the economy’s resilience providing a tailwind to their portfolios. These new investors know what they are doing. There are many well-reasoned, bullish analysis on Wall Street bets, and they understand and are enthusiastic about call options. They’re comfortable with risk and speculation and are accepting of losses when the trades don’t work out.
The subreddit had 8 million members and provided a welcoming community to newcomers. They pushed each other to commit to hold these speculative trades. At times it looks like a cult. Then they discovered GameStop.
GameStop is a slowly failing, mall and shopping center based video game retailer. But as internet downloads replaced physical cartridges, there was less reason to visit the stores. They were, in technical terms, circling the drain. Hope arrived in Ryan Cohen, who had built the pet supplies company, Chewy. He bought 10% of GameStop stock and fought his way onto the board with fresh ideas to move GameStop’s business online and offer other new initiatives. The stock had rallied from around 5 to 15 on Cohen’s vision. Some remained skeptical and bet against the company’s renaissance by shorting the stock, thinking the shares would decline to five dollars or lower. They borrowed shares from somebody long on the stock and sold those shares in the market short, hoping to buy back the shares at a lower price, return the borrowed shares and profit from the decline. This happens every day in almost every stock. There are always optimistic long investors and pessimistic short sellers.
What made GameStop unique was that every available share was borrowed and sold short, then many of the new buyers of these borrowed shares lent out their shares. This led to the anomaly of 140% of GameStop’s float being sold short. Melvin Capital is a $13 billion hedge fund. They shorted GameStop heavily, despite GameStop having a market value of only $500 million. This meant Melvin Capital needed to be short a lot of GameStop for the possible profits to matter to a fund their size. Investors must disclose their long positions quarterly, but not their shorts. A weird twist to SEC disclosure rules is that you must disclose long put positions. This tipped the Wall Street bets crowd that Melvin was heavily short. Melvin quickly became the villain as they stood against the bullish thesis. Targeting Melvin, the Redditors managed to incite an epic short squeeze, driving the stock from the teens to almost $500 a share, closing a 53% loss to Melvin and requiring Melvin to seek a bailout from Citadel and Steve Cohen.
This led to a contagion of lesser, but still spectacular squeezes in AMC Entertainment, Blackberry, Bed, Bath, and Beyond, and others. The strategy was simple and elegant. They bought out of the money calls, which gave them the right, but not the obligation to buy GameStop at 40, 50 and $60 a share for several months. With the stock in the teens, this right only cost a few cents per share, but allowed them to potentially control many shares if the stock price exceeded those levels. Then they bought the common stock and relentlessly promoted it to each other. As hundreds of thousands of Robinhood accounts all bought GameStop, the shares moved higher. As this call options now became in the money, the options dealers had to buy increasing amounts of stock to remain hedged, adding to the frenzy. The shorts could not sell more. They too had to buy simply to prevent ruin.
The Redditors mistakenly believed it was not possible to have 140% sold short, that it was a game of musical chairs. And 40% would be unable to find shares to buy causing the stock to rally endlessly. This was wrong, but it didn’t matter. They drove the price to unimaginable levels while exhorting each other to hold. Of course, not all did. The most prominent of the redditors, named Roaring Kitty, sold $13 million worth of stock on his initial $50,000 investment. However, not all could sell. And the stock once again became borrowable. New short sellers emerged and within eight days, the stock lost 90% of its value leading to a lot of new investors, receiving a hard lesson in stock speculation.
Robinhood became a villain. In the midst of the short squeeze, they prevented customers from buying more. It turns out this was an act of self-preservation, as the thinly capitalized broker was unable to meet capital calls to the central clearing house on pending trades. Citadel became a villain. Not only did their hedge fund bail out the biggest villain, Melvin Capital, but the zero-commission deal comes at the cost of Robinhood’s orders being sold to Citadel for execution. Since Robinhood doesn’t charge a commission, this revenue stream is critical. Small traders are better off paying zero commission in exchange for having their orders sold to Citadel. But this would not be the week to try to explain that to a bag holder. The Robinhood crowd is a threat to the investment establishment, while mostly self-taught and unschooled in traditional investment research, they outperformed the pros. But because their strategies have more in common with sports betting than Graham and Dodd style investment research, they are viewed as apostates and mere speculators.
With the collapse of the short squeeze, the Wall Street establishment feels vindicated. Politically, this is just bad, very bad. The upcoming congressional hearings will be a nightmare as uninformed politicians try to twist the facts they find convenient into their preferred narratives, and there are lots of narratives to craft here. A David versus Goliath populous revolt, the dangerous gamification of the serious business of investing, the unfairness of Robinhood prohibiting further buying to aid Citadel in the hedge funds caught in the squeeze, Citadel’s massive riskless profits gorging on the immense order flow sold to them by Robinhood, and many others.
I looked on in horror last week as Alexandria Ocasio-Cortez, Elizabeth Warren and Ted Cruz all found common philosophical ground in attacking Robinhood. Very bad policy ideas, like a transaction tax, they rise from the grave as well as more paternalistic interference in the markets by politicians and regulators.
Gamestop Special: Julio Depietro
Julio Depietro Transcript
Our next speaker is Julio DePietro. Julio, can you go ahead?
Thanks, Larry. It is difficult to overstate the magnitude of the shockwaves that the GameStop short squeeze caused on Wall Street just two short weeks ago. Seemingly overnight, the struggling brick and mortar video game retailer had catapulted into mass cultural consciousness with startling velocity, even featuring prominently in the cold open on Saturday Night Live the night before. But in keeping with the speed of information flow and attention spans in the digital age, the GameStop phenomenon has already largely subsided with several other similarly ill-fated manias, in cannabis stocks and silver to name just two, already having boomed and busted in the interim. While all this might have seemed very familiar, even predictable to many grizzled Wall Street investors who had seen similar meteoric rises and crashes over the years, the what, the why, and the how in this story all represent something new in the world of finance, and will have profound effects on the investing landscape for years to come.
So what exactly happened and why did it happen when it did? The kernel of the idea of the GameStop trade was intelligent, sophisticated, and dovetailed perfectly with the pervading cultural zeitgeist in late 2020 of distrust of institutions and belief in a system rigged against the little guy.
Evil hedge funds, so the narrative went, had conspired to short over 140% of GameStop shares outstanding with the intent to drive this beloved company, so central in our collective nostalgia, into the ground.
This not only sounds nefarious on its face, but lends itself to the idea of a crowdsourced short squeeze. The Reddit sub-threads had a field day. If we all joined forces and buy and hold and never ever sell or diamond hands as the rallying cries went, then ultimately these funds will have to cover their shorts at increasingly higher prices, and then we win. And even more importantly, they lose. At some level, this is just classic eat the rich pitchfork capitalism, but on digital steroids, amplified by a global pandemic that had just created millions of home bound day traders worldwide and powered by a new free mobile trading app with a video game interface and slot machine level addiction and maintained by a genuine sense of community, which entertained itself with inside jokes, hero worship, and funny videos, all promoting the buy and hold mantra.
Some of these went viral, which served to recruit and galvanize more and more soldiers to the cause. Not to mention the very real prospect of getting rich themselves in the process. From the hedge funds perspective, by late January, the barbarians were well at the gates and this time, they had brought memes, but these were not your run of the mill financial barbarians using traditional Fiji tactics to storm the castle and capture the treasure. These are more akin to an army of white walkers to whom the castle and treasure were largely irrelevant. Their true goal was to destroy the status quo of the financial world.
This excerpt from a widely shared Reddit thread during the heat of the frenzy entitled, “GameStop ends financial culture,” captured the sentiment perfectly. “It is the first time that the financial market is being used against the same monsters who bet on the failures of companies and enjoy manipulating the markets and impoverishing investors.” And maybe the most novel part of all was that for a few weeks the little guys were actually winning and crushing the hedge funds at their own game. At the peak of the squeeze, with GameStop having gone all the way from $5 to nearly $500 per share, and $25 billion in market value, some of the biggest names in the hedge fund world had lost billions and were teetering on the edge of collapse.
So when the Robinhood platform, which had been the engine behind this retail revolution, suddenly prevented their users from buying GameStop and other stocks that were at the heart of it all, the outrage was extreme and I think completely understandable. And then when the people learned that one of the hedge funds at the heart of the squeeze was also one of Robinhood’s biggest paying customers, the conspiracy theorists went wild and the betrayal was complete.
So, how exactly did this happen? How did this particular squeeze reach such an extreme level, bringing multiple billion dollar funds close to the brink of collapse and causing some of the biggest banks on Wall Street to warn of a looming domino effect that could destabilize global markets. This army of day traders, and almost certainly some much larger institutions as well, who had sniffed out the pending disaster had weaponized the relatively new weapon of financial mass destruction, the Gamma Squeeze.
To go back to the Game of Thrones analogy, if the Robinhood Traders and the Reddit army were the white walkers, then the gamma squeeze was the zombie dragon that no one saw coming that they unleashed to finally burn down the wall.
So what is the gamma squeeze? These traders were buying the farthest out of the money calls on these stocks in vast quantities. This gave them both maximum leverage in terms of the number of shares they could ultimately own, and also create a second order effect, which proved devastating to the short sellers and market makers who got caught selling these options too early. How was that? Well, when you buy a call option in the open market, the seller of the option, almost always a computer algorithm these days, typically buys a certain amount of that underlying stock as a way to hedge their new position. But if the stock rises, this standard risk management process causes those market-making algorithms to buy more and more stock at higher and higher prices just to hedge their rapidly increasing short exposure in what becomes a nightmarish vicious circle for them, or a magical virtuous circle if you’re on the other side of that wall.
At the peak of the GameStop frenzy, tens of thousands of the farthest out of the money call options representing millions of shares of short exposure were being bought daily in an explicit attempt to drive the stock price higher. The strategy had been wildly effective in previous weeks, and I believe it’s worth considering what might have happened if this saga had continued for even a few more days. The billions of dollars that had been lost already on the short side could have been orders of magnitude greater, and the second order dislocations may well have been catastrophic for multiple market participants, if not the stock market overall.
So what happens next? The implications for hedge funds are very profound. From a risk management perspective, how can you justify being short on stocks that could go up a thousand percent in your face on account of a wicked awesome meme that some guy put together in his basement the night before? And how can you risk manage on the short side against an army of traders publicly posting and bragging about how much they are paying for a stock that you might be short? And finally, I’m sure there is a much smaller army of recent Ivy league grads at hedge funds who are at home right now, trying to figure out how to profit from all of this as we speak.
Gamestop Special: Larry Goodman
Larry Goodman Transcript
Our next speaker is Larry Goodman. Larry is the founder of the Center for Financial Stability and he’s going to talk about bubbles.
Thanks, Larry. Look, the events surrounding GameStop and Robinhood extend well beyond the immediate stories and headlines. They signal future issues that financial market participants are destined to confront and regulators are eager to confront. There are big stories here. They stretch from financial market manias to regulatory policy, to new technologies, to the struggles between good and bad, and the struggles between the big and little. Based on these many fascinating vectors, a team of
seven experts from the Center for Financial Stability wrote a multidisciplinary paper on Robinhood and GameStop. The paper stretches from finance to law, to technology, to education, to public policy recommendations.
Today, I will focus briefly on two issues. First, broad implications for financial markets. How it’s a bubble and why. And second, public policy, regulatory risks and what to do. First, financial bubbles are flourishing. The GameStop, Robinhood saga simply adds further evidence to this perspective. Quite simply, there would be no GameStop story without retail momentum traders. And there would be no retail momentum traders without easy or near free money. The fundamental underpinnings to this facet of the story are not new. It’s the combination of easy money and a new technology. Charlie Kindleberger And Bob Aliber’s famous book, Manias, Panics and Crashes, has an entire chapter devoted to fueling the flames, and monetary expansion. In seven editions of this book, this chapter has changed very little over the years. The only real substantial change is Bob’s emphasis on credit in addition to money. So where are we today? Today, the risk-free cost of credit is near zero and central bank liquidity injections are massive.
For instance, the cumulative injection of base money by the Federal Reserve in the last 13 years is 600%. This dwarfs anything witnessed since the founding of the Fed. In fact, the cumulative expansion is 200% more than what was needed to rescue the economy from a great depression and to fight a world war ending in 1945. So, there’s a lot of free money sloshing around for day traders and momentum investors to fuel their activities.
For investors and officials, we need to recognize that it’s the quantities that matter. Quantities are fueling speculative retail behavior, equity indices, FX rates, and credit markets. We are no longer in an interest rate world.
At CFS, we’ve developed and studied a range of quantities that measure liabilities in the financial system. These measures have been helpful at charting market moves and economic behavior patterns. Here, base money injections have and will continue to drive asset prices. But now we’re beginning to see a seepage of these policies into the economy and goods prices. Our broadest measure of money, we call CFS Divisia M4, has grown on average by 22% on a year to year basis since April of 2020. And most recently, it’s at 29% versus 3.4% on average since the global financial crisis in 2008. This matters, as a sustained move towards higher inflation could mark the turning point in this seemingly endless bubble that has been so nicely illustrated by the recent Robinhood and GameStop story.
So what are the regulators to do? To be sure regulation is essential, especially regulation that creates incentives for actors to behave prudently. It often, after financial crises or episodes of discomfort, the risk of regulatory overreach is high. Many come swooping in after the fact to explain what happened and create constructs to prevent the reoccurrence of previous problems. The call for action today is strong. Ahead of the hearing this Thursday, Chair of the House Financial Services Committee, Maxine Waters, is using terms such as predatory short-selling, vulture strategies and unethical conduct.
The case of short selling is especially interesting. Most economists agree, short sellers are not necessarily the enemy, but are often the friends of retail investors. Firms that engage in short-selling have an incentive to uncover and or disclose fraud and an issuer. And those firms bear heavy risks, as prices can rise without limit and short sellers can lose an unlimited amount. Regulatory action that drives them from the market can be expected to have a materially adverse effect on the incentive to gather negative information such as the kind that can be used to expose fraud and limit two way flow.
