Jeffrey Snider’s

Follow the Money:

Second Shoes

FIRM OVERVIEW
Jeffrey Snider is the Head of Global Investment
Research at Alhambra Investments. The Follow the
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Second Shoes
In June 2020, the city council of Nashville,
Tennessee began its usual budget process. The city
was facing an enormous fiscal shortfall and pretty
soon the only question being asked was, what do we
do? What can we do?
To the politicians it was clear from the start. Taxes
would have to go up, the only real question being
how much. How much could they hike without
sparking a taxpayer revolt? Nashville’s gang settled
on 34%. Another third. As if 2020 couldn’t get worse
for people in that fair city.
Does there always have to be another shoe? The
original story behind the expression “waiting for the
other shoe to drop” describes this anxiety perfectly.
The earliest version of the idiom appeared in the
Indianapolis News in an advertisement posted on
June 30, 19041. A traveler seeking lodging found no
vacancy at a hotel in Monticello – save one. There
was a small room divided by the slimmest partition,
the other half occupied by an extremely nervous
wretch.
__________
1 1904 June 30, The Implement Age, Advertisement Department,
Nervous Man in Next Room, Page 28, Column 2, Implement Age Co.,
Philadelphia-Chicago.
http://listserv.linguistlist.org/pipermail/ads-l/2011-August/111810.html
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Weary from his travels, the traveler took this only
empty bed under advisement that he stays completely
silent lest he disturb his nervous neighbor with the
slightest noise. Having disrobed “quiet as a burglar”,
he made the mistake of unlacing his first shoe and
dropping it “man-like” on the floor “with a great
noise.”
Cursing himself the traveler took off his second shoe
and placed it ever-so-gently on the surface and in
“absolute silence” “crawled between the sheets.”
A half hour later, having just dozed off, the shoe
dropper was awakened by furious knocking from the
other side of the partition. Unsure of its nature, he
meekly asked the still-unseen stranger why he was
offended – only to be cursed by the neurotic next
door for having kept him awake in panicky
anticipation.
“Blame you! Drop that other shoe.”
We all know what happens when we hear the sound
of the first shoe hitting the floor. It practically
announces the imminent arrival of its mate in the
same way; the 1904 joke a pun upon human
evolution.
Not simply cliché, though; there’s ample science
behind the psychology, a deep history of practical
experience spanning all disciplines. You can call it
feedback, or feedback loops both negative and
positive. In economics these are noted as second and
third order effects.
Something happens, the first shoe slams on the
ground, and then we all know intuitively to brace for
its partner.
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In terms of the business cycle, a significant enough
economic shock might qualify as the first shoe. The
resulting recession is actually the second shoe.
But what if we skip the shock and go straight to
recession? What if the first shoe is the recession?
Well, here we are in 2020. The COVID-19 inspired
shutdown mania unleashed the most insane, and
unnecessary, economic shock in generations; easily
besting the 2008 “Great Recession” in many facets.
Like flipping a switch, the economy was turned off,
and as Summer 2020 arrived the hope was that the
switch would just be flipped back to its ON position.
Soon enough, the thinking went, we’d be right back
to where we left off.
Unless you’re a property owner in Nashville.
Orders of Orders
The Great “Recession” itself offers us an
introductory lesson in these arrangements. The shock
wasn’t, as has been consistently alleged, subprime
mortgages. Rather the subprime mortgage
difficulties sparked a conflagration in a global dollar
system few even knew existed. On August 9, 2007
everyone ran for the hills despite not knowing
exactly why.
That initial dollar crunch was localized largely to the
US and Europe, to the extent that in early 2008 there
was talk by “serious” people of Emerging Markets -
particularly Asia - “decoupling” from the American
“subprime mess.”
Ben Bernanke’s Federal Reserve had sprung to life,
belatedly, for one key economic purpose: to limit the
shock’s effects to what first order disruptions had
already popped up. Like Bear Stearns.
1-888-777-0970
The one valid lesson Economists learned from
studying the Great Depression was it was critical for
policymakers to interrupt these feedback loops lest
they develop into a destructive self-reinforcing
pattern. Modern monetary policy, especially
expectations theory, is centered on disrupting this
organic transmission mechanism.
Economists claim you can’t anticipate a shock (well,
at least they’ve proven they can’t) so monetary (and
fiscal) policy’s primary role is to limit the effects of
the shock so that they don’t propagate, spawning
more destructive second and third order effects
which make recessions or depressions so bad they
require the Great modifier.
What do we mean by a second order effect?
Nashville’s tax hike for one. With no sales to tax, the
shutdown opened a massive hole in the city’s budget.
The burden of filling that hole will fall to the
businesses that manage to survive and property
owners with the cash to pay those increased taxes.
The prize for surviving the shutdown is a bigger tax
burden leaving businesses with less capital to do the
things that create economic growth.
Economists call this pro-cyclical. One thing
depresses activity (shutdown), which leads to a
reaction which further depresses activity (massive
tax hike). Shoes dropping all over the place.
What the Fed intends with its communications policy
(forward guidance, expectations theory) is to calm
the nervous fellow next door in the shoe drop story.
After the first shoe dropped Ben Bernanke
announced in a clear, confident voice that he was a
one-legged man and so there was no reason to expect
a second shoe.
Bernanke expected the nervous man (markets,
