Sketch of the Economic Paradigm of the 2010s

Know thy terrain

Economic paradigms

Individual economic actors don’t make decisions in a vacuum. They exist within an environment that is larger than any one of them and therefore must make decisions with reference to that context. The topography of the economic environment is shaped by various factors, from the actual physical topography of the land, to shifting consumer preferences, to new technologies. Government policy is also a major factor shaping the landscape.

The combination of these various factors create an economic paradigm; the businesses that succeed are the ones who align themselves best with this paradigm. And these paradigms are constantly changing.

The 2010s was dominated by a certain economic paradigm. If I had to create a rough list of the factors that shaped it, it would look something like this:

What kind of economic behavior did this paradigm generate?

First, the monetary policy incentivized borrowing. After spending the first few years post-08 de-leveraging, the American economy seemed to turn the corner and jump back on the debt train some time around 2013. And this was true across all segments of the society, whether government (which never stopped borrowing), corporate, household, or individual.

Financial asset values rose unstoppably. Almost every major asset class increased in market value during the 2010s. The liquidity guarantee provided by the Fed overcame almost any perceived bad news.

Stock buybacks became standardized as a strategy for easily delivering returns to shareholders. Corporations were able to borrow at rates cheaper than ever before, and they funneled a big chunk of that money into buying up their own shares. (The good folks at Epsilon Theory have done a compelling analysis suggesting that, in many cases, stock buybacks were a clever way of transferring wealth from shareholders to managers, rather than increasing shareholder value per se. I encourage you to check that out.)

Meanwhile, capital flooded into the digital sector. In the 2000s, following the dot com crash, the “tech industry” entered a rebuilding phase. Most of the highly speculative companies of the 90s were wiped out, though the darlings of the industry survived and continued to build themselves. Capital became more hesitant. Computer power continued its rapid ascent on the wave of Moore’s Law. And the motley crew of misfit engineers in Silicon Valley and elsewhere continued to devote their energies to building open source tools that made this power more accessible.

These true believers, still mesmerized by the possibilities of the internet and computers, continued experimenting with new business models. Then, towards the end of the decade, the era of the modern smartphone began, creating a whole new computing platform and a whole new host of possibilities. Their products penetrated the market, increasingly appealing to consumers who valued (and eventually became addicted to) the enhanced connectivity, access to media, and general utility.

Capital markets’ enthusiasm for tech surged back as investors started to realize the various advantages of the emerging business models. Software businesses offered a double whammy for investors, the promise of high profit margins AND immense growth potential. Ideas like “network effects,” “winner-take-most,” and “asset-lite business models” started to reverberate in the collective consciousness of markets.

Starved for return elsewhere, and buoyed by massive Fed-enabled liquidity, capital started pouring into these tech companies in droves, setting off a new “tech boom.” FAAMG became a category unto itself, as these software-dominant businesses invaded the ranks of blue chip corporations. The vastness of liquidity in private capital markets increased the negotiating power of tech startups to such a level that the most successful among them could avoid the onerous business of going public for way longer than their predecessors. The “unicorn” was born as a kind of spectacular new business species.

These were some of the major behavior patterns that evolved during the decade and, to a large degree, shaped the world we find ourselves in today. Let’s take stock of some of those longer-term effects.

First, today we have historically high levels of indebtedness. After the 2008 Financial Crisis, the U.S. private sector went through a painful deleveraging process. Corporations and households decreased the debt on their balance sheets, either through bankruptcy, foreclosure, diverting funds to pay down debt, etc. The Fed lowered rates and injected emergency (presumably "temporary") liquidity through quantitative easing (QE) at this time to support the system as the private sector deleveraged.

Perhaps this could have been the beginning of a new, more fiscally responsible economic culture in America. But we’ll never know, because the “emergency liquidity” lasted for almost a decade and debt levels across the board have reached historic levels.

Second, wealth inequality became exacerbated to the point of creating severe sociopolitical tensions. Extended, loose monetary policy pushed financial asset values higher, creating a wealth pump effect that benefited asset holders disproportionately.

And perhaps the most obviously transformational effect for the average person was the amplification of digital technologies in ways that not only generated significant business gains, but altered the culture, fundamentally changing our way of life and maybe even altering our psyches in the process.

Note on the “tech boom”

A short sidenote on the tech boom phenomenon which we’ll touch on again in a future post: in light of America’s renewed interest in building out infrastructure and manufacturing capacity, it is interesting to reflect on why those investments weren’t made earlier, when capital was much cheaper.