The deepest of ironies is that not so long ago, after the global financial crisis, the big heroes were the big shorts or short sellers. So regulators should thoughtfully ask and answer questions regarding lessons from GameStop and Robinhood for financial stability. Many of these questions are posed and answered in our paper. I’ll conclude briefly with three. Are short sellers the real problem? Can new technologies improve both surveillance by the SEC and settlement times? And lastly, most importantly, how is abundant monetary liquidity impacting regulated markets and institutions? In fact, since the release of our paper, steps in the official sector are already moving forward here. I’ll leave it at that.
Gamestop Special: Randy Cohen
Randy Cohen Transcript
Our next speaker comes from Harvard Business School, Randy Cohen. Go ahead, Randy.
Great. So I want to talk about what happened and then I want to talk about what it means and what, if anything, we should do. I think the media really missed a huge chunk of the story. Maybe the main chunk of the story. I certainly understand their focus on Robinhood and retail investors and Reddit. It’s a very alluring tale. But I think it’s a bit of a sideshow. It’s not that it played no role, but look, we know that this was essentially institution on institution violence. And what I mean by that is, the people who pushed the price up to the staggering levels in GameStop that caused the short sellers to be forced to buy, to cover at the huge prices and get wiped out, were other institutions. I’m not going to say hedge funds because people just refer to institutional investors as hedge funds when they want to view them negatively for some reason. But the point is, institutional investors as the category.
We know that because what’s the point of Robinhood? How does Robinhood have a business? Well, as was explained earlier, what Robinhood does is it sells its order flow to firms like Citadel and other market makers. And that’s how they’re able to make money without charging commissions. Why would anybody pay for their order flow? Because the order flow of Robinhood investors is viewed by Wall Street as uninformative. When you take an order and you take the other side of it, you’re worried the guy you’re trading against knows something that you don’t know, and you’re getting taken advantage of. You’re getting picked off as the Wall Streeters say. But when you get a bunch of orders from retail investors, you’re not too worried that they’re experts who are picking you off. The result of this is that retail investors don’t move stock prices very much. Because again, the whole point of paying to get that retail flow is that you know that it’s not very informative, that you don’t have to move the price in response to it. And that’s on top of the fact that retail investors are just a way smaller piece of the market than they used to be.
So who was pushing the price up to 200, 300, 400, almost $500? That was institutions. Now, why does this matter? Well, here’s the thing. If a bunch of big institutional investors, hedge funds, whatever it might be, call each other on the phone and say, “Hey, you know what? There’s a couple of guys who are short a huge amount of GameStop. Let’s all buy, buy, buy, buy, and push the price so high that they’re forced to buy to cover, and we can sell to them at the higher price and make money.” Well, I’m not an attorney, but my impression, and Marcy can help us out here, is that that would not be legal. My understanding if they passed rules back in the 1930s against reignings and other things that make it illegal to do that. So they are not allowed to make that call and have that conversation.
So what role did the Redditors and the Robinhooders play if they weren’t the ones primarily driving prices up? Well, if it’s medieval Europe and you need all the troops to gather at one point and they don’t know when to gather, and you don’t have telephones, you light a signal fire. You light a signal fire on the hill top, and everybody’s, “Ha, ha, tonight’s the night that we get together for the invasion,” or whatever it might be. So that’s what the Redditors did. They lit the signal fire. The hedge funds and other institutional investors, they didn’t need to call each other to make a plan that would have been skirting the law or would have been illegal or whatever, they just all read in the Wall Street Journal, “Oh, looks like there’s a short squeeze potential in this stock.” So then they all were able to jump in.
So I think that is the main story of what’s happened. I think when the data eventually becomes available… Of course, it’s true that if you were the first person on this train on Reddit, you made a lot of money, 50,000 into 13 million or whatever, that’s amazing. But the retail investors, some of them bought in early and got out. A lot of them bought in late and lost money. You’re not going to see a ton of importance to the retail investors. This was really a story about institutions making money off other institutions.
So what do we do with that information? How do we view this? Is this something that was just an amusing… Well look, I will say one good thing came out of this. For the first time in their lives, my teenage kids came to me and wanted to talk about the stock market. So that was kind of great. So if we have one of these a decade or so, just to get interested in the stock market… Look, let’s face it, people say good investing is like watching paint dry. And one thing we know about teenagers is they don’t like watching paint dry. So you can argue that getting something that’s a little bit gamified, a little bit gambling like, a little bit exciting, that there may even be some value in that, but if it happens over and over and over… And by the way I’ve got, in my entrepreneurship class, I have two teams of students right now who are trying to create gamified versus a stock market investing where things go up and down faster and you’re betting on your stocks and other things to make the whole thing more exciting.
So there’s interest and money in that idea. But I do think that there is potentially real costs to society when you push all this additional volatility into the market, and some of the previous speakers I think, have done a good job articulating these issues. So if you make markets more volatile, then as an investor, it’s a much riskier decision if you want to put money in markets, you know you’re going to have more ups and downs, and that means you need a higher compensation, but the profits of the companies and their dividends aren’t going to be any higher. So if you’re going to bear more risk and you demand a higher return for that, it means lower prices on everything and a higher cost of capital for companies. And that means great exciting projects get shelved instead of getting done, because it’s too costly to fund them. So there I think is a real cost to society, to things that-
… to fund them. So there, I think, is a real cost to society to things that increase volatility. Now, is that going to happen? Well, what I’d say is, if there aren’t a hundred thousand folks out there asking themselves, “Hey, could I get one of these going, do I have enough influence online to make this happen?” And frankly, if they understand that it’s not all about the retail people, that the retail folks just light the signal fire, and then the troops are the Wall Streeters, that makes it even easier. And I’ll point out, it doesn’t have to be the Wall Street [inaudible 00:31:28] group or any kind of stock group, it could be any affinity group. The most obvious is the political people, the woke folks, or the MAGA people, but frankly it could be Red Sox Nation, it could be the people who love Keeping up with the Kardashians and follow, Kim’s got like 50 million followers.
You could imagine lots of different ways that groups of people could gather and start pushing something and it just takes one person saying, “If I could turn 50,000 into 13 million, I’ll spend the 50,000, I’ll try to get things going.” If you can get enough attention, then maybe Wall Street wakes up and says, “Hey, here’s another opportunity for us to make money.” So I think there is legitimate risk of that happening and becoming commonplace, but we don’t know that it’s going to happen. Now, as I mentioned, if it does, one cost would be this volatility issue, which is costly for everybody. The other is the attack on short sellers, which I think Larry Goodman did such a great job laying out, so I don’t need to say much about it.
We know two things about short sellers. One is, people hate them. And the second is, they actually hugely benefit markets. One of the things that often surprises people to discover is not only do short sellers make markets more accurate. And I want to point out that’s really important, if you’re involved in Wall Street as all of us on the panel are, and as probably most people listening to this are, if you want to feel that your life is not just about getting and spending, but that you’re actually playing an important role in the economy, which I do, then you have to believe that getting prices right in markets matters for capital allocation and for building the economy. And so if people are doing things that are pushing prices to weird random places, that really is costly for the economy. Short sellers do a great job at helping make prices more accurate. But here’s the thing that often surprises people.
It’s not just that they make prices more accurate, they make them higher. When they’ve studied cross countries and in places where short selling is legal, stock trade at higher multiples and have higher valuation, conditional on other factors because people coming into the market know that the bad information has probably already been discovered, instead of fearing that it’s being kept secret because no one can make money off knowing bad information. So I do think it’s very costly for a society to attack, to make short selling a less attractive and more difficult thing. And anybody who’s making them the villains of this story, I think is adding to that damage. So putting it all together, the question is, what do we do? And my instinct on this and this just maybe my lack of expertise shining through, probably nothing right now, because if this was a one-off loop, or maybe not one because of the AMC and silver and so forth, but basically a one-off short-term fluke, then legislating or regulating in response to a weird one-off fluke is often a big mistake.
So I’m eager to hear in a moment from Marcy, to hear what she has to say about A, what the regulations that currently exist in law say about this stuff and B, how they might be applied to future situations. I will say that if this were a regular occurrence in the market, it would be damaging enough that I would feel like we should think about actions we could take that would have an impact. So I think I should wrap it up there and hand it off to Marcy.
Thank you, Randy.
Gamestop Special: Marcy Engel
Marcy Engel Transcript
Marcy, why don’t you go ahead?
Great. Well, thanks, Larry. And it’s great to be participating in this wonderful show that you’ve been having for almost a year now. Let me jump right in. As this already has indicated, we’ve all watched the GameStop stock as it went crazy over the course of a few weeks in January and everybody who just spoke did a great job of laying out what happened and the market impact. I want to address a few of the questions that everyone was asking and try to offer some preliminary answers. First, was anything that happened illegal and if so, who acted illegally? Was this a planned and coordinated attempt by a disaffected group of people using social media to stick it to rich hedge funds by forcing a short squeeze? Or just a group of people who saw a get rich quick scheme and wanted to jump in and have some fun? Was the use of power or an abusive power? Did anybody actually act illegally?
The easy non-answer answer is, we don’t know. What do all the chats, comments, WhatsApp’s, and other communication say? It will end up being very fact specific. In my experience, there’s always some dumb email someone wrote that can make even innocent activity look illegal. So we’ll have to see what comes out. The harder answer is figuring out what actually might be illegal. First, I want to remind everyone that the SEC and the CFTC did not have criminal authority, any charges they bring are civil and are subject to a lower standard of proof than a criminal proceeding. Although those may follow as well. The two main provisions of the security flaws I want to discuss are securities fraud, which includes things like making misleading statements and insider trading and manipulation. Let’s start with an illustration of securities fraud, as it could relate to the GameStop situation.
If one of the investors communicating on Reddit pumps up the stock, said he or she is buying or holding their position, but was actually instead selling the position, that could very well be a case of securities fraud, because it would be making a misleading statement in connection with the purchase or sale of a security. There’s a well-known case where the SEC brought charges against Jeffrey Vinik when he was an influential investor at Fidelity, where he effectively did this the old fashioned way by going on television. The more interesting issue is whether what took place was manipulation. Surprisingly manipulation is not clearly defined. Although some acts like wash deals and fictitious trades are examples given in the law. Manipulation involves transactions made by someone acting alone or with another person that creates actual or apparent activity or raise or depress the price of the security for the purpose of inducing the purchase of sales of security by others.
Well, that’s a mouthful and it was clearly written by lawyers. Manipulation involves the creation of an artificial price, one that does not reflect true supply and demand or the true value of a stock, whatever that is. It also usually assumes some degree of market influence or power, which any of the investors acting alone wouldn’t have. So the claim would probably have to be that the investors acted as a group in some sort of coordinated way, to gain that power. But manipulation is usually not done in the open. It assumes a degree of deception. Here, there was no secrecy at all. If though, the public posts show that there was an agreement among the group of investors to buy and hold their shares, to keep the stock price high and squeeze the shorts, it’s much closer to the line. If you add in an agreement not to lend the stock, a manipulation case can probably be made. But in either case proving an agreement among hundreds and thousands of people will be nearly impossible.
Another issue that has already been raised in class actions and other civil claims, is whether Robinhood acted at the behest of the big hedge funds or other institutional players in the market when it restricted trading in GameStop shares. Robinhood was clearly not capitalized sufficiently for its level of business and a high degree of concentration it had in a few stocks. When the volatility and trading volume through the Robinhood app became overwhelming, the clearinghouse massively increased its collateral requirements. If Robinhood had failed to post the collateral, it could have led to its bankruptcy or loss of its license. If, as Robinhood claims, it restricted trading because of the increased demands of the clearinghouse, the question becomes whether the risks that Robinhood might have to do so was adequately disclosed to investors. It is worth noting that the restrictions only applied to buying shares, did not prevent selling and reducing risk, raising the question as to what would be the harm or damages in any action against Robinhood.
Well, few would argue that the clearinghouses need to be able to increase collateral requirements in the face of increased volatility and risk, the uncertainty and lack of transparency in how this is done, including how the requirements are calculated and the circumstances in which they can be so suddenly raised, clearly undercut investor confidence in the fairness of markets and contributes to the sense that the market is rigged for the big guys. The GameStop saga also raises an interesting question about the suitability requirements that traditional brokers have, since they clearly don’t work in the online trading world, but should they, here instead of a traditional broker fulfilling that responsibility, it was effectively transferred to social media. The Wall Street [inaudible 00:39:42] community became the trusted advisor. And it seems like many of these investors thoroughly understood the risk of loss and even reveled in it, adopting yellow as their mantra.
The last issue I’ll discuss has already been touched on by others, is the practice of payment for order flow. While people are drawn to online brokers for their no commission trading, they may not realize that their broker is selling their order flow to another broker who executes their trades, which might result in risk execution. Just two months ago in December, Robinhood settled an SEC enforcement action, paying $65 million for misleading its customers and failing to satisfy [inaudible 00:40:20] best execution in connection with receiving payment for order flow.
While Robinhood has probably now improved its disclosure, there’s little chance that investors are scrolling through and reading those disclosures when they open their accounts or understand how Robinhood is profiting off of them. The investigations, lawsuits and congressional hearings are just beginning. The big question is whether they will result in a rethink on how we regulate in today’s world, or will they just scapegoat the usual suspects such as hedge funds and short sellers and fail to address the issues we face today and tomorrow. The real risk is that, as was just said by Randy, if in fact, this kind of activity makes greater volatility, it could really result in loss of confidence in the market, which could be very damaging. We’ll have to see what happens. Thank you.
Nicholas Bloom — Future of Work
Brendan Hoffman — the State of the Shoe Industry
Brendan Hoffman Transcript
We’re going to move on to our next speaker who is Brendan Hoffman. Brendan is currently the President of Wolverine Worldwide. Brendan, go ahead.
Thanks, Larry. It’s good to be back. As you mentioned, I was here in April talking about the early days of the pandemic and how it impacted the consumer shopping behavior seen through the eyes of the fashion industry. My prior role, running the lifestyle brand Vince. In September, I took a new role as president of Wolverine Worldwide. We’re a portfolio of 11 footwear brands, including Sperry, Merrell, Saucony and Wolverine. I could probably speak for six minutes about switching jobs during the pandemic, but we’ll try to stick on the topic you assign me.