economy) to relax so that everything could go back
to normal, that first shoe forgotten. What happened
instead is that the man next door couldn’t help
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wondering why the other man next door only had one
leg. What kind of awful mistake had he made to lose
a leg? Was the man next door accident prone or was
he reckless or did he have some really nasty
enemies? And why did he feel the need to tell the
world he only had one leg?
Now the nervous man was even more concerned and
jumpy at the slightest sound. He was no longer
waiting for the other shoe to drop but rather the entire
prosthetic leg that he knew had to exist. Bernanke
turned his neighbor’s mild irritation into a full-blown
panic attack.
Monetary policy intended to interrupt the vicious
part of the business cycle ended up being pro-
cyclical, too, contributing mightily to the second and
third order effects which followed.
The Prior Outbreak of Shoes
Unable to properly interpret clear signals from the
deepest, most sophisticated money and bond
markets, monetary policy officials took all the wrong
inferences from the mess surrounding Bear Stearns
in March 2008. There were many angles to this
misinterpretation, but one passage spoken by Kansas
City Fed President Thomas Hoenig during the June
2008 FOMC meeting offers an ample summation of
them2:
MR. HOENIG. More broadly, turning to the
national economy, I have revised up my
growth estimate for the first half of 2008, but
it has made little change in my longer-run
outlook. Compared with the Greenbook, I see
somewhat stronger growth in the
__________
2 Transcript, Meeting of the FOMC, June 24-25, 2008; page 33.
WWW.ALHAMBRAINVESTMENTS.COM
second half of this year and somewhat
weaker growth next year and in 2010. I
continue to judge that the potential spillover
effects from the financial distress have
understandably been overestimated in this
Committee’s recent decisions and in
Greenbook forecasts in recent months.
Remember, this was June of 2008. Indeed, the
Philadelphia Fed’s Greenbook had by April 2008
begun to reduce the chances of any recession in that
year – even though, retroactively, the NBER would
admit one had already commenced months before,
back in December 2007.
Bernanke and his fellow policymakers came to view
Bear Stearns as a triumph, a skillful handling of a
wild, but limited, problem. Ignoring the bond and
money signals, they pressed forward from there,
confident that financial and economic agents agreed
with them.
In the particular case of financial agents operating in
the monetary system, this was far from the truth.
Instead, these agents (banks and other financial
intermediaries scattered all over the world) saw Bear
Stearns as confirmation of their worst nightmare –
their own potential demise. Not only was the Fed of
little help to Bear specifically, but nothing it had tried
up to that point managed to calm the dollar storm.
And Bear, it needs to be said, was not some
ridiculously overstretched subprime peddler.
If the Fed was so helpless - it was - and this could
happen to a firm like Bear, who was really safe
operating in this monetary environment? The answer
was, no one.
Instead of the Fed rescue of Bear being seen as a
triumph, a staving off of the second and third order
effects, it instead was seen a cautionary tale, one that
all but guaranteed contagion.
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This caution was evident in the repo market, which
was the actual cause of Bear’s demise, where lending
after Bear was limited and conducted only with the
most pristine collateral. And when risky securities
showed up lending wasn’t just scarce or pricey, it
was non-existent. Rather than just scaling back,
dealers just pulled out of the market altogether.
That’s a second order effect, the second shoe to drop
in the 2008 saga. By mid-September the repo market
was shut down completely.
What followed from there, the complete and horrific
financial gravity of GFC1 during the Autumn, was a
number of third (fourth) order effects.
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With financial and money markets fully frozen, and
the Fed powerless to change it throughout late ’08
and early ’09, even the best, highest quality
companies were faced with their own shaky survival
prospects. Even good businesses found it
exceedingly difficult to navigate the most basic fiscal
chores, like funding operating capital.
As one Treasury official recounted to the New
Yorker about September 20083:
“The commercial-paper market was on the
brink of destruction. At this point, the
banking system stops functioning. You’re
pulling four trillion out of the private sector
and giving it to the government in the form of
T-bills. That was commercial paper funding
GE, Citigroup, FedEx, all the commercial-
paper issuers. This was systemic risk.
Suddenly, you have a global bank holiday.”
Not quite what successfully shepherding Bear
Stearns into the reluctant embrace of JP Morgan was
supposed to yield. Instead of avoiding a recession,
the second and third order effects made one
inevitable and then made it “great.”
Another Treasury official, Neel Kashkari, told
Charlie Rose of PBS4:
“We were getting calls from large American
businesses, blue-chip businesses, saying they
couldn’t fund themselves, they couldn’t
make their payroll, they couldn’t fund their
inventory.”
Kashkari, of course, went on to run TARP and is now
President of the Minneapolis branch of the Federal
Reserve. How’s that for instilling confidence? Fail
them all upward, the Peter Principle in action.
________________
3 https://www.newyorker.com/magazine/2009/09/21/eight-days
4 https://alhambrapartners.com/2017/01/18/labor-leverage/
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Another third (or fourth) order consequence of this
financial breakdown was deflation, a scourge that has
plagued economists since the dawn of political
economy. When confronted by a monetary
breakdown, businesses do what they always must. As
Keynes said almost a century ago, this was the most
evil of monetary diseases5:

“We see, therefore, that rising prices and

falling prices each have their characteristic
disadvantage. The Inflation which causes the
former means Injustice to individuals and to
classes—particularly to rentiers; and is
therefore unfavourable to saving. The
Deflation which causes falling prices means
impoverishment to labour and to enterprise
by leading entrepreneurs to restrict
production, in their endeavour to avoid loss
to themselves; and is therefore disastrous to
employment.”
Prices needn’t actually fall; as we found in late ’08
and early ’09, just the probability and
liquidity/monetary shortfall was enough even if
consumer prices were only disturbed by a little to the
downside.
The consequences of this third order effect were, as
Keynes observed, devastating to the labor market.
And, to be plain, the labor market never fully
recovered from that blow because companies
completely altered their behavior since to factor in
what are now permanent liquidity risks.
Consumers reacted to these events in predictable, and
harmful, pro-cyclical fashion. With markets melting
down, jobs disappearing by the hundreds of
thousands, wallets were slammed shut and risk-
taking curtailed and not just for those unfortunate
enough to find themselves in the unemployment line.

The most pernicious aspect of the vicious cycle was

what these things did to those at the periphery, those
who remained employed while the Great
“Recession” raged around them. They were never the
same for having survived it, affected greatly by the
unnerving tension of the reduced margin of safety
that separated them from their former neighbor in the
throes of foreclosure.

_______________
5 John Maynard Keynes; Essays in Persuasion, Social Consequences. 1923.

WWW.ALHAMBRAINVESTMENTS.COM 6
This phenomenon is most readily observed in the
use, or more often, the disuse of revolving consumer
credit. Many of the newly unemployed defaulted on
their credit card debt but higher income borrowers
also reduced their debt, as a measure of caution and
prudence, given the Keynes-level destruction across
labor markets. One more shoe. It was years before
consumers finally dipped their toes back in what had
been a key (risky) component to consumption.
Nothing the Fed did during the crisis era could
forestall this pro-cyclical response.
A final but most important third order effect was the
spread beyond the shores of the US. It had become
clear before Lehman that this was already the case as
global markets like commodities suddenly turned
deflationary in the middle of July 2008. As a
consequence, the “G” in GFC would end up standing
for Global.
There would be no decoupling; everyone was made
to suffer because the chain of events was never once
broken by clueless, incompetent policymakers. Their
repeated failures shaped the events of 2008 into one
of the worst financial crises in history.
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2020’s 2008-Style Shoes
The events of recent months are eerily similar to the
events of a dozen years ago just described. Some
things are reversed. The worst part of the recession
was front-loaded this time so, in the post-GFC2
period, we aren’t still talking about an economic
contraction that will necessarily continue to grow
worse. We’ve jumped straight to the economic
prospects for the post-shutdown recovery.
That changes the goals of monetary policy, but only
a bit. Jay Powell’s Fed, like Bernanke’s, remains
committed to breaking the pro-cyclical chain;
keeping first order effects from becoming second
order and so on.
The economy was (unwisely, in my view) shutdown
for non-economic reasons. There were economic
problems beforehand (Euro$ #4 and its pre-existing
globally synchronized downturn), but we’ll set those
aside here. The economic switch was flipped off and
many seem to believe that since only non-economic
factors were involved reopening will necessarily
mean full and immediate recovery.
And it might mean that…if non-economic factors
were all there is to it.
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At the onset of the crisis, financial markets nearly If it could borrow more funds reliably, and for
ceased functioning due to problems that were never temporary purposes, that might forestall these drastic
solved from the last crisis – especially collateral in pro-cyclical measures hanging over their corner of
repo. Yes, it is true that the highest quality companies the labor market. I’m sure they’ve looked at that and
didn’t have to go beg the Federal Reserve to buy their decided that, among other things, this isn’t
commercial paper this time around and so the crisis temporary.
was maybe of a lesser magnitude. But that isn’t
because the Fed solved the problem but rather For United Airlines and its employees, the other shoe
because companies changed their liquidity is about to drop. And airlines won’t be the only
preference. Companies have been run lean since industry for which that is true. Retailers are dropping
2008 to limit the risk potential of another liquidity like flies.
crisis.
While economies appear to be recovering, posting
That doesn’t mean that a lot of companies are not in large positive changes in a variety of economic
survival mode; they are and, in some cases, it is entire series, this is somewhat misleading. Rates of change
industries, not just a few companies. Firms have are positive but, in most cases, the levels are far from
borrowed and scraped for every last dollar to bolster satisfactory. The rate of change coming out of the
their balance sheets from drawing down lines of shutdown hole is necessarily large due to the depth
credit to government backed borrowing to forgivable of the contraction.
government loans and grants. For some industries
this isn’t just a rainy day; the deluge has arrived.