In theory, when interest rates are low, businesses should be incentivized to make riskier, more capital-intensive investments. Low market yields mean that investments with lower expected returns (i.e. riskier) can be more easily justified. And capital-intensive projects seem relatively more attractive because capital is cheaper to borrow.

However, the historically low interest rates of the 2010s did not translate into a boom in new factory development or infrastructure building fueled by vast pools of liquidity hungry for returns. There was a huge buildup in energy infrastructure, especially operationalizing shale deposits, which did benefit from the cheap capital. But we didn’t see it in the areas that the country seems highly interested in today, when those investments are technically less attractive due to the higher rates and higher inflation.

Instead, we saw huge waves of capital flooding into digital economy investments, which were prized specifically because they were less capital intensive. High-profit-margin, cheap-to-scale software businesses are the types of businesses that would do well even in a high interest rate environment. Of course, this only appears like a contradiction on the surface; from the perspective of a return-maximizing investor, investments that do well when cost of capital is high, will do extremely well when cost of capital is low.

Friedrich Hayek, the legendary thinker from the Austrian school of economics, presented his triangle model of production in the 1930s; I think the model is quite useful in making sense of this phenomenon. But I also think it is important to recognize that the mood in the country was different ten years ago. Globalization was encouraged, not seen as a threat. Building factories in America didn’t make sense when there were inexpensive and more efficient options elsewhere, even if capital was cheap to come by.

Shock to the system

The progression of economic paradigms follows Hemingway’s law – change happens gradually, and then suddenly. Under the surface, things are constantly changing. Certain areas of the economy and society are becoming stronger, more vibrant, and resilient, while cracks are forming elsewhere.

But eras are usually marked by crises. At some point, there is a shock to the system, either external or internal, and the cracks are fully revealed. Almost overnight, society awakens, as if out of a dream, into a new understanding of things. Expectations are recalibrated and the most powerful players drastically change their policies. A new economic paradigm firmly locks itself into place.

The financial crisis of 07-09 was such a paradigm-shifting shock that ushered in the economic paradigm discussed above. The COVID-19 crisis will likely be seen as the shock that ushered in a new one.

Liquidity was injected into the economy at rates that were never seen before. In some sense, the government relied on the tools it had become most used to; one could see the Fed’s stimulus programs during COVID as just an extension of the QE tool set. However, the scale and speed of the liquidity injections were unprecedented. This was truly emergency level funding; the government took the guardrails off, running historic deficits to deliver money directly to the people.

Of course, those guardrails were there for a reason. The link between monetary stimulus and financial asset inflation became impossible to ignore as stock markets skyrocketed amidst an economy-wide shut down. The absurdity underlying comedic observations like “bad news is good news” and “stonks always go up” during the 2010s reached new heights as congressional committees grappled with the rise of “meme stocks.” And further down the line, that massive money-injection during COVID would contribute to painful inflationary pressure in the economy, which we still haven’t fully overcome.

The digital infrastructure that was built in the prior decade showed its value during the crisis. Whole sectors of the economy were able to continue working without much hindrance due to remote work access. Digital applications were able to handle a massive surge in demand for delivery services and financial payments relatively gracefully. People were able to stay connected during lockdowns and schools were able to shift remote due to the availability of video conferencing.

In short, we were able to mediate a large chunk of social activity via digital channels when the perceived risk of physical contact was too high. A vast number of consumers and businesses rapidly adopted a new set of technologies, changing the way the country works, shops, handles its finances, etc.

But we also saw the darkside of the digital world in full force during the pandemic. Internet addiction sunk its teeth deeper into the populace as people were starved for other activities. The hyperconnectivity offered by social media seemed to foster vitriol and antipathy between people more than it forged togetherness. We saw major socio-cultural upheavals in the U.S. and around the world, which continue to reverberate today.

And one glaring hole in the American system was laid bare – we were dependent on others for our material supplies. The richest country on earth found itself dependent on foreign suppliers for critical PPE and respirator equipment. Moreover, a shutdown in China and other disruptions to the global supply chain drove shortages and inflation at home.

Today many people are questioning the wisdom of just-in-time manufacturing and unbridled globalization, two trends that dominated business strategies for the past several decades.

Economic institutions do not operate in a vacuum. They operate within a terrain that is characterized by forces larger than any one of them. The terrain is constantly changing and periodically experiences a phase shift, usually ushered in by a crisis. I believe the COVID crisis has pushed us firmly into a new paradigm.

This post attempted to describe the economic paradigm that we’ve left behind. In a future post, we will try to analyze the one we’re currently in.