So a little more background on the company. Our 2019 revenues were just north of $2 billion. We’re publicly traded under the ticker symbol WWW. We’re over 135 years old and headquartered in Grand Rapids, Michigan. We have offices around the world, and in fact about half, our payers are sold outside the US. Since we are a public company any remarks I make specifically about our brand, is through the lens of early November when we last reported quarterly results. We report Q4 next month. However, I will provide some commentary on what happen more generally throughout the holiday period on what I’ve learned from our customers and partners.
When I last spoke during the early days of the pandemic, stores were closed and none of us had any idea or could have imagined what the next year would look like. I spoke about how we were pleasantly surprised that the customer had pivoted online. And while it couldn’t come close to making up for the closed stores, it was all done at a discount. It generated much needed cash, and did allow us to exhale that the consumer would still shop.
Fast forward nine months, the stores opened back up over the summer. And while traffic generally has been down 40 to 50%, most retailers reported sales drops that were not nearly as dramatic, as anyone willing to venture out to a shopping center was intent on buying. That seemed to have continued into January with traffic improving off those lows and conversions staying high. More importantly, e-commerce has boomed in all areas. McKinsey consulting reported that over 10 years of e-commerce development was accelerated into six months. Specific to Wolverine, our e-commerce business, on our own sites, was $235 million in 2019. And we stated in November that our goal for 2021 is $500 million. I would estimate that as two or three years ahead of when we otherwise would have expected to reach that milestone pre-pandemic.
What we have also seen is a shift in the categories consumers are buying. Anything having to do with being outside has seen a lift for obvious reasons. For us that has greatly benefited like Merrell and Saucony. Merrell’s the number one brand for hiking. And however you want to define hike, whether it’s hiking the Appalachian Trail or like me hiking around my neighborhood on a socially distant walk, brands like Merrell have greatly benefited. And here’s a plug for our franchise shoe, the Moab.
Similarly, there has been a running boom since the start of the pandemic. Saucony is one of the leading running brands competing against others in our sector like Nike, Brooks and Hoka. Again, whether you are a true runner logging multi miles a week or just walking with friends, it’s been a great tailwind for brands like Saucony. And another shameless plug, our Endorphin Collection was launched last year and has won multiple industry awards, if you’re looking for the best sneaker to walk or run in.
Another category that has been lifted by the change in consumer behaviors is the work boot category. Wolverine is the number one brand in the sector, which caters to workers in factories, warehouses, et cetera. Industries that have been working tirelessly to support all of us as we hoard toilet paper and other essential items. Businesses like Amazon will give their warehouse employees coupons to purchase their footwear in order to provide the highest level of safety and comfort to keep them on their feet. With the extended hours and shifts that have resulted during the pandemic, our work brands like Wolverine, CAT, and HYTEST have benefited. The same is true for frontline workers who are on their feet all day, and many of our brands cater specific styles to literally support them.
Obviously, the examples I gave go beyond footwear as the apparel and accessories needed to participate in outdoor activities and/or support the efforts of those at work have benefited as well. While it pains me to say it, the clear winner of 2020 was Crocs. They’ve benefited from all the above as well as being well positioned as a slip-on comfort shoe to benefit from all those working from home or just staying home looking for the path of least resistance when getting ready for the day.
In April when I spoke, I mentioned that online sales were driven by deep discounts that otherwise would not have been offered as we all worried about the buildup of inventories. However, as we got into the back half of the year promotions normalized, and for many of the categories I mentioned above were less promotional than the prior year. There were the typical Black Friday and Cyber Monday promotions that our customer has become accustomed to, and they started earlier to try and compensate for the reduced store hours during the holiday period. But very quickly demand was outpacing supply in key categories. This is both because the shift to categories like outdoors and performance wasn’t anticipated pre-pandemic, but also because most every manufacturer halted production in March for a few months while the early days of the pandemic played out. Likewise, the retailers cut all their purchase orders since they didn’t know when they could open up their doors.
The result of this is that demand way outstripped supply in many of these categories, reducing the needs for typical end of year clearance events. I would anticipate these leaner inventories continuing into the first half of 2021 as factories that were forced to close have not been able to ramp up back to their pre-pandemic levels, especially as new waves of the virus have occurred further complicating access to the workforce. All of this has been exasperated by the transportation logistics backlog caused by the dramatic reduction in air freight from Asia causing the need for more freight, to go by sea both thriving up the cost and causing huge delays as the ports and pathways are overloaded. Of course, as categories have benefited from a shift in consumer behavior, others have been decimated. I’m glad I’m not manufacturing men’s suits or in the brown shoe business right now.
Globally, we’ve seen shopping patterns mirror the US in the shift to online. However, depending on the region, we have seen physical stores bounce back at different levels to the US depending on the response to the pandemic. China, for example, recovered quite quickly last summer, and we continued our aggressive rollout of Saucony and Merrell stores in the back half of the year. Although with the resurgence of the virus and the new strain, we will see what the next few months look like. I can go on further, but I think my six minutes are up, so I’ll turn it back over to Larry.
Brendan Hoffman QA Transcript
Okay. Brendan, I just want to reflect on a story from 2008, when we had lunch. We had lunch at the Lord & Taylor and I asked what it was like in the men’s department. And you said that if you fired a machine gun in the men’s department you would only nick a scarf, nobody would be down there. And I asked why, and you said, “Well, men, if they don’t buy a suit for a while, it’s no big deal. They can just deal with it.” And I’m wondering, you mentioned the issues related to apparel, are there whole sectors of apparel and footwear that depend upon business casual or business work for both men and women that have been just completely obliterated? And do you feel like this is going to be a trend about how we currently dress, as how we want to dress going forward? Is it going to affect broadly… Is it a temporary phenomenon, or is this something more permanent?
I think, as you see some of the bankruptcies that have happened in my industry: Brooks Brothers, Men’s Wearhouse, while they’re certainly pointing fingers to the pandemic, I mean, they were on that steep decline for over a decade as your comments reflect. And so, I think, again, as we’ve heard many times, this crisis is just accelerating trends. And the way we dress and the way we work, as Betsey just mentioned in terms of how the workforce is going to work remotely or in office, is going to have a forever change on the way we dress.
I mentioned in my remarks that Crocs, was the shoe of the year. And think what you want about how fashionable it looks, it checks a lot of boxes for the way we’re living our life today in terms of functionality, comfort and ease. And so those are the trends we’re seeing amongst our brands as well. And I mentioned in my remarks, I’m glad I don’t own a brown shoe company, that’s a company that makes dress shoes, traditional lace-up dress shoes. Those are going to be… While there will always be a place for them, I think the need for them will be far reduced.
It was interesting, and I saw some market data the other day. And what struck me in Q4, end of the December, was women’s footwear across all the different categories, declined about 15 points while men’s footwear was only down two or three points. And so, I think that speaks to just the lack of dress apparel and dress shoes and high heels that they’re being bought now. But that being said, I do think there will be some revenge purchasing that happens when the world opens back up. Speaking of my own home, my focus group of one with my wife, who I know has shopped less or at least shopped differently, I know she will not hesitate when the world opens back up to go after that dress shoe category again.
Betsey mentioned in her talk, that main street retail is going to be having troubles. Now, you mentioned that your 2019 revenue was two billion, and that you were looking forward to 500 million, about one in $4 spent would be on e-commerce. And 2021 is going to be sort of a weird year because it’s going to be, I’ll call it a part COVID year. But let’s say it was 2022, what do you kind of expect from mainstream retail to sell your shoes or to come back as a place to shop? We knew it was in decline, is it really going to accelerate in its decline? How do you think about mainstream retail as a path for you to sell your products?
Well, I think it’s always going to be an important part of the channel mix, but I think that there’s no question the trend was happening towards e-commerce. Truthfully, the trend was happening towards owned e-commerce, meaning brands like ours trying to sell through their own websites rather than other websites. And that’s just, as I said, picked up two or three years in our own business over the last 12 months. And you see the biggest shoe company in the world, Nike, talking about how their main focus is direct to consumer i.e., e-commerce. And that they’re actually pulling out of a lot of their wholesale partner’s websites and brick and mortar to try to run more directly through the consumer. Obviously, that has a lot of positive consequences for a brand. You double the margin, you own the customer data, you story tell directly with customers with no interference, so there’s a lot of positive things.
And it’s what we were doing at Vince, and it’s what we’re going to be doing at Wolverine is trying to accelerate and invest in those areas while still having partners that can reach customers that we otherwise wouldn’t have. I will tell you, in our field, Amazon is a very important partner for us and a very good partner for us, so these digital titans will gain in importance as well.
During the beginning of COVID, I too decided to buy a pair of Merrell shoes because I was going on walks that were kind of muddy so I needed an outdoor shoe, but I bought it on Amazon. How do you get customers like me to show up on your website and not Amazon’s website? How do you succeed in doing that so you can get all those benefits of both margin and storytelling?
Yeah, well, again, I’m glad I just mentioned Amazon because they are a great partner, and a very profitable partner, so I don’t know if that would be where I’d burn calories is trying to get you off Amazon and onto merrell.com. There are other places that-
… that I’ll try and get you to merrell.com. And quite frankly, with the digital titans, the more assets of ours they use, the more direct branding experience we get. So, Amazon, there’s a lot of talk about how they own the customer and what they do with that, and do they share it, and all that is valid, but on a balanced scorecard for brands like ours, they’re a good partner.
I want to talk about logistics for a second. So, let’s imagine that a shipment of shoes is on its way from China to the US, and it’s going to be a little slower, you wanted it a little earlier in the season to sell out. And in comes an online shopper who desperately wants a shoe, and you can’t deliver it that soon, but you can deliver it. Are you able to manage that process and say, “I will sell you the shoe, I promise it within X number of days.” So that you have the capability of both making the sale and dealing with the logistical consequences? I mean, for some consumers, I don’t think they care when the Merrells show up, if it’s 14 or 21 days, relative to like a Prime customer who may want it in two.
Yeah, I mean, sure. I mean, that’s part of the magic of marketing is how you interact with your customer to turn a negative like that into a positive. We might call it a pre-order or we might do something else to let them know when the hot shoe of the moment is back in stock, even if it wasn’t such a hot shoe, it was just as you said, a shipping delay. But I do think the greater point is, as I mentioned in my remarks, these logistics are going to be real and going to be with us for a period of time based on making the proper decision in March and April of last year to shut production while we all assess the situation. And just the consequences of that are now being felt, they weren’t held so much the first six months because the goods were already in process, but now you’re seeing it across the board. If you go into stores, if you go online.
Peloton was mentioned earlier. I mean, the waitlist to get a Peloton now, went from weeks to months. And that’s one, because of the surge of demand, but also because of the lack of ability to be able to ramp up the supply chain, including the logistics in a way that we were all kind of accustomed to.
And just kind of going back to Betsey’s talk a little bit, let’s imagine that logistics is permanently damaged in some way. Is that going to encourage you to do more domestic manufacturing, or does that mean to just plan your season a little bit earlier as to handle the delays in logistics?
Well, I don’t think it will be permanent, but I think we were already dealing with disruption with the tariffs from 2019. As I jokingly say, I wish that was all we were dealing with now. As difficult as that seemed at the time, it was nothing compared to what we’re dealing with now. But that already motivated companies like ours to move a lot of production out of China and diversify throughout Asia. I mean, as we discussed during the tariffs for a lot of industries, bringing jobs back to the US just, you can’t do overnight. The infrastructure isn’t in place, the education and training just can’t be done overnight. So, it will continue, I think, to be done across Asia, but I don’t think it will be permanent.
And I think actually one of the things we’re finding is, as was talked about work from home, the use of digital tools, even in a creative industry like design and production, should greatly reduce the lead time that we had been used to. In an industry like shoes, it’s well over a 12 month lead time, so the opportunity to use these digital 3D imagery and printing and all these techniques that we are forced to have learned and adopt over the last eight months, I think we’ll have a very positive consequences to our supply chain going forward once we get out of this temporary backlog.
Are you basically saying that we were very, just-in-time inventory oriented and now with logistics we’re just going to have to hold a larger inventory and be a few more days earlier? And are there substantial cost for that additional working capital, et cetera?
No, I think, just, at least in fashion and shoes, well, we didn’t do much on just-in-time as well as we could have, our other industries did. In fact, we worked so far in advance because we make our orders from our retail partners that I think there’s a lot of ability to compress the lead time, especially as we go and sell more through our own channels and get that instant feedback. I do think in 2021, towards the back half, you might see some buildup of inventories just because of reacting to what the industry is dealing with now. But I think, as we get past this, I think it’ll be very positive for the efficiency in turn and lead time of inventory levels.
Brad Stone — Amazon: Alexa, Groceries, and Logistics
Brad Stone Transcript
We’re now going to move ahead to Brad Stone. Brad is the author of The Everything Store and The Upstarts, and he recently just published this last Tuesday, a new book called Amazon Unbound: Jeff Bezos and the Invention of a Global Empire.
Thank you, Michael. I went and bought your book, and I guess I’m going to have to go and throw away my Flaming Hot Cheetos after that illuminating talk. Well, my book is Amazon Unbound, it tracks the history of Amazon, particularly over the last 10 years, and its impact on society, and on our economy, as it has grown to a $1.6 trillion company and Jeff Bezos has become the wealthiest person in the world.
Well, Larry asked me to talk about Alexa, the grocery business and logistics, which are three parts of this story. They’re sort of different, but when I reflected on this, I thought, the theme here is how Amazon’s corporate compass really follows, not just Bezos’s innovations, but his investment decisions and with poorly understood repercussions for, as I said, our economy.