United Airlines, for example, wrote to its employees

earlier this month to share with them what this
actually means6:

“The reality is that United simply cannot

continue at our current payroll level past
October 1 in an environment where travel
demand is so depressed. And involuntary
furloughs come as a last resort, after months
of company-wide cost-cutting and capital-
raising.”

Notice how similar that statement is to those made

back in 2008 by the Treasury officials quoted in the
previous section. The current expectation is that the
airline will have to layoff ~36,000 additional
employees.
______________
6 United warns 36,000 employees of potential job cuts as pandemic roils travel demand, CNBC article. July 8, 2020.
https://www.cnbc.com/2020/07/08/coronavirus-united-braces-36000-employees-for-job-cuts-as-
pandemic-roils-travel-demand.html

WWW.ALHAMBRAINVESTMENTS.COM 8

It is the quality of the rebound that will determine the
severity of the second, third and further order effects.
Will the economy recover completely, get back to
where we were? Or maybe even surpass the previous
peak? Or will it fall short and if so, by how much?
This is why the appearance of second order effects
right from the get-go have been so concerning.
Consumer behavior, like corporate behavior has
already turned; the aggregate proclivity to spend is
way down, as is revolving credit, confirming once
again the pro-cyclical response.
Add to that any number of additional problems that
are certainly going to show up - such as big local tax
hikes – and robust recovery seems a much iffier
proposition.
1-888-777-0970
If the economic rebound falls short because of these
second and third order effects, it may be because the
economy is suffering from a prolonged deficiency
that was revealed – for most of the economics
profession anyway – by the virus shutdown. The
rebound so far is only impressive due to the severity
of the recession. The degree to which the economy
recovers, and how long it takes to do so will be
determined, at least partially, by these second and
third order effects. And the lingering effects of the
still unsolved monetary issues.
Powell talks a good game, especially when he lies so
blatantly about these things7. In the financial system
as the real economy, there remains a palpable sense
of anxiety. Where are the other shoes???
Unlike Ben Bernanke in 2007, Jay Powell didn’t
drop the first shoe. It was ripped from his foot and
thrown on the floor by panicked politicians. Yes, it
was already untied and it probably would have fallen
to the floor eventually but the virus accelerated the
process. Ever since, Powell has been trying to calm
the nervous man next door by assuring him that he
has installed a net to catch any other shoes that might
drop. Will that reassure the nervous guy next door?
_____________
7https://alhambrapartners.com/2020/05/19/the-reason-for-so-many-lies-he-finally-realizes-hes-in-way-
over-his-head/
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Or will he just worry about how big the holes are in
Jay Powell’s net?
Looks like holes to me.
How We Can Help You
Do you have a strategic investment plan? Are
you wondering how recession will affect your
portfolio? If you haven’t reviewed your investment
plan recently – or you don’t have one – we think we
can help.
Give us a call today at 1-888-777-0970
and we’d be happy to arrange for one of our
investment professionals to discuss your situation
with you – completely complementary. Let’s start
the conversation today.
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