Alexa, we go back to 2010. Jeff Bezos is reflecting on AWS and the advantages that Amazon has in the cloud, and he sends an email to his executive saying, “We should build a $20 computer whose brains are in the cloud, that’s completely controllable by your voice.” Now, he’s kind of a famous Star Trek fan, so he’s trying to make real this vision of a fully conversational computer. And I actually have the whiteboard drawing in the book of the first illustration of an Alexa, but that’s the innovation, and what follows is really the investments. He handpicks his Chief of Staff to go run this project. He tells this executive that he can basically hire any AI engineer or voice engineer he wants, and acquire companies.
One of the big challenges is getting enough data for this device to make it smart, so they basically finance this secret effort, to bring Alexa out into the world. They hide it in apartments and houses, and they hire contractors to run through these houses and apartments and speak. They don’t even know who they’re speaking to or what they’re speaking to, but this big data gathering effort results in the introduction of the Echo in late 2014.
Now the contrasting example is the grocery business. Amazon introduces something called Amazon Fresh in 2007. And it just languishes in Seattle for years, and Bezos just believes that this isn’t a land grab, but this is more of a green field opportunity online ordering of groceries, and he takes his time. And then what happens in 2015 is this little company called Instacart starts to get funded by Silicon Valley, and it starts to have traction; Google introduces something called Google Express, it launches in Seattle, Bezos’ backyard, Bezos takes notice, and finally he starts to take it seriously. This involves the introduction of a service called Prime Now, and the expansion of Amazon Fresh, and it’s actually not all that successful. It’s very slow growth, it’s unprofitable, but Bezos sees this now as more of a land grab. And this is the kind of thing that really provokes big investment decisions from him.
Now at the time, Whole Foods Market is languishing. This is a grocer, to Michael’s point, that swam against the tide for many years, with an organic selection, not stocking things like big pallets of Coca-Cola and the Flaming Hot Cheetos, and yet it’s stagnating on Wall Street. Then John Mackey, its CEO, is basically looking for a way to preserve control, so of course, Amazon famously buys Whole Foods for $3.7 billion in 2017. Interestingly, it’s kind of let John run it autonomously, and Amazon is instead introducing its own network of grocery stores called Amazon Fresh, and in a very Amazon-like way, it’s trying to differentiate itself, not with the product selection as Whole Foods did, but with technology. And so, you go into one of these stores and they’re just starting to open them, and it’s either got these Dash Cards where you can put a product into your grocery cart and it automatically tallies it, or the ghost store technology where there are cameras in the ceiling, and sensors on the shelves, and you pluck something off the shelf and it automatically charges you. It’s a very Amazon-like thing, these type A disruptors believe they can save us some time waiting in the cashier line. I don’t know about you, but for my particular vantage point, that’s not really a huge pain point. So we will see how successful Amazon can be in the grocery business.
The last topic I want to talk about is logistics. And again, we go back now to 2013 where UPS and FedEx, are Amazon’s major delivery partners, and they fail to keep up with Amazon’s growth, and it’s really interesting to consider why. Amazon operates at online store, you can order from it anytime of day, anytime of night, any day of the week.
Those fulfillment centers are running basically around the clock. UPS is a union shop, it’s only operating five days a week, back then in 2013, and it’s taking off holidays such as Thanksgiving. And so over Christmas of 2013, UPS chokes on Amazon’s growth, and it declines to make the investment decisions that will allow UPS to keep pace with Amazon’s growth. FedEx is the same. These are relatively high margin logistics businesses, Amazon is like a locust, a low margin locust that will simply consume all of its capacity, and so Amazon starts to grow its own logistics business. Bezos wants a partner that’ll keep up with it, and this is why today you look out and there are cars on the street that say Amazon, and trucks on the road and airplanes in the air.
Amazon does not employ those drivers or those pilots. It’s a very “fissured relationship”, to take a term that David Weil, a professor at Brandeis University has popularized. Amazon wants the advantage of a logistics network, without any of the pain of employing those workers, of exposing themselves to possible unionization, and that has led to some amount of chaos on the roads as these drivers get into trouble, and I think contributed to income inequality across the board.
Brad Stone QA Transcript
We had David Weil on the show about three, four weeks ago, talking about the gig economy. And we didn’t really talk about Amazon so much, so let’s bring it home. You’re right, Amazon is not hiring the pilots, they’re not hiring the drivers, and they’re hiring independent firms to take it that last mile. They do it for a number of reasons, one is for unionization, another might be that they don’t want to get involved when someone runs over a child and you have to have a 24/7 news cycle on that topic. In your own mind, why do you think Amazon’s doing that, and why should we care? Should we allow firms to choose to focus on certain things? Amazon has like a million employees already, the fact that they don’t have 1.2 million, is that really a problem?
Well, first of all, the news cycles already happen when an Amazon driver hits a pedestrian. So they can’t escape the bad press, but they do try to escape the legal liability, often not successfully. There have been some settlements that I write about in the book, where they’ve had to pay a family because of a driver’s mishap. And what they’ve been trying to do is exert more control over those drivers with in-car surveillance and different kinds of software that monitor their performance. I think David makes a pretty good case that this does matter, that labor models like Uber’s and Amazon’s are having an impact on income inequality. Amazon tries to polish the halo over its head when it was announces things like a $15 an hour wage or $17 an hour wage.
But this network of middleman and independent contractors, they’re treated like employees, but they don’t have the protection of labor law. They don’t fully enjoy the same wages or the rewards of Amazon’s growth. And it’s a great illustration of inequality among the workforce in a single company. So, when we ask why is the problem of income inequality getting so bad in the US with major political repercussions, this is a microcosm. And I think David Weil makes a good argument that this labor model needs to be addressed. And last I heard, the Biden administration was looking at him to bring him back as a wage regulator. So if that happens, perhaps he could have an impact.
Let’s go back to grocery stores. You heard Michael Moss’s talk about providing the right foods to consumers. How does Amazon think about that in the context of Whole Foods, Amazon Fresh and how they’re going to be providing food to the public?
Amazon’s compass points only one way, and that is towards what its customers want. And if the customers want Fritos and Cheetos and Coca-Cola, they’re not going to take a principle stand on that. I do think it’s remarkable that they have left Whole Foods alone, and I think one of the big things that the activist investors were clamoring for in the battle over Whole Foods, was trying to open up those grocery aisles to those popular products, and so maybe it was a bit of a principled stand, that they let John Mackey run Whole Foods. But the new Amazon grocery store stores have all the junk that you would expect, the online delivery services like Amazon Fresh have all the junk.
And when you look at Amazon, well it’s interesting when you look at their private label products, and they’re just starting to get into this, they do tend to go for a higher quality skew of snack foods and whatnot. So perhaps they’re taking the high road, but I don’t think we can count on Amazon, like we probably can’t count on Walmart and other big grocery stores too, they’ll offer the selection, but I don’t think they’ll try to make a significant impact on their customers tastes.
Variety was another theme of Michael’s talk, and no one offers more variety of products across the board than Amazon does. I mean, they offer everything, to your previous book, The Everything Store, it offers everything, and we like that variety: we want it, and we want it fast. These run core to Amazon’s mission statement, provide everything, potentially even in a day or two. How do you think about variety as the critical aspect of Amazon’s success?
I mean, it’s right there, back in 1994, when Jeff Bezos is a vice-president at D.E Shaw, a Wall Street hedge fund, and he’s actually researching ideas for D.E Shaw and he comes upon the idea as he’s observing the massive growth of the worldwide web, that you can create an everything store. That the selection of a normal store is going to be bounded by shelf space, but online, it can be unbounded, even if you don’t have an obscure book, if somebody orders it, you can potentially go get it. And so variety, it was the first advantage Amazon had, that endless selection. The price is always going to be higher because you had to store it and pack it and ship it, and convenience was always going to be worse because customers would have to wait a couple of days, but selection was right there.
And one of the stories I tell in this book is how Amazon has pursued selection overseas, and it’s opened up the marketplace to overseas sellers, particularly in China, close to manufacturers, and a wave of low cost goods have flooded into the marketplace. If you’re an Amazon customer, you probably sometimes can recognize that. And the selection has come with a lot of negative aspects, like poor quality or sketchy brands that basically don’t stand behind the customer promise. So yes, selection’s been key, variety has been key, but it’s also brought some unintended consequences.
Let’s go back to Alexa for a second. So Bezos came up with this idea, he put it together, but I haven’t heard a lot about the product in the last couple of years. I imagine that when he designed it, he expected this to continue to grow exponentially, in both use and quality, that there might be some third party designed apps. Why hasn’t Alexa exploded as a solution to helping people solve problems?
I feel like it has slowed down a little bit, perhaps with the migration of Bezos’s attention to other things that are happening in his personal life, and of course his responsibilities, his philanthropy, and now he’s moving on as CEO. But I do think they have encountered, well, two challenges, one, a technical challenge. The idea that he had was a fully conversational computer, the practical concerns his executives had was launching this thing with some actual skills that they could advertise. And I think they did that with music and ‘turn on the lights, turn off the lights, recite the weather or read the news’. And it hasn’t grown that much, and I think they’re hitting some natural barriers on artificial intelligence and conversational computing.
And then the second part is, as you mentioned, it hasn’t created the kind of ecosystem of apps that you have on your smartphone, and they have tried, but I think there’s a fundamental limitation there because it’s frankly mostly conversational, there are some Alexa devices with skills, it’s hard to see what’s available and summon the right skill, it’s just not there in front of you. And maybe, perhaps we as humans, when it comes to our technology, still really rely on words on a screen. And so it is slow, but by any measure, it’s pretty much a success. I mean, they’ve got over a hundred million devices out there and more than any other company, they probably are further in terms of networking the home, bringing home appliances and light bulbs and doorbells, and other aspects of the home onto a computer network and making it easily operated by the homeowner.
It was in your first quote at the beginning of the book, you mentioned that Thomas Edison’s genius wasn’t inventing, it was inventing a system of invention. And we had Ernie Freeburg on the show a couple of weeks ago, talking about Edison and the teamwork involved in the process of invention. But like the story you’re telling today, is the vital ingredient Jeff Bezos personal part of the process, where he’s coming up with the big idea and then throwing resources to solve it. How important is he to the system? Because, in some ways, I imagine these systems are enormous. When you discuss logistics, for example, he hired an excellent team and followed some big ideas, but he wasn’t in there day to day managing that process. Why do you think he is so critical to the success of the institution itself?
Brad Stone: He’s critical to a certain kind of success, when you peel back the layers of the big technology innovations like AWS and the Kindle and Alexa, he is there, but I think you’re right in that while he has sponsored the big changes, like logistics and groceries, the marketplace, and AWS, there have been other leaders there. And so when I talk in the book about a system of invention, I’m talking about the customs, the leadership principles, the rituals like the six page documents that some people probably know about, but they can read more about in my book or you could even Google Amazon’s leadership principles. And that system of invention has actually been very successful outside of Amazon, so Bezos instituted it at The Washington Post, they present documents to him, he reads them, he asked the executives to bring him new things.
And so, I mean, I do think that he has set up an enduring franchise that will continue to succeed when he steps away for good, it might be this fall, but I suspect he will linger for a bit. But you’re right, in terms of like that disruptive new technological idea, the insight that he had with Alexa, the $20 computer, brains in the cloud, operated by voice, Amazon might miss that. And when I look at Andy Jassy, his successor, or other members of the Amazon leadership team, there’s no one like that. In fact, there are now very few technologists. And so that could be a challenge for Amazon going forward.
One of the most incredible things about Amazon is their willingness to start another division that will attack one of their core businesses. Take the Amazon marketplace and the willingness for creating an environment for their competitors to compete on the same products that they sell in their own store. Very few companies I’ve ever heard of were willing to do such a thing. Is it Bezos, is it the institution as a whole that says, “You know what, let’s attack what we’re doing right now and just see what happens.” How do you view the Amazon marketplace, and thier willingness to take themselves on?
Brad Stone: Yeah, you’re right, it’s a willingness to endure the corporate discomfort that comes from setting competing teams against each other inside. Amazon’s history is replete with them. Bezos selected an executive to start the Kindle business back in 2005, I think. And he instructed the guy, “I want you to proceed as if your job is to put everyone selling physical books out of business.” And then you fast forward, I talked about the grocery stores and Amazon is introducing these Amazon fresh grocery stores in direct competition with Whole Foods, sometimes in the same neighborhood. So the reason they do that is because they want to be everywhere, they want to provide what their customers want. They view business expansion as active experimentation, trying a lot of different things, finding what works and then doubling down madly on it.
And they are able to do that by virtue of their enormous resources. At first, for the first 20 years, it was the relationship with investors and how Wall Street allowed Amazon to lose a lot of money. Those days are gone, the company is very profitable and now it’s just financing all of these experiments, expanding in all of these directions, figuring out what works and then doubling down on it. And that’s a reason why there are lots of reasons to criticize Amazon, to regulate it, I think I get into those in the book, but when you look at the years ahead, this company is like a boulder running downhill, and I think it’s hard to look at the competitive environment and judge who might slow this company down or even stop it.
Our next speaker will be Dietrich Vollrath, he’s going to talk about the lack of productivity in the service sector. Amazon is in a lot of service sectors, they’re in the business of retail, they’re in the grocery store business. How do you think about opportunities for improvements in productivity in the areas that it touches?
Yeah, give me an example.
Getting goods to people.
Well, last week Amazon issued, or announced it was going to issue, $18 billion in 40-year bonds. And they borrow money like this when it’s cheap and the reason they do it and they don’t have to do it, is to build more fulfillment centers closer to customers, to hire more of these middlemen transportation companies, probably to build more data centers. And what it means is, going back to the boulder analogy, they’re getting closer to customers, they’re going to deliver faster. They tried to make prime a one day proposition a year and a half ago, and then suspended that during the pandemic. But I think the economics of the business support this kind of expansion, I think those deliveries are going to be ever quicker.
And what that means is, when we talked about convenience, selection and prices, convenience being one of the variables that always lagged, Amazon is solving that and pretty soon these deliveries are going to be ordering something, getting it on Amazon, is going to be just as convenient as going to the store. And depending on how you view that company, that’s either an enormously appealing proposition or a very dangerous one.
All right, thank you, Brad.
Dean Adler — What Happens Next in Real Estate
Dean Adler Transcript
We’re going to move on to our next speaker, who is Dean Adler. Dean is the co-founder of Lubert-Adler Real Estate Fund. He has spoken at our program previously. He’s going to discuss today what’s happening next in real estate. Dean, please go ahead.
Thank you, Larry. We’re going to address the impact of the pandemic on the real estate industry, basically who thrived and who died and whether these impacts will be temporary or permanent going forward. So, let’s just take a look back, we’ll call it the pandemic period, March 15th, 2020 to an estimated September or 2021. At the outset of the pandemic, certain real estate segments were absolutely crushed. Brick and mortar retailers, the occupancy of people going to work in offices, hotels, travel, all closed down. And we had a closing down the restaurants, gyms, theaters, and major events.
During the first three months of this pandemic period, the real estate market entered a period of severe dislocation. There really was no transparency as to what the future looked like. The capital markets froze. The public REIT stocks dropped significantly, particularly in the hotel, retail, and office sectors.
As in other real estate downturns … and basically real estate goes through a cycle every 10 years, 1981, 1991, 2001, 2009, and ’21, certain opportunities present themselves to what we’ll call the real estate opportunistic investors. In this case, the early distress opportunities included the following. Number one, recapitalizing distressed hotel owners who did not set aside capital to pay debt service and the operating expenses. And many of these hotel owners funded their money from family and friends. And when it came to calling money from these limited partners, they basically said “no más” or we’re not contributing. So that was one source of what we call rescue capital opportunities.
Number two, many owners of assets that were just going to start the redevelopment process of taking an older building and remaking it, lost their redevelopment capital and lost their financing. So those who had capital to go in and invest in that cycle really got in at a very favorable basis. Number three, there’s the Wall Street debt fund lenders, where these lenders would borrow short off a repo and make long-term loans. And when the capital markets froze,
many of these lenders blew up due to leveraging their loans with repo paper. And the repo paper got marked to market, they didn’t have the capital, and they had to liquidate assets at low prices.
And finally, many of the public shares of hotels, offices, and retailers were at perhaps all-time lows. Interestingly enough, despite this early period, there was not a significant amount of activity for buying distressed debt or buying foreclosed assets, as the lenders across the board provided forbearance to most borrowers and they gave moratoriums to basically allow people to wade through this period.
On the other side of the distress, there were certain segments of the real estate sector that boomed. The logistics: Amazon. I’ll call a real estate boom, where basically in every major market, talking about 50, 60 markets, Amazon added up to two and a half million square feet of distribution centers. They would do about 15, we’ll call it distribution centers of 150,000 square feet each, and they’d have one or two, one million square foot warehouses. So this was an area which was really booming.
Number two, you also saw a similar boom in the life science industry and the data center industry. Look at Cambridge, MIT, and look at the explosion that happened there. And the third group that benefited significantly were the grocery chains, who basically no longer had restaurants as their competition for this period. And they ended up achieving far superior returns because they were the really only source in town for food. And we’ll discuss the grocery a little later.
So that’s sort of looking back on this last year. Going forward, the impact of this pandemic has potentially altered how we will work, how we’re going to live, and how we’re going to play, shop, and travel, all in one category, in the future. So, let’s address each of these four categories. Number one, work. The pandemic highlighted the success of online connectivity, connectivity from remote locations. This going forward has raised two questions. How will people work in the future? What will be their office needs and space requirements? And number two, where will they work? We believe at Lubert-Adler, that the urban office buildings will change moderately and must adapt and there will continue to be exodus from big city gateway markets … will continue albeit not as dramatic as people may think.
So let’s first address office space. Office space will become more of a sense of place where team members can come up and meet and collaborate and want to come to the office because they want to personally see someone. And at the same time, the office space is going to have to be more flexible because there will be a number of workers who can work remotely or don’t have to be in five days a week. And this space has to accommodate a much more flexible workforce. I think you’re going to see a lot more activity where people come in three to four days a week, not five to six, and a space need to accommodate that.
In addition, I think there’s been a heightened awareness for healthy buildings. And for the last 30 years, we’ve always talked about making healthy office buildings, but it never really resonated. I think it resonates now. I think having fresh air, right air infiltration system, sustainable materials, and outdoor space, will separate those … what I’ll call the Class A buildings and the next tier buildings.
Certainly, I think firms will consider more than ever to move divisions to lower cost markets. It’s not just because the cheaper office rent, it’s because their employees can’t afford housing in San Francisco, in New York, in Boston, and Washington. It’s not equal across the board. So I think you’re going to see more and more firms take divisions and they’ll move from those divisions … particularly with the accelerated technology and connectivity, there’ll be able to move them from the gateway markets, San Francisco, New York, and Boston, to what I’ll call the emerging markets with lower costs of living, better services, which include Austin, Miami, Charlotte, Dallas, Salt Lake, among others.
For the investors, who invest in office, I think it’s a real tough slog above ahead. We were oversupplied pre pandemic plus the WeWorks of the world sucked up space based on future demand. That will not be there. I think that you will see, in particular in places like New York, rents are going to flatten out but expenses are going to rise. Think about the services that are going to need to be provided. And the vacancies will rise. And buildings such as the B buildings, which were sort of older, 1980s buildings, I believe will get crushed and will need alternative uses. And we’ll have real markdowns on valuations.
Let’s move on to living. And living I’m going to call multifamily rentals and single-family homes. Number one, the urban apartments were initially impacted significantly by the pandemic because why would you rent an apartment when you’re not working in town? But just recently, you’re now gathering steam where these apartments are going to be released as people anticipate going back to work. And we expect this to rebound, although it may take a few years to rebound and it’s going to be at flat rents. There’s no reason why rents would escalate.
Number two, the suburban single-family market, both from a sales and rentals, soar with bidding wars again. I think look for this to continue, but I think the real hot … what I’ll call the hot area is going to be the inner ring suburbs. I think you’re going to see a lot of the millennials move out, not all the way to … into real McMansions way out. I think they’re going to go for these inner ring suburbs and I think they’re going to come alive again.
And finally, when we look to build an apartment building, a retrofit, there’s going to be new relevant amenities. Number one, you got to promote fresh … You’re not going to promote just the rooftop bar and all the living spaces. You’re going to emphasize fresh air. You’re going to emphasize indoor, outdoor space. You’re going to emphasize in your room, we’ll have superior at home connectivity in case you stay home. Or in each building, we’ll have Zoom rooms. Not like the old cheesy business offices you see in most of these facilities, real Zoom rooms, so you can stay home and work.
And then also the whole marketing program is going to change. I think this pandemic has really highlighted how social media is really the premier area of marketing and advertisement. Interesting enough, apartment landlords are very old school, lazy, and they’re going to have to really adapt to meet … to really figure out how to market and connect with their customers via social media.
Let’s finally talk about play, shop, and travel. On the shop side, brick and mortar retail is a falling knife, and actually accelerated during the pandemic. One reason just simply was … I’ll give you an example of grocery, which never really was impacted by online, but during the pandemic, customers who never ordered online were forced to do so. And guess what? They liked it. Groups like Amazon Instacart, Door Dash Delivery boomed. And they left many carcasses behind. I think you’re going to see traditional brick and mortar continue to be crushed. We started with 1200 malls a few hundred years ago. I think we’ll be down to 200, from 1200 to 200. And unfortunately look at urban Main Streets, look at urban main streets, look at Madison Avenue, look at Walnut Street in Philadelphia. You could have 30, 40% vacancies. On the one hand, you could say it’s because the rents were so high. On the other hand, you’ve got to ask yourself if these retailers are moving up, who’s moving in? What type of retailers, because not many brick and mortar retailers are even being created today? What are the ramifications if our first floors of our urban areas are 50% vacant? May have a real impact.
Finally, hospitality, select-service with low overhead will come back first. The drive to resorts is thriving because people want to go somewhere and they don’t want to get in the airplane. Business and group hotels are several years away, and the international comeback, that’s going to be the longest to recovery. Interesting, all the hospitality markets are going to come back. The one who’s hurt the most in New York.
You may see 20 to 25% closed hotels not only due to no business, because the high union labor cost. If you’re a full-service hotel in New York, you got really, really tough labor issues. In sum, the pandemic had a significant impact to real estate, owners must adjust to the changes with the pandemic and look at this both as an adjustment, but an opportunity. If they adapt, my belief, real estate is still a very attractive asset class because it has the ability to generate very strong current yields in a world with little to no yield.
Dean, thank you
Dean Adler QA Transcript
I want to start with some of your last comments, particularly about Madison Avenue. Having lived on the corner of 63rd between Fifth and Madison for a decade, what I noticed was a complete turnover in retail on that street. For example, on the corner of 59th and Madison, there was a Crate & Barrel that had been on that corner for decades, and it obviously made no sense at current rents for Crate & Barrel to be on Madison Avenue. That was closed, and a number of very high-end retail shops went in. I think what you’re saying is that those retail shops that went in aren’t going to be able to afford those rents, and then your point was who’s going to go in there. Do you imagine a world where the Crate & Barrels of the world will return to Madison Avenue, or do you think rents will come down-
Yeah, well, it’s interesting, I think. Look, New York may be a little exception because you have so much density in people that there’ll be occupants there, but here’s an interesting: Before, many retails had to be on Madison Avenue because it was the way they marketed. They needed a presence there. I think with the pressure of e-commerce and how people are connected to the brand, having a permanent location on Madison Avenue may not be as critical as it was before. I think most retailers, very interesting, used to benefit by adding stores. That’s how their value was enhanced on Wall Street. They showed the growth through new stores.
Now, if you’re a retailer, except for the what I’ll call the value retailers, the Five Belows, the TJ Maxxes, but generally, if a retail is expanding stores, they get punished because analysts are saying, “My God, you’re spending money on brick and mortars. You should be spending money on e-commerce because if you don’t develop a robust e-commerce program, you could be out of business.” There are really no incentives for many landlords to increase their locations by brick and mortars because many don’t get credit for it.
Number two, you have a lot of landlords who bought these assets at very high valuations based on high rents. It’s going to take them a long time to decide to rent to a user at half the rent because if you put someone in at half the rent, they’ve lost their equity, they’ve lost their investment. I think you’re going to find it’s going to be the next few years you’re going to have a lot, a lot of vacancies there, a lot of pop-ups.
The bigger risk is, for something like Madison Avenue, if the only retailers who could afford to go in are the value retailers, when you start putting in the TJ Maxxes and Burlington Coat and use it like that in the outlet stores, how does that impact what Madison Avenue once was? Those are the expanding retailers, and restaurants on Madison Avenue is very hard to do because it’s too expensive, so it’s going to be very interesting to see, but it’s worrisome. We should all be worried about what’s going on.
Using a completely different example, my parents live in Sarasota, kitty corner to Sarasota Square Mall. 25 years ago it was a brand new spectacular mall. That mall is now completely dead. I wouldn’t even call it on a lifeline. There’s like one store left open. But across the street are strip malls- They seem to be very successful. They seem fully rented while the big mall is dead.
The grocery store service, what I’ll call open center, if you say there’s anything that has positive, open lifestyle centers, we could walk outside, feel you’re in a park, do your daily grocery shopping services, some restaurants that have indoor/outdoor space, I believe those will thrive. Those would be the winners. But the old interior malls, except for the big fortress malls, are just not going to be there. You’ll see a rebirth on lifestyle centers. They’ll put some apartments in there. They’ll put some office. It’ll be a nice community center. I think you’re going to see those continue to thrive, but on the other hand, you’re going to see main street retail and the malls really have some tough times.
Repeating this same idea, so I grew up in Glencoe, Illinois, and Northbrook Court is right down the street. It is also a terrible dying mall. Inconceivable to me 20 years ago that it ever would happen, but today, it’s not on its death throws, but it’s heading that way. This space is enormous. It’s got thousands of parking spaces. It’s got all this interior space. If you were going to buy… Let’s say I could sell you Northbrook Court for a dollar and said, “What are you going to do with it?” what would you do with it?
Okay, so I think it’s pretty easy, actually. It’s a hundred acres that was improved and then titled. You tell me where are you going to find a hundred acres in Northbrook? You can’t-
Actually, a valuable piece of land, and let’s start over. I think you’ll start with some apartments. I think you’d do something like what I’ll call service, retail, and apartments. You create a community with some apartments, a park inside. You create your restaurants. It becomes an amenity. You create some cool gym spaces. You’ll create a flexible office. You’ll knock down everything. There’s no reason to save anything there. You’ll create some townhouses, which have liquidity, maybe some single-family homes.
It really becomes a superior development site, and you’re going to find that the city of Northbrook will be supportive because they can’t have that dying mall sit there forever. It’s a security issue. It’s a crime issue, and you have the ability to bring new housing, indoor/outdoor restaurants, a grocery store. The retail becomes a more amenity retail than what I’ll call real shopping centers. That’s what you’re going to see in the future.
I want to switch to office. We had an HVAC specialist on the show way early in the crisis, and he was suggesting that you could redo and greatly improve an HVAC to bring in fresh air rather cheaply. He said he could do it for between $1 or $2 a square foot, and I was, frankly, in shock how cheap it was at the price. How do you think about how to reinvigorate or re-improve HVAC and create what you thought was this healthier office space for air?
Well, number one, I’m not sure you could solve it on the HVAC and people will give you credit for it. I mean, you’ll tell them you have this new filtered air, and most people won’t realize. What you do need to do is create some outdoor space. Here’s the ways to do it.
Number one, you can take some of your windows in every floor and bring them in 10 feet. Not all of them, but some of them to create balconies on every floor. You’re going to need space on every single floor so your tenants, if they want to go outside and get fresh air, that sends a real message, “Here’s fresh air.”
Number two, you could go to your rooftops. I mean, you see these cool rooftop bars. Tell me why you’re not using your rooftops to provide people in the building access to outdoor? You’re going to pump up your filtered water. You’re going to create some flexible space in your buildings so small tenants could come there. I think there are ways that you can reposition your office space so it’s much more indoor/outdoor. I think that’s critical because if you think about today, do you want to be hermetically sealed on the 17th floor? You go from a stuffed up
elevator to the 17th floor, and you can’t open your windows. I mean, it’s depressing in today’s world where people are aware of this. I think there are interesting ways to create great outdoor space and market your outdoor space for use.
I mean, it’s sort of ironic that the current B and C buildings, you can open the windows in your offices, and all of a sudden that’s fantastic, so-
I think you’re going to be able to take your A buildings and just think about the window glass one moving in certain areas, moving it in 10 feet, just like we’ve done, and we’ve converted old offices to apartments, and we just stuck the window out 10 feet in so we could create balconies. Now, if you could create a balcony on each floor for people to use, you can use that to market, and I think people feel good about it. Whether they use it or not is a different question, but I think they’ll feel good about having that.
I also want to expand on moving out of high rent districts, and I mean what you call Boston, New York, San Francisco and moving to Dallas, Miami, Austin, Nashville, Charlotte, et cetera. How easy is that going to be, and who’s going to be driving that decision? What makes you think that it’s going to be domestic? Will it be easier for them to use foreign workers if, in fact, they’re moving people outside of these areas?
I think if you really think about what makes up an office, you have the decision-makers there in the office, and normally, they have their accounting departments and a lot of back office with the regular office with your decision makers. I think what people are coming to recognize, especially from the pandemic, is many of the back office functions do not have to be in a hundred dollars a foot space.
Then number two is think about the burden of living, if someone has an accounting job or even a finance job, and they’re living in New York City, and the cost of living, for a fair paying job, they’re not super high end, but fair paying job, think how much more they can get in their lives by being in a much lower cost environment not only for the office space, but how they live and how do they go to school and how to get to work. You see a lot of… Look, a lot of big firms now… Goldman Sachs got an enormous back-office presence in Salt Lake City. Enormous.
Now you see that Goldman and Blackstone are putting divisions down in Florida. I think you’re going to now see that particularly because I think the connectivity on working apart shows that you can be productive. Even though you had the video conferencing before, I think Zoom has really allowed us to know that working remotely doesn’t mean these people are not important.
I just think people are going to revisit what their office means to them, who needs to be there, and who doesn’t. I think they’re going to find there’s a lot of markets. I think people would be quite attractive to live in and avoid the cost. I mean, you read about the cost in Seattle, San Francisco, New York. It’s prohibitive for most people, and this allows them to stay within the company and not incur those daily costs.
Well, in the 1990s, I worked at Salomon Brothers in New York, and we decided to move our operations department to Tampa, Florida. We offered everyone the chance to move, but very few people did move. We ended up hiring new people in Tampa to take on the positions at lower prices because of the unwillingness of people who generally lived in New Jersey and Staten Island weren’t willing to leave their communities. Do you think that will result in movement of people, or we’ll just hire different people in those new locations?
I don’t know exactly how that will come up, but I think for the first time in a long time, the one thing the pandemic did was force people to step back. I mean, everyone’s on this treadmill, “I have to get to the office at 7:00 in the morning. Someone calls me. I’ll be flying to Chicago so I can be there at the 8:00 meeting, and then I’ll go to Dallas the next morning.” We were on this go-go treadmill. I think you’re always going to have people who are following that course, but I think a lot of people stepping back and saying… rebalancing, and they said, “Hey, I could really look at how I’m conducting my life, and I am going to be considering other vocations because it’s just too tough to play the rat race in some of these big markets.”
I think there’s more of awareness. The answer is I don’t know if they’re actually going to pick up and go because they have friends, they have family, but I think you’re going to find companies encouraging this more and more. I also think the stigma of not being in the home office is less today. Just the last example, if someone from your office stayed home on Friday, you didn’t think they were working. If they stayed home every Friday, you would not consider them to be a rising star in your organization. There’s going to be something wrong.
I think now you realize, what we’ve gone through in the last year, that if someone really doesn’t come in Friday, doesn’t come in Tuesday, they could be as productive or more productive than if they were in the office. I think the stigma of spending more time flexibly, I think you’re losing some of that stigma, and I think that’s a good thing.
Charles Goodhart & Manoj Pradhan— the Great Demographic Reversal
Charles Goodhart and Manoj Pradhan QA Transcript
I’m going to start with the topic of Japan as our first topic. Just as an aside, I ran the arbitrage Japanese fixed income business for Salomon Brothers in the late 1990s and lived in Tokyo. And when I was there, what shocked me about the yield curve then was how low interest rates were and how flat the yield curve was and how slow the Japanese economy wasto return to a more normal interest rate environment. The great Japanese downturn, occurred in the early 1990s, and we’re almost at the 30th anniversary of it. So you mentioned that the world was benefiting from these Chinese deflationary pressures, but when I was in Japan in 1998, the rest of the world had yet to really experience the Chinese deflationary pressure. Japan was already in the heart of the deflation.
I think one of the great, interesting aspects about Japan was it appeared that Japan was doing quite poorly economically. But in your book, you mentioned that in fact Japan had, when you take inflation out of it, it’s been growing at something like a 2% clip for the last 20 years. How should we think about the Japanese economic performance? And as its population ages, how does that productivity of the older worker, play itself into some of those productivity statistics? Namely, does that mean that the Japanese productivity of 2% per annum that they’ve clocked is actually incredibly impressive, given the age and demographic aspects of its society?
So I’ll jump in for this first one. As you’ll know from Japan, nothing about Japan is simple, but let me try and work through this. Indeed, Japan has to be seen through two sample periods. The decade after the asset price bust is a very, very, very singular experience which, after the great financial crisis, many economies in the advanced world have also faced. And that truly was a lost decade, there is no doubt about it. But the period after that, there’s been a lot of literature in Japan also titled divine wind or productivity as attributes that allowed Japan to escape this bust, and it was a mix of the two. So if you look at Japanese productivity afterwards, what you see is that growth has been 1%, while the labor force has been shrinking by 1%, and that 2% gap in between is actually something that the advanced economies would, right now, bite your hand off if you give them a shot at it. Most of them have underperformed Japan pretty significantly.
And if you look at the services sector now, the BOJ has probably the most boring title for an exciting report called the Report on Economic Activity and Prices. And what they’ve outlined very clearly in there is very differently from what manufacturing had achieved, which is to reduce the stock of capital and move people onto the services sector, thereby increasing productivity in manufacturing. What the services sector is seeing now is increased automation with an unwillingness to pass on price increases to their customers. So you’re really getting productivity with an entrenched disinflationary process that has been handed down from China, and that is something that I think explains Japan’s interest rate performance. That the first period that first decade was really a deflationary shock, but after that Japanese interest rates, if you look at debt servicing costs versus a rise in debt in Japan, it is exactly the same picture whether you draw it for Italy, whether you draw it for the United States or most parts of the advanced world.
Another interesting thing about Japan was they did not import young people from the rest of the world to kind of buttress their demographic problem. Instead, corporations, and usually the most productive Japanese corporations, set up plants all over Asia, particularly in China. How should we think about the decision of corporate Japan to take advantage of this new labor market to produce goods, not only for Japan, but for the rest of the world and to improve their long-term profitability?
So again, I have a small comment here, and I’d love to hear what Charles has to say as well about this. We give actually a particular amount of importance to exactly what you’re talking about, Larry, which is that in Japan, this concept of OFDI, overseas FDI, has actually been seen very negatively, as something like a brain drain, and Japanese corporates almost being looked upon as traitors for abandoning Japan. We don’t think that’s the case at all. We thought what the Japanese corporate sector saw was a very difficult environment with very expensive labor, and at the same time they saw this giant tsunami of Chinese disinflationary labor integrating into the global economy, and they said, why not? Why should we look at a very difficult profitability scenario? Why not take advantage of China, North Asia, Poland, Brazil? And that’s exactly what they did.
So they were acting, rather than the picture that is painted of the Japanese corporate sector, that they were debilitated by this deleveraging at home, it wasn’t that at all, I think. It’s that of course they had leverage that they wanted to get rid of, but they acted very rationally, very globally, and in a profit maximizing sense, to relocate their industries to the more dynamic and cheap parts of the global labor supply. And that’s how they protected their profitability and still came out on top. Charles, anything that you’d like to add to that?
Well, one point that I would make is that with a retreat from globalization and onshoring coming back in place of offshoring, that we actually do expect the very poor productivity record of most other advanced economies in the last decade or two to improve. And of course, investment will come home rather than be done in the low wage areas, and with more investment in order to keep down unit labor costs and reduce the need for the scarce labor at home, we think that productivity will rise. Indeed, it will have to. But we doubt whether the productivity rise will be enough to offset the decline in the growth in the working age population.
Let me bring in China as the next big topic. The core of your new book relates to the one-time phenomena associated with bringing the Chinese rural and now urban worker into the global economy, and that this is a one-time phenomenon. Can you just, in its most broad strokes, explain what the implications were for, I’ll call it the G7 manufacturing, that was crippled by bringing the Chinese workers online as a competitor?
It varied a bit from country to country. It very badly adversely affected Italy, while actually Germany got away scot-free, because what the Chinese needed to buy was cars and machine tools, which Germany specialized in, and what China produced was cheap shoes, cheap clothes, cheap sort of products of the kind that Italy made. So it wasn’t actually common among all countries, but as a generality, what happened was that manufacturing shifted to China away from the advanced economies, and those manufacturing sectors where China had a particular advantage, the offshoring was greatest. And that is particularly true, of course, in America as well. There was a very good paper by Justin R. Pierce & Peter K. Schott entitled The Surprisingly Swift Decline of U.S. Manufacturing Employment at https://www.nber.org/papers/w18655 on all of this.
So one quick thing to add here, there was a particular friction in the global economy that made some of this possible. If you look at what happened exactly the way Charles is describing it, a lot of the manufacturing processes were shifted onshore onto China, and the IMF printed a one-time report that I’ve never seen that repeated afterward in which it outlined a absolutely gigantic subsidy that the Chinese administration gave to firms setting up in the Pearl River delta. So the idea was clearly, don’t export. Come and set up shop on our shores, and we’ll help you produce for the rest of the world.
However, the Chinese policymakers did not allow financial capital to access its financial markets. So what they could do by stopping the flow of capital at its borders, something that’s known as breaking the impossible trinity, to those of us who do economics, is that they could set interest rates locally in order to encourage further investment and global interest rates would not be equilibrated. So physical capital was allowed to flow into China to take advantage of the extremely benign borrowing cost, but financial capital flows could not do the same. So you created this two world structure, in which China had a very unique equilibrium at home, and the global financial markets were not allowed to reflect adequately what was happening on the physical side, so that investment in the advanced economies fell and investment in China went up very, very, very strongly. But it’s the advanced economies that set interest rates globally, so interest rates had to fall in the rest of the world.
And savings ratios in China were extraordinarily high, in because the state provided virtually nothing in the way of pensions, and the Chinese life expectancy was rising. And so the Chinese population saved at very, very unfavorable interest rates, which were forced upon them by the government.
The core thesis of your book is that this is a one-time Chinese demographic benefit that will slow down. And I’m just wondering, just to push back a little bit, is that current productivity of a Chinese worker is still a small fraction of a Japanese, American or a German worker, and with time and with education, that Chinese worker could be nearly as productive as a G3 worker. And given that room, does that allow for the potential for increasing productivity and increasing supply, even with the demographic challenge?
Well, the demographic challenge is particularly marked in China, and maintaining the one-child policy for as long as they did was one of their few really major economic mistakes. And it’s going to mean that the Chinese population is going to cut down, and they’ve already had most of the internal migration that can be expected. And indeed, a great deal of the leveling out in wages has already occurred. We’ve got a table in our book which shows that back in, I think it was 1990, an American worker received something like 35 times the wage that the average Chinese worker did. By the time we get to 2019, that 35 times had fallen to seven times. In other words, it had already been cut by a factor of five within 20 years, which was a really quite remarkable shift. One of the reasons why world inequality has actually fallen over this period is in part because there are so many more Chinese than there are Americans, or almost anybody else.
So yes, there is more room, but given the dramatic turnaround in the availability of labor in China that is on its way, I think that the idea that they will increase their share of world exports, which have risen really quite dramatically over the last 30 years, is really rather unlikely.
One small thing, if I may, a very small one, is that I think the Chinese economy benefited dramatically by this influx of physical capital. The structure of foreign direct investment was that you formed partnerships with the local Chinese company, and that allowed for significant transfers of technology and human capital and the way of managing things, what we’d call total factor productivity, across to the Chinese counterparts. But that flow has slowed down quite dramatically. Of course, China is making great strides in things like power grid technology, they’re going ahead in green tech, but I think overall, the speed at which you are pushing new tech and new forces of innovation into China have slowed down a lot. They have to depend a lot more on homegrown increases, and they’ve done so very successfully in many parts, but the process is not as automatic. And I think that’s why the catching up story over here, as Charles said, whether it’s from a local point that you know you have to generate the certain greater amount of productivity that you mentioned, Larry, in order to just take care of your own population or try and import it from somewhere else, both those processes actually have a few more challenges in their way, rather than that one very simple, linear dramatic catch-up that we’ve seen so far.
Another aspect of the story, is it’s about young people being productive and joining the global economy. And the last two decades has been the story of the Chinese entrance, and then the next question is where are the world’s young people going to be next? And in my mind, I can see three places, Africa, the Arab world and India. And how should we think about the integration of the Hindu Muslim and African worker? And to what extent do we expect movement of people, immigration out of these three locations to Europe, the United States, and elsewhere where they can be most productive? And what will that mean?
I think that the answer to that one is it’s politically, at the moment unthinkable. And the micro migration at present is far too small to really make a significant change to the demographic trends that are clearly underway, and waving that immigration against the wishes of the majority of base countries domestic population is just, I think, politically unfeasible. And in a very large proportion of what you might describe as populous politics, has been anti-immigrant. And that is one of the reasons why the increase in inequality and the stagnation of real wages in many of the advanced economies has not led to a political resurgence on the left, it’s led to a resurgence on the right. And that has been because the workers see rightly or wrongly, some larger extent wrongly, the increase in immigration as a threat and one of the causes to their own relatively poor wage increases. Politics trumps economics in this respect.
Will we be able to get the Indian, the Pakistani, the Bangladeshi, the multiple African workers to participate in the global economy? Will corporations be able to take advantage of it? Will these local economies be able to balance it? I think it was a complete shock, I think if I’d asked you 40 years ago, do you think it’s possible that China could explode and take over, become the largest GDP country in the world? I think all of my friends would have said, that’s inconceivable. Is it possible or conceivable that Africa, India or the Muslim world could rise to the occasion and become a very productive element of the global economy?
Well, remember that China was the leading country in the world for millennia, really up until about 1800, they got a very, very ancient well-run system. One of the great questions of history is why didn’t China take over the world when they were so far ahead? And then the point that Manoj has made rightly, is that what you really need for growth, essentially are two keys: governance and education. The Chinese and Eastern Europeans were generally pretty well-educated and they had an effective centralized government, which was driving forward single-mindedly to try and get economic progress. You cannot say that about Africa, unless one of the countries which had the brightest future economically in Africa, was Ethiopia. Look what has happened to Ethiopia in the last month, and that I’m afraid is an example of the problems that Africa faces. Again, it’s politics.
Larry, take a look at it like this. This is something that we wrote in the book as well. If you look at the population of Africa, the population of India, they’re very similar. India’s got significant problems between the center and the state, there’s a lot of friction there, we saw that when the VAT laws were passed. But what Africa has is even more serious issues, they got more than 50 states for the size of the population that India has between 50 different national policies. And coordinating that to have a coherent response, like you were saying, instead of exporting labor, why not import capital? Produce and then re-export the final product back into the advanced economies, which is what you were mentioning? The problem is that coordination, the way the Chinese policymakers went about it in a single-minded fashion, getting state owned enterprises to rise to the challenge to aggressively attack capital formation, that’s something that’s incredibly hard to provide.
If you look in the Indian economy, the impetus has been on private capital. But don’t get us wrong, we are very optimistic about India. We think that there’s about a third of the countries in Africa who have actually standards of doing business which are better than even China, and they will do well over a period of time, they will attract capital, they will grow and the advances will be dramatic. However, the issue is China was growing at a time when the advanced economies had a very, very good progression of their own, and so it received a lot of backing in terms of strong growth, strong consumption, which allowed it to go at bound by leaps and bounds. What India and Africa will need is probably to be three times as effective as China to compensate for what’s going on in the rest of the world, while not getting the same amount of consumption support that China received. So it’s a very different animal going forward, and I think while they will do very well, whether they’ll be able to offset the aging problem in such a huge part of the world, which dominates global growth right now. That’s the part to us that seems very difficult to try and get any confidence in.
Daron Acemoglu — Will the Post-Covid World Have Too Much Automation
Kenneth Rogoff — Negative Interest Rates and the End of Cash
Chad Syverson — the Economic Consequences of COVID Fears
Chad Syverson Transcript
We’re going to move on to Chad Syverson. Chad is a professor at the University of Chicago Booth School in labor economics. He will discuss the economic consequences of the fear of COVID. Go ahead, Chad.
Thank you. Austin Goolsveeand I set out to measure the effect of shelter in place and other so-called shutdown orders on economic activity. And in the process, we learned some broader lessons about pandemic economics that could serve decision-makers going forward. We used mobile phone location data for the study. These data are anonymized. We can’t follow any of the individual over time. Instead, what they offer is essentially a counter on the door of about two and a half million businesses in the US. So we can see how many people visit a business in any given week. If you remember what was happening one year ago, you were seeing two things occur at the same time. Shelter in place orders were being imposed in a lot of jurisdictions and economic activity was falling precipitously. That’s what we see in our data too. A shelter in place order in a county was correlated with very large declines in foot traffic at businesses in that county.
But as we know, correlation is not causation. There was after all, another factor at work, the pandemic. It’s possible that fear about the pandemic was driving both politicians to impose shutdown orders and causing people to remain at home of their own volition. And that case, the correlation between shelter in place orders and drops in business activities might reflect the common influence of the pandemic rather than a causal effect of shutdown type orders on economic activity. Here’s how we teased apart these two potential effects, pandemic fear versus shutdown orders. We focused on businesses within the same Metro area where some counties were subject to shutdown orders while others were not. If the state of the pandemic is roughly the same within a Metro area at a particular moment in time, then any difference in activity across borders where one side’s under order and the other isn’t would reflect the causal effect of the orders themselves.
To see this in example, consider the Quad Cities. Rock Island and Moline on the Illinois side, went under a shelter in place order in late March. Davenport and Bettendorf in Iowa never did. We can compare traffic in a given week at say, two sporting goods stores, one on the Illinois side, versus one on the Iowa side. The effect of the pandemic and people’s fear of infection should be roughly the same on both sides of the border. That will be reflected in any common drop in activity across the two stores. Therefore, the difference in traffic between them would reflect the effect of the shelter in place order per se. What we found repeating this comparison across hundreds of thousands of businesses is that of a peak to trough drop in foot traffic that average around 50%, only about seven percentage points of that, or 10% of the total, was from the shelter in place orders themselves.
Those sporting goods stores on both the Iowa and Illinois side saw big declines in traffic. It’s just that the drop on the Illinois side was a bit bigger. In sum, about 90% of the total drop in economic activity was due to people avoiding going out voluntarily. Later on when some jurisdictions started lifting shutdowns, we measured those effects in the same way and found the mirror image. Measurable, but modest. In fact, the same size, modest increases in businesses’ foot traffic when shutdowns were lifted. And when we recently went back and looked at the effect of reimposed stay in place orders in this past fall, we found the same small effect. So fear of the pandemic seems to move around activity much more than policy. We found further evidence bolstering this notion first within Metro areas, businesses and counties that had more COVID deaths saw larger declines in business traffic.
Further, while our businesses saw declines, those that were busier before the pandemics saw proportionately larger drops than those in the same industry that were less busy. In other words, when people did go out, they shifted away from, for example, the coffee shop on the busy corner. And instead went to more out of the way places to get their coffee. One actually sizeable effect of these orders was in shifting traffic across related businesses. So we found that orders restricting restaurants and bars did in fact, cause large declines in traffic at those establishment, but led to an almost equal size increase in traffic to local grocery and liquor retailers. Similar shifts occurred from businesses deemed non-essential and toward essential ones. The bottom line of our results is that the largest driver of reduced business traffic by some distance has been the pandemic itself. Individual’s concerns that they might infect themselves, their families or their friends kept them at home. Shut down orders had additional measurable effects, but they were relatively small.
The implication is that the way to really move the needle on economic activity is to make people feel their health is protected. You have to deal with the fear of the disease. Our study focused on customers patronizing businesses, because that’s what our data allowed us to measure directly. But there’s been some speculation about whether a similar phenomenon also affects the labor market. Are people less willing to work or look for work because of concerns about infection? We couldn’t measure that directly in our data, but it’s certainly an interesting and plausible hypothesis. Any effects that might be there could shape the speed and locations of the recovery in the coming months. Thank you.
Chad Syverson QA Transcript
Thanks Chad. My first question relates to societal norms. When you compare Iowa and Illinois, particularly in the Quad Cities, you’re really in the same community with consistent social norms. I spent a good portion of my COVID year in Miami Beach, and I’m currently in New York City. The difference between these two communities is unbelievably shocking stark. Miami is a party, New York is a ghost town. Both have similar concerns, have similar COVID outbreaks, but it’s not taken very seriously in Florida at all. How do you think about these differences in social behavior?
That’s a great question. I mean, that’s one of the reasons why we wanted to measure the effects that we did by focusing within Metro areas, because we did recognize that there might be reasons why, for example, New Yorkers would respond differently than folks in Southern Florida. So we were comparing different parts of New York under the New York Metro under different shutdown orders in different parts of South Florida. So what that essentially would do is the size of the overall drop would vary across Metro areas. And we do find that, but it’s still allowing us to measure the effect of any shutdown orders themselves by making that comparison within Metro areas.
Now, if you want to zoom back and say, “Well, why is it that New Yorkers responded differently to the same state of COVID than south Floridians?” I think that’s a broader set of questions that other social scientists could help with. And I could speculate some. I think there are different people in the different areas and different political attitudes and so on and so forth. But differences are exactly the reason why we tried to measure the effects of the orders themselves in the way that we did.
Another question about public policy as it relates to increasing or decreasing fear. I listened to the radio briefly today, and there was an advertisement by a government agency in New York saying that you need to keep diligent on COVID, that it’s still active, that there are variants and you need to get vaccinated now. What they didn’t say was, “Once you’ve been vaccinated twice with the Pfizer vaccine, feel free to take off your mask and enjoy life and go to the party. Get back to work and start shopping.” Do you think that if fear is the number one driving force for this economic activity, and if it helps public policy to get back to school, get back to work, get back to life, should public announcements, articulate that once you’ve been vaccinated, you should take off your mask and get back to work?
Yes, I think they very much should. If the fear is no longer warranted, policy should not try to inculcate any more fear. And just in terms of incentives, if we want to give folks who aren’t yet vaccinated an incentive to vaccinate, I think saying, “Look, no one likes the way the world was for the last year. Maybe we responded to it differently, but if you want to get back to something that looks more “normal,” get yourself vaccinated, and you will be able to be free to interact in a way where you’re not at any concerns that you have or concerns that your friends or family have are considerably lessened.” I think that that is an important part of what needs to be done to get folks vaccinated.
And I think continuing to play up the risks, which exists and certainly for unvaccinated people, I think we’ve hit the level of diminishing returns with a lot of that already. The folks who are truly still extremely afraid and the people who had double masked two months after they’re vaccinated, even if everyone else isn’t etc, =, those people, you’re not going to move their behavior anyway. Those aren’t the kinds of people who we want now to move in terms of, “You’re not quite sure about getting the vaccine, but let’s try to get you to take the vaccine.” Well, you’re not going to get them to do that by saying, “Boy, even after you’re vaccinated, everything is still dangerous.” I think you’re exactly right. We need a mix of messaging and the dial starts to, or should be turned more towards the, “Hey, here’s the carrot that comes with being vaccinated and reducing the overall state of the disease. We can all go back to things we want to do.”
There was an article in the Wall Street Journal last weekend that quoted you indirectly about your consumer behavior data. And they asked a different question, which you had studied in great detail, which is if people are really scared, are they going to rejoin the labor market? If we’re going to speculate on that, what have you learned from your consumer traffic that would apply toemployment behavior?
I think you could apply very similar logic that there is going to be a sluggishness of the response now, rather on the demand side, but on the supply side, of folks willing to go back and participate in the economy. The size of that sluggishness is going to be related to the local state of the pandemic. And so to the extent you’re concerned about moving the dial on labor supply, one of the things you can do to effect that is to address the pandemic and make sure you we’re vaccinating people as quickly as possible and taking other reasonable steps to try to get the Covid case loads and infection probabilities down.
What we don’t know, because we didn’t have the data on is how large of a response that is on the labor supply side. We know, and I described how big it was on the demand side, but to the extent it’s there and measurable, the speed with which we recover the number of people returning to work and so on is going to be determined by this partially, this fear response. And so, again, in terms of policies to address that, one of the things to do is solve the pandemic problem as quickly as possible.
Chad, you’re using high-frequency consumer data. Is that something that’s going to be exciting for economists going forward to use to understand consumer behavior?
For sure. And I’ve seen a lot of that and we’ve talked many ways today about how COVID has changed the world around us. One minor way for the rest of you but big for me is the kind of data that economists are using to study the state of the economy has been much more granular and even bigger I would say, than the granularity, is the reduction. The reduced distance between when that data is collected and when we can analyze it. For example just another example is back during the Great Recession, 13 years ago. If you wanted to look what was going on with, “Well, how many businesses are going out of business? What’s going on with job losses through that? What’s going on with business formation? How much has that fallen?” You had to wait a long time before the Census Bureau or someone else came out with those numbers.
We now have that very quickly. The Census Bureau is publishing business formation data with a leg of only a couple of three weeks. And this consumer level data that Austin and I use to measure these effects. Also, you’re maybe looking at a month long leg to get this very granular data on consumer behavior. Now you don’t see all that… We could see these numbers of consumers. We couldn’t see dollar spent, but there are other kinds of data that are analogous to ours that do have dollars spent. So we’re able to see much more stuff, much more quickly. In part, because I think that the apparatus was there to measure it but I think the pandemic actually created the impetus on the parts of the entities that have been collecting this and aggregating it with delay and putting it out cleaner, but slower, just making this available much earlier than it was. And I think that it’s going to be very useful going forward, both again, increased granularity and the quicker leg, the shorter leg times.
John Kay — Radical Uncertainty
John Kay Transcript
I am now going to hand the call off to our first speaker John Kay.
Thanks, Larry. The Chevalier de Mere was a French aristocrat of the 17th century, and he was an inveterate gambler, but he had a friend with an interest in mathematics called Pierre Fermat. The Chevalier asked Fermat whether Fermat could help him play his cards more effectively. Now, Pierre Fermat knew Blaise Pascal, who was a polymath and an even more distinguished mathematician. And in correspondence between Fermat and Pascal, in 1654, the two worked out the basics of what we now know today as the Theory of Probability. That theory gave an answer to questions like, if we agree to play five rounds of cards and I win the first two games, what is the probability that I will win the whole series of five?
There proved to be many applications of the Theory of Probability. An Englishman called John Gaunt went round the tombstones of London going through each graveyard, noting the ages at which people died, and he used that information to construct the world’s first mortality table, telling us what the probability was of someone dying at a given age.
In the 19th century, the Irish brewing family of Guinness decided they needed to recruit smart young men to help them run the business. They hired a bright Cambridge graduate called William Gosset who applied probability theory to production at the Dublin brewery. It was the basis of what would eventually become Six Sigma quality control in the hands of Motorola and Jack Welch in the 20th century.
The success of the Theory of Probability led to many attempts to use it more widely, but there was resistance to that. And exactly a 100 years ago, the American Frank Knight and the Englishman Maynard Keynes each published books emphasizing the distinction between risk, which could be described probabilistically, and uncertainty, which could not. Over the next 50 years, that distinction was alighted. In the 1960s, Milton Friedman, who succeeded Frank Knight as doyen of the Chicago School of Economics, would write, that while his predecessor, Frank Knight, had made a distinction between risk and uncertainty, Friedman would not make further use of it, because he believed that people could attach probabilities to every conceivable event.
It’s hard to overestimate the influence of that claim on modern economics, especially financial economics and certain aspects of macroeconomic modeling. But it is a claim which is false. If we’re talking about games of chance, about human mortality, about the production of beer in the Guinness brewery, then we’re talking about stationary ergodic processes in which what we observe is that a result of repeated trials of the same process.
But most uncertainty in business, finance and politics is not like that. When the financial crisis broke in 2007, David Viniar, who was then CFO of Goldman Sachs, told the Financial Times, “We’ve experienced 25 standard deviation events several days in a row.” If you understand any of the probability theory that has been developed since Fermat and Pascal, you know that it’s impossible to experience 25 standard deviation events several days in a row. What Viniar perhaps meant, and certainly should have said, was that the Goldman Sachs models, which assumed that the factors that could give rise to loan defaults were constant over time, had completely failed to deal with a changing situation in the first few years of the 21st century.
Three years after that Barack Obama was faced with a decision as to whether or not to order a raid on the Abbottabad compound in which spy satellites had identified a man who resembled Osama bin Ladin. Now, after the intelligence failures in the Iraq War, agencies were told they must express their findings probabilistically, and different estimates of the probability that the man in the compound was bin Laden ranged from 25% to 95%. And at the end, Obama threw up his hands and said, “Look, it’s 50/50, it’s a flip of the coin.” He didn’t mean that the probability that it was bin Laden was not 50%, what he meant was that he simply did not know, but had to make a decision anyway. And that’s the nature of what we describe as the world of radical uncertainty.
We don’t know what’s going to happen. We may not even know the kind of things that might happen, but we have to make decisions anyway. So, we need to restore that distinction between risk and uncertainty.
We experience risk when we fear that our plans will be derailed by events that we have failed to predict, that something will go wrong for us, risk is bad. Uncertainty, on the other hand, is often to be welcomed, the pleasures of new experiences, new friends, new places. We manage risk by adopting strategies that are robust and resilient to things we cannot predict. And if we do these things, we can embrace and enjoy uncertainty. We don’t manage an uncertain future by pretending to have quantitative knowledge of that future, which we do not have and could not have, but far too much of that has happened in the world of politics and finance in the last few decades.
John Kay QA Transcript
John, thank you. Let me start with some questions about Barack Obama’s decision to go after Osama bin Laden. You mentioned that the methods that he used with his military planners and intelligence officers was that they were asked to make probabilities, predictions, if Osama Bin Laden was in the compound. And you said that the predictions were all over the map between 25 and 95% that in fact Osama bin Laden was in that fortress. And that, you said, it was probably correct for Barack Obama to give it little credence, and that he decided it was probably just 50/50.
It seems to me that you don’t particularly like the nature of the question, which is to put an estimate on probabilities. What should Barack Obama have asked if he had not asked about the probabilities? Or was it valuable to ask the probabilities, find out that the distribution was all over the map, so that he knew the distribution around those probabilities was quite wide and understand there was a large standard deviation around those respective estimates?
I think what Obama should have asked was, “Tell me a story,” and there are various stories which he should have been asking for. How reliable are these spy satellite photographs? What’s the basis on which people have made these kinds of estimates? If I ordered the raid, there are lots of things that can go wrong, what are they and how will we extricate themselves from them if we can? That’s what we mean by saying people naturally don’t think in terms of probabilities, they think in terms of stories, narratives, they think in terms of what can go wrong with these kinds of narratives. And that’s the way over thousands of years, essentially, people have found to cope with uncertainty.
The key thing is to build a strategy that is robust and resilient to the kind of things you don’t know. So, there were a lot of these uncertainties about the raid on Pakistan. Equally, if one compares the raid of the compound with a failed operation in the desert in 1979, when Carter ordered the operation to get the hostages out of Iran, we can see what was wrong—the plan to achieve that was not robust and resilient enough to things that actually went wrong when the people were on the ground in Iran.
Going back to the Iranian fiasco with Jimmy Carter, in Charlie Beckwith’s book Delta Force, he talks about the operation , and how he had made the decision that if a certain number of helicopters were inoperable then he would cancel the mission. And as I understand it, when the number of helicopters were destroyed on the ground, Carter may have suggested to continue going on, but Beckwith pretended he couldn’t understand the president and ordered the operation to be terminated.
Sometimes, things do go wrong and maybe the plan wasn’t robust and resilient enough, but oftentimes bad things happen. It could have been, for example, that Osama bin Laden was not in that compound. And it could have been the fact that enough of the helicopters wouldn’t have broken down and they would have continued onto Tehran, whether successful or not, I don’t know. But how do we think about just because we only have one draw, whether one should be a success and one should be a failure, in terms of operational success or good planning, good execution and luck?
It’s a good question. And the decision wasn’t right, because bin Laden was actually killed, and the decision wasn’t wrong because the Iranian hostage mission failed. There’s a professional poker player called Annie Duke, who’s written an interesting book on some of these subjects, and she talks about the idea that you decide whether the decision was good or bad by whether it worked well or not. And if you’re going to play poker, well, you have to understand that you can’t do resulting.
So it can be that things go wrong, and what was with foresight, a good decision, turns out to be with hindsight, a bad decision, and we have to learn to cope with these things. But the only way we can cope with them is by trying to find strategies that are robust and resilient.
So in both the bin Laden case and the Iranian hostage case, you could be pretty confident that some things were going to go wrong. It turns out in the hostage case that the strategy wasn’t robust enough to actually achieve its goals. I don’t know what would have been involved in making it robust enough, and we can certainly criticize people for not having made it robust in that kind of way. Equally, in the Obama case, a lot of things might have gone wrong, but didn’t, and in that case, we might very well have had a different view of the raid. We might have a very different view of Obama as president.
We can’t simply judge decisions by looking with hindsight as to whether they worked out or whether they didn’t work out. But if one goes back to something like the financial crisis, we can have a pretty good idea as to whether people in the financial sector have a good track record on balance, getting things right, or too frequently getting things wrong. And that’s very different, it’s relying on judgment and experience and the expensive predictive modeling.
Last week on What Happens Next, we discussed GameStop, and the crazy market behavior that existed in that stock over the last few weeks. A number of market makers had sold options at relatively low implied volatilities, and then lost a fortune. When in fact, the realized volatility over the last few weeks was astronomical. Did those traders make a fundamental mistake in their misunderstanding of the non-stationary aspects of volatility? Or was it just a bad draw where there was something completely out of the ordinary that they either could have recognized, should have recognized, or something that was just such a remote draw, that these are the times when you lose the money? How do you think about, being a market maker and trying to figure out what the future will hold as it relates to options or something else?
I think it was both those things. Part of the problem was believing that you could derive estimates of current volatility from observation of volatility in the past, and the market conditions we’ve seen in the last year or two are ones where it’s very clear that assumption is false.
There’s also an element of just making a bad draw. If you’re going to have short positions, sometimes something is going to go wrong. But also, if you’re taking out large short positions, you need robustness and resilience, you need to have some kind of exit strategy. And one of the things I think we’ve learned about short selling is it’s quite difficult to have robust and resilient exit strategies, when something starts to go wrong for you. And I think we’ll learn more about it in a few months when everyone can take a cooler view on it. But I think short sellers will have to do a lot more thinking about effective exit strategies then they’ve clearly done in the past.
I’ve been looking back on Europe’s biggest example of that kind of thing, which was a few years ago when there was a similar short squeeze in Volkswagen.
For a time Volkswagen was actually the most valuable company in the world as shorts were squeezed out. I think anyone who’s ever shorted markets knows that you need pretty strong nerves to stay in these positions.
In the example you gave with the card playing, what you have is a deck of cards that is a stationary distribution, but in warfare that isn’t the case. You’ve got two parties without any rules going full at it, but you still have to make a decision, just like Barack Obama had to make a decision. when you look at some of the great military decisions, where the other side can
undermine it, take D-Day for example, how do you think about that sort of decision in the context of uncertainty with regards to, let’s say, weather, technology and the response of the Germans?
So you have a whole variety of unknowns in that, and there were a whole variety of devices which were put in place to try and make D-Day work. One of the great achievements was the selling of misinformation to the Germans, so they were not sure, even at the last minute with a huge buildup of forces on the English coast, where the landing was actually going to be. There had to be exit strategies. What was Eisenhower going to do if things turned out to be much worse than the central plan anticipated? And also, of course, the weather was a big deal, and we know that the planners put a lot of reliance on weather forecasting, which is one of these things that has a relatively stationary process, which means we can do it quite well.
And they adjusted the timing of the D-Day landings to give them the best chance of making these successful. It’s interesting, because weather forecasting is a good example of a stationary process where we can make predictions, although we have a lot of questions about what these predictions are. I’ve asked myself the question of when the app on your phone tells you there’s a 40% chance of rain tomorrow, what does that actually mean? And what is that number actually based on? And we lost a bit of confidence in it all by going through these inquiries.
Let me try a more basic question. You referenced Frank Knight’s distinction between risk and uncertainty. I just wanted you to articulate what that difference was, for the benefit of the audience who hasn’t read the book.
Yeah, for Frank Knight, it was the difference, risk was what you could describe probabilistically, uncertainty was what you could not describe with probabilities. And Keynes, essentially, made the same distinction in his book in the same year. We actually make that distinction rather differently, and we describe resolvable uncertainty as uncertainty that you can describe problematically, and radical uncertainty as uncertainty, which you can’t.
What we mean by radical uncertainty is, uncertainty is not knowing… mostly it’s not knowing what is going to happen, although it can also be not knowing what is happening, as in the Obama case. You don’t know whether the man in the compounds is bin Laden or not. So, uncertainty comes from imperfect information, and you can resolve that in one of two ways. One is, you can go out and get more information. The other is, you can say there’s a stationary distribution and we can, therefore, construct a probability distribution.
Radical uncertainty is where you can’t do either of these things, which is pretty often. And as we’ve kept emphasizing this conversation, even where there’s radical uncertainty, you typically do actually have to make decisions.
Dodd-Frank requires that banks prepare for, I’ll call it, catastrophic events, how are they going to do that? And somehow this is going to give reassurance to the regulators as to the plans of a living will for these institutions. When you hear about this approach to minimizing the damage of another financial crisis, do you think this is a wise idea? Do you give it any credence? Or does it give another false sense of hope that this is something that will add value in the process?
I give it some credence. Since the 2008 crisis, we’ve raised minimum capital requirements quite a bit, and we’ve also required people to go in for these stress tests, and to construct the living wills you describe. But we haven’t, to be honest, changed very much. And capital requirements are higher than they used to be, but they’re not so much higher.
And one of the things we’ve learned looking back on the 2008 crisis, was how much capital they had was almost useless as a predictor of how severe the financial crisis would be. We mentioned earlier in the call, Northern Rock, who literally announced itself to be the best capitalized bank in Britain, and according to the regulatory rules it was, and it announced that six months before it went bust.
That said, when you have such a complicated world, if someone said to me, “What design would you have to improve the efficacy of the banking system?” I would just simplify the problem and just say, “Put more capital in, and then you can just not rely on bogus models.” Those same sort of models that you poke fun at David Viniar for.
Yep, that’s right. You need robustness and resilience, and we emphasize this again and again. In complex engineering systems, robustness and resilience, typically, means modularity and redundancy. Modularity means you design systems such that if parts of it fail, that doesn’t mean the system as a whole, fails. Redundancy means you don’t build things to the tolerances you think you might be able to get away with, you build things to accommodate a storm worse than has ever been experienced.
And that’s really important, because in the financial system after the financial crisis, both modularity and redundancy were regarded as measures of inefficiency. If banks had more capital than the regulatory requirements obliged them to have, we called that surplus capital.
Modularity meant siloing different activities into, ideally, different firms or certainly different parts of firms, so that if aspects of investment banking failed, that didn’t jeopardize retail banking.
But one of the main things about the deregulation of the ’70s and ’80s was that it removed these silos. And at the same time, having more capital than the regulation demanded was regarded as surplus capital, and you were inefficient unless you distributed it back to shareholders. Now, that’s been a lesson for many other firms in the recent pandemic, that, again, they’d reduced modularity and built just in time supply chains. And that meant they didn’t necessarily have the robustness and resilience to cope well with a crisis.
Donald Rumsfeld, in a famous speech, discussed the unknown unknowns, and for you, that is a key aspect of uncertainty. So not only is it a non-stationary, but we don’t even know what we’re talking about. What is your comment on that insight from Rumsfeld? And how should policy makers or, for that matter, investors think about the unknown unknowns as it relates to their evaluation of events?
It’s interesting and Rumsfeld terms, unknown unknowns are the things we don’t know, we don’t know, and we were rather interested to trace the history of that remark. As it turns out, Rumsfeld got it from Boeing, and Boeing engineers. It came about in the 1950s, when some of the first Jet airliners that flew, British planes, had two disastrous crashes in 1952 and 1953. And it took people a long time to work out what the source of the problem was, and it was paradoxically simple.
It was that you couldn’t have square windows in planes, because stresses built up round the corners of the square, which actually produced metal fatigue in the aircraft frame. And that’s why if you look, all planes nowadays have oval windows rather than square windows. But this was the unknown unknowns, and Boeing engineers, from then on, knew they had to keep looking for unknown unknowns, trying to build planes that were robust and resilient enough to cope with things they could not predict. I think we might infer that Boeing perhaps forgot that lesson in the last decade with some of their recent fiascos.
Does that mean that you can never get around the unknown unknowns, no matter how much work you work or how many estimates you make?
Well John, thank you very